Effective Way to Allocate Resources - Essay Example

? Macro & Micro economics Contents Contents 2 Introduction 3 Discussion and Analysis 3 Conclusion 8 References 9 Introduction Every economy seeks to find a solution to the basic economic problems. Since the amount of resources available to a particular economy is scarce but there is no limit to the human wants there should be a technique in which this allocation should be done. A competitive market or a free market is an economic system that resolves the economic problems of resource allocation with the help of the market mechanism. In such a kind of economy the invisible hand operates and therefore the decision making regarding the prices and the quantity is decentralised among the producers and the buyers who are the active participants of the economy (Slater and Tonkiss, 2001, p. 8). This essay looks into the various aspects of the competitive market economy and analyses the fact that the resources can be allocated most efficiently if the economy operates in a competitive framework. Discussion and Analysis In a free market economy the price and the quantity of the product demanded is determined by the market forces of demand and supply. According to the theory of demand as the price of a product increases the quantity demanded for the product gets reduced. On the other hand, other things remaining constant as the price of a product decreases the demand for the product increases. The inverse relationship between the price and the demand for a commodity gives rise to a downward sloping demand curve. The supply curve for a commodity is however upward rising curve. The equilibrium price and quantity is determined by the interaction of the demand and the supply curves (Samuelson and ?Nordhaus, 2010, p. 57). This market mechanism has been explained with the help of the following diagram. Figure 1: Interaction of Demand and Supply Source: Besanko and Braeutigam, 2010, p. 36 In the figure it is seen that the initial demand curve id D1 and the initial supply curve is S. Now the market will reach equilibrium at the point A where the quantity demanded for the product would match the quantity supplied. At this point the quantity demanded would be Q1 and the quantity supplied would also be Q1. The price at which the market equilibrium would be reached is P1. This price is neither determined by the buyers or the sellers but the combined forces of the demand and supply existing in the market. Now suppose the market demand for the product increases from D1 to D2, with the same level of market supply the price of the product will increase to P1 and the quantity demanded of the product would increase from Q1 to Q2. Hence the new market equilibrium would be changed to B. At the point B the quantity demanded would match the market supply. The demand curve would shift to the right due to a variety of reasons. When the income of the individuals increase the disposable income of the people would increase and it would lead to a rise in the demand for a particular product. Similarly the supply of products may also decrease due to a variety of reasons. When the price of the raw materials increases the firms are not able to supply the product at the same cost. Thus the supply decreases. As a result the equilibrium price and quantity would undergo change. Figure 2: Shifts in the Supply Curve Source: Besanko and Braeutigam, 2010, p. 36 In this figure the reduction in the supply of the commodity pushes the supply curve to the left. The quantity supply reduces from Q1 to Q2 but the price increases from P1 to P2. Therefore at the same level of market demand the new equilibrium is formed at the point B. The demand and supply forces would act naturally in a free market where there are no restrictions by the government. This is true for the perfectly competitive markets where none of the buyers or the sellers has the power to control the price in the market. Therefore a competitive market is one in which there would be large number of buyers and sellers (Petri, 2004, p. 77). The sellers would have their aim to maximise the profit of the firm while the buyers would aim at getting the best product at the least price (Anderton, 2009, p. 37). In a perfectly competitive market the summation of the demand of all the buyers in the market would be the market demand. On the other hand the sum of the total production of all the sellers in the market would provide the market supply. Perfectly competitive markets are characterised by lack of barriers to entry or exit, information asymmetry among all the agents in the economy and the sale of the same or homogenous product by all the buyers in the market. Thus the perfectly competitive market would be reaching allocative efficiency because the firms would be producing at the point where the marginal cost curve cuts the marginal revenue curve. Though in the short run, the MC=AC would not be the production point for the firm, in the long run, P=MR=MC=AC. Thus from a long run point of view the firms will be able to achieve both productive and allocative efficiency (Tucker, 2010, p. 198). An allocation of resources is said to be Pareto efficient if no person can be made better off without making another person worse off (Mas-Colell, Whinston and Green, 1995, p. 284). A Pareto efficient allocation is better explained with the help of the Edgeworth Box diagram. In Edgeworth box it is a two good economy with two individuals who demand for both the goods in definite combinations. Figure 3: The Edgeworth Box Source: Varian, 2010, p. 583. In the figure, it can be seen that person A and person B both consumes good 1 and good 2. W is the initial endowment where the person A consumes WA1 of good 1 and WA2 of good 2. On the other hand, person B consumes WB1 of good 1 and WB2 of good 2 as shown in the above figure. Now if the person A wants to consume more of good 2 then the consumption of good 2 by B would be reduced. On the other hand, person A cannot increase the consumption of good 2 unless B consumes less (Frank, 2010, p. 393). This takes place because the amount of good 2 in the particular two-good economy is limited. On the other hand A has to reduce the consumption of good 1 in order to utilise his limited budget for buying more amount of good one. Therefore, there is a trade off that takes place in the consumption of good 1 and good 2. If the consumption of one good is increase, the consumption of the other has to be reduced with a given budget for the consumers. Thus the new equilibrium resulting in the Edgeworth Box is the point M. This is a Pareto optimal allocation of resources. Now the first theorem of welfare economics states that a competitive equilibrium leads to Pareto Optimality in the economy. An economy is said to be Pareto efficient if the allocation of resources in the economy takes place in an efficient manner. Thus the first theorem of welfare economics supports the doctrine that was put forward by Adam Smith. This means that the economy in which invisible hands is allowed to operate and the markets are competitive the resources in the economy would be allocated in an efficient manner. On the other had the second theorem of welfare economics states that resources can be allocated efficiently only when the competitive markets exist. In case of a competitive market if one particular producer does not supply the product at the lowest cost the buyers would go to the other producers. Thus most of the firms try to implement the lowest cost technique of production so that they are able to retain the market share (McEachern, 2013, p. 178). The buyers would have a variety of options to choose from and thus the producers would not compromise on the quality of the products so that the customer base is retained. The allocation of resources would be done to those individuals who would pay maximum for a particular product. Conclusion Thus from the above analysis it is clear that the allocation of resources would be optimal in case of a perfectly competitive market. On the other hand, in case of the other market structure like monopoly or oligopoly, the market power would be in the hands of either one producer or a group if producers. This would have an effect on the price determination. The producers would produce less and would charge a higher price compared to that of a competitive market. Thus in a free market where there are a large number of firms, the producers would have to rely on the market demand for setting their prices and the quantities of products that they produce. Thus a competitive market allocates the resources in the most efficient manner. References Anderton, A., 2009. Economics: A Level Student Book. London: Pearson Education. Besanko, D. and Braeutigam, R., 2010. Microeconomics. New Jersey: John Wiley & Sons. Frank, R. H., 2010. Microeconomics and Behavior. New York: McGraw-Hill Irwin. Mas-Colell, A., Whinston, M. D. and Green, J. R., 1995. Microeconomic Theory. New York: Oxford University Press. McEachern, W.A., 2013. Microeconomics: A Contemporary Introduction. Mason: South Western Cengage Learning. Petri, F. , 2004. General Equilibrium, Capital and Macroeconomics. Cheltenham: Edward Elgar Publishing. Samuelson, P. A. and ? Nordhaus, W. D., 2010. Economics. New Delhi: Tata McGraw-Hill Education. Slater, D. and Tonkiss, F., 2001. Market Society: Markets and Modern Social Theory. Cambridge: Polity Press. Tucker, I.B., 2010. Microeconomics for Today. Mason: Cengage Learning. Varian, H. R., 2010. Intermediate Microeconomics. New York: W. W. Norton & Company, Inc. Read More