How the price mechanism provides answers to the basic resource allocation decisions of what, how and for whom to produce

The Allocation of Resources – Price Determination

Learning Objective

Explain how the price mechanism provides answers to the three basic resource‑allocation decisions:

1. What goods and services should be produced?
2. How should they be produced?
3. For whom should they be produced?

1. The Three Allocation Questions

In any economy resources are scarce, so decisions must be made about:

• What – the type and quantity of goods and services.
• How – the techniques and inputs used in production.
• For whom – the distribution of output among members of society.

2. The Price Mechanism

The price mechanism (or market system) uses the interaction of demand and supply to answer the three questions.

2.1 Demand and Supply Curves

Demand shows the relationship between the price of a good (\$P\$) and the quantity demanded (\$Qd\$). Supply shows the relationship between \$P\$ and the quantity supplied (\$Qs\$).

Typical functional forms:

\$Q_d = f(P) \quad\text{(downward‑sloping)}\$

\$Q_s = f(P) \quad\text{(upward‑sloping)}\$

2.2 Market Equilibrium

Equilibrium occurs where quantity demanded equals quantity supplied:

\$Qd = Qs \;\Longrightarrow\; P = P^*,\; Q = Q^*\$

At \$P^*\$ the market “clears” – there is no excess demand or excess supply.

3. How the Price Mechanism Answers the Allocation Questions

3.1 What to Produce

• High consumer demand pushes the price up.
• Higher prices signal producers that profits can be earned, encouraging entry into that market.
• Resources flow toward the production of goods with the highest price (and thus highest potential profit).

3.2 How to Produce

• When the market price is high, firms can afford to adopt more expensive, efficient techniques (e.g., automation).
• If the price falls, firms may switch to cheaper, less labour‑intensive methods to maintain profitability.
• Profit maximisation condition:
  

  \$\text{Marginal Cost (MC)} = \text{Marginal Revenue (MR)} = P\$

3.3 For Whom to Produce

• Individuals with higher willingness and ability to pay can purchase at the market price.
• Those with lower incomes may be priced out, leading to an unequal distribution of goods.
• In a pure market economy, income distribution is determined by the distribution of factors of production (labour, capital, land).

4. Role of Profit and Loss

Profit (\$\pi\$) is the difference between total revenue and total cost:

\$\pi = TR - TC = P \times Q - TC\$

• Positive profit → attracts new entrants → supply increases → price falls.
• Losses → firms exit → supply decreases → price rises.
• This self‑correcting process moves the market back toward equilibrium.

5. Comparison with Other Economic Systems

6. Government Intervention (When the Price Mechanism Fails)

• Price ceilings – set a maximum price (e.g., rent control) to protect consumers but can cause shortages.
• Price floors – set a minimum price (e.g., minimum wage) to protect producers or workers but can cause surpluses.
• Taxes – raise the price of undesirable goods (e.g., tobacco) to reduce consumption.
• Subsidies – lower the effective price of desirable goods (e.g., renewable energy) to increase demand.

7. Summary

• The price mechanism uses market prices to coordinate the decisions of millions of buyers and sellers.
• Prices answer “what” by signalling which goods are most wanted.
• Prices answer “how” by indicating which production techniques are most profitable.
• Prices answer “for whom” by allocating goods to those with the greatest willingness and ability to pay.
• Profit and loss provide feedback that moves markets toward equilibrium.
• Government may intervene when markets produce undesirable outcomes.