The Market System and Resource Allocation

The market system operates by matching buyers and sellers through price
signals. Scarce resources are allocated efficiently when the forces of demand
and supply interact without distortions such as government price controls or
monopolistic interference. This system answers three fundamental economic
questions:
1. What to produce? Determined by consumer preferences and
profitability, influenced by demand.
2. How to produce? Guided by cost minimization and available technology.
3. For whom to produce? Based on purchasing power and willingness to
pay, typically favoring those who can afford goods and services.
This decentralized approach harnesses individual incentives and competition to
allocate resources dynamically, adjusting to changing market conditions.
Demand: Behavior and Determinants
Demand encapsulates the willingness and ability of consumers to purchase at
various price levels, characterized by the downward-sloping demand curve
reflecting the law of demand. Two key reasons explain the inverse price-
demand relationship: real income effect (lower prices increase purchasing
power) and substitution effect (lower prices attract more buyers).
However, demand is influenced by several non-price determinants summarized
by the acronym HIS AGE:
 Habits, fashions, and tastes: Shifts consumer preferences affecting
demand for trendy or obsolete goods.
 Income: Higher income increases demand, particularly for normal goods.
 Substitutes and complements: Availability and price changes in related
goods affect demand.
 Advertising: Marketing campaigns can create or boost demand.
 Government policies: Taxes and subsidies alter effective prices and
demand.
 Economy: Economic cycles influence consumer confidence and spending.
Understanding these factors is vital for businesses forecasting demand and
governments designing policies that affect consumption patterns.
Supply: Incentives and Influences
Supply represents producers’ willingness and ability to provide goods and
services at different prices, typically depicted as an upward-sloping curve due
to the law of supply. Higher prices incentivize more production as firms seek
profits and new entrants join the market.
Non-price determinants of supply, captured by the TWO TIPS acronym, include:
 Time: Short-term production is less flexible, limiting supply elasticity.
 Weather: Especially critical for agriculture and seasonal products.
 Opportunity cost: Producers switch resources to more profitable goods.
 Taxes: Increase production costs, reducing supply.
 Innovations: Technology enhances production efficiency.
 Production costs: Lower costs increase supply.
 Subsidies: Financial support encourages output.
Producers must consider these factors to optimize production and respond to
market changes effectively.
Market Equilibrium and Disequilibrium
Equilibrium price and quantity occur where demand equals supply, ensuring no
leftover stock or unmet demand. Disequilibrium—when prices are too high or
low—causes surpluses or shortages, respectively. Market forces push prices
towards equilibrium: surpluses prompt price cuts, shortages push prices up.
This dynamic is critical for resource allocation efficiency. For example, unsold
seasonal goods post-holidays are discounted to clear inventories, restoring
equilibrium.
Price Elasticity of Demand (PED)
PED measures consumer responsiveness to price changes and is influenced by
substitution availability, income share, necessity, habit, advertising, and time.
Key insights include:
  Elastic demand (PED > 1): Consumers are highly sensitive; small price
changes cause large demand shifts.
 Inelastic demand (PED < 1): Demand remains stable despite price
changes.
 Unit elastic demand (PED = 1): Proportional responsiveness.
Businesses exploit this knowledge to set prices that maximize revenue, while
governments target inelastic goods for taxation to maintain revenue without
drastically reducing consumption.
Price Elasticity of Supply (PES)
PES gauges how quantity supplied reacts to price changes. Elastic supply
implies producers can ramp up output quickly, often due to spare capacity or
stocks, while inelastic supply signals production constraints, such as perishable
goods or limited resources.
Special cases include perfectly inelastic supply (quantity fixed regardless of
price) and perfectly elastic supply (quantity can vary infinitely without price
change).
The determinants of PES—stocks, spare capacity, number of producers,
substitution ease, and time—shape how industries respond to market
conditions. For example, tech firms can quickly increase output (elastic supply),
whereas agriculture is less responsive due to growing cycles (inelastic supply).
Practical Implications
Understanding elasticity aids:
 Businesses: Optimize pricing and production strategies to enhance
competitiveness and profitability.
 Governments: Design taxation, subsidy, and regulation policies to
influence markets effectively, address externalities, and promote
equitable resource distribution.
 Consumers: Anticipate how price changes affect availability and costs of
goods.

In conclusion, the interplay of demand, supply, and price elasticity forms the
backbone of market economics, determining resource allocation efficiency,
pricing strategies, and policy effectiveness. Mastery of these concepts is
essential for economic decision-makers across sectors
In 2021, the Suez Canal was blocked by one of the world’s biggest container
ships. This affected some firms’ profits and caused a shortage in a number of
products. The delivery of luxury chocolate and salt, for example, was delayed.
These two goods have differences in their price elasticity of demand. The
disruption to international trade created particular difficulties for those
countries which import most of the food they consume.

c) Analyse the reasons why the price elasticity of demand for one brand of
luxury chocolates is likely to be different from that of salt. [6]
Digital money, such as cryptocurrencies, is increasingly being used. Digital
money transactions take place on electronic devices such as computers and
smartphones. However, there can be market failure due to external costs
arising from high energy usage of non-renewable sources. One way of reducing
external costs is to tax the product.

c) Analyse the consequences of market failure. [6]

d) Discuss whether or not a tax on a product can reduce external costs. [8]
Global spending on the health sector, by both the private and public sectors, is
the highest compared with all other sectors including education and defence.
Investment in education and the health sector has resulted in new life-saving
technology being introduced. However, demand for certain vaccinations has
decreased over the years, shifting the demand curve of vaccinations to the left.

d) Discuss whether consumers would benefit more from healthcare being

provided by the private sector or the public sector.