Allocation of Resources

Question 1

What is Adam Smith’s theory of the ‘Invisible Hand’?

Answer 1

• It tells consumers what the price of products is and allows for consumer supreme authority where producers have to take into account their wants and needs.
• This provides for allocative efficiency.

Question 2

What does the market mechanism ultimately determine?

Answer 2

• Determines the allocation of resources if demand increases.
• As some markets die, others would grow and so firms and constantly using market research to inform them regarding production decisions.
• As markets are competitive firms will strive to lower costs, leading to productive efficiency.

Question 3

What are some of the disadvantages of the price mechanism?

Answer 3

• Firms cannot adapt as trends in the market change will go out of business.
• This would then lead to unemployment, impacting heavily on society, particularly if there is structural change.
• When there are multiple firms going for the same resources, this creates inflationary pressure as demand bids up the price of these resources.

Question 4

Why would the price mechanism sometimes be undesired?

Answer 4

• It might reduce the number of merit goods available to society whilst increasing the number of demerit goods.
• Factors like education and healthcare may sometimes lead to long term social costs.
• Firms might increase the supply of demerit goods such as drugs, alcohol and cigarettes if left to meet the demands of the market without government intervention.

Question 5

Ultimately, what are the nature of activity of the markets?

Answer 5

• Markets are dynamic, and there are constant changes which impacts the nature of economic activity on a daily basis.
• Markets for substitutes and complements will change.
• Economic variable such as inflation and unemployment will be affected as resources are reallocated.
• The whole of society is indirectly involved in these changes and the laws of demand and supply will dictate the effects as new markets are created.