Resource Allocation in Competitive Markets: Price Theory

Question 1

What are the 4 key features of the free market economy?

Answer 1

1. Private ownership of property
2. Freedom of choice and enterprise
3. Pursuit of self-interest
4. Competition

Question 2

What does private ownership of property imply?

Answer 2

Individuals have the right to own, control and dispose of land, capital and natural resources. They have the right to the income earned from using these factors of production.

Question 3

What does freedom of choice and enterprise mean to firms, consumers and workers?

Answer 3

1. Firms are free to choose what to sell and how to produce
2. Consumers are free to choose what to buy with their incomes (consumer sovereignty)
3. Workers are free to choose where and how much to work

Question 4

How to firms, consumers and workers act in the pursuit of self-interest?

Answer 4

1. Firms try to maximise profits
2. Consumers try to maximise satisfaction
3. Workers try to maximise jobs that yield the highest returns

Question 5

How does price competition work in a free market economy?

Answer 5

• Large number of buyers and sellers
• Each has insignificant share of market and hence little influence on the market demand and supply
• Cannot control market and exploit other sellers or buyers

Question 6

Why is there a need for rationing the available resources in an economy?

Answer 6

All societies face the problem of scarcity, where unlimited wants exceed limited resources

Question 7

What are the different ways of rationing goods and services?

Answer 7

1. Price mechanism (leads to most efficient use of available resources)
2. Queueing
3. Coupons
4. Lottery
5. Political power

Question 8

How does price mechanism answer the question “What and how much to produce”?

Answer 8

• Price as an indicator of consumer’s preferences
• Then price as a signal to producers indicating what goods are demanded by consumers
• Producers respond by increasing or decreasing the production

Question 9

How does the price mechanism answer the question “How to produce”?

Answer 9

Price of production methods: labour vs. capital

Help companies find least combination of inputs to produce given level of output

Question 10

How does the price mechanism answer the question “For whom to produce”?

Answer 10

Who gets what? Resources are allocated to the production of goods and services according to the purchasing power/”dollar votes” of consumers