The allocation of resources

Question 1

Incentives

Answer 1

Much of economics covers how economic agents respond to incentives. For example:
- consumers respond to lower prices by increasing demand
- firms respond to higher profits by increasing supply

These responses form the basis of how economists model economic effects. The assumption is usually that economic agents react rationally to incentives to achieve their objectives

Question 2

The effectiveness of incentives

Answer 2

The fact that economic agents respond to incentives is a basic economic assumption. In many causes it is likely to be true. For example, if you are searching for a new pair of jeans and find them on sale in a shop,, you may be more likely to purchase them if you have just enough money.
- Will you always buy something just because it is cheaper?
- Will a firm always use the cheapest methods of production to reduce its costs?
- Will a government always ban something if it causes people harm?

Economic incentives are important, but they are not the only forces that act on decision-making. It is important to analyse what an economic agent should do based on the given incentives, but then to evaluate why this may not happen

The effectiveness of incentives is likely to depend on a number of elements, which can be used to evaluate;
- the size of the incentive
- the timescale involved
- the type of good/service
- the objectives of the economic agents
- other changes in the market/economy

Question 3

Market, planned and mixed economic systems

Answer 3

An economy is about finding a way to allocate scarce resources. There are three main types of economy.
- planned/command economy: the government controls the factors of production and decides on the allocation of resources

• mixed economy: a combination of market forces and government policies decides the allocation of resources
• market economy; the allocation of resources is decided by the interaction of supply and demand (market forces)

Most economies sit somewhere between the two extremes of a market economy and a planned economy - in other words, a mixed economy. For example, in the UK we allow market forces to decide the allocation of many goods, such as a haircut. However, the government controls the majority of the UK’s healthcare services through the NHS

Question 4

Evaluation of economic systems

Answer 4

Each economic system has advantages

Most countries operate a mixed economy to gain the advantages of both a planned economy and a market economy. Which goods and services are controlled by the government and which are controlled by market forces depends upon a number of factors:

• the will of the people: different political systems around the world prioritise different goods and services. In the UK we choose to have planned healthcare, but in the USA much of the healthcare industry is based on market forces
• Government objectives; some goods and services are considered particularly beneficial to a society and the control of these goods may be important. For example, the amount of money spent on defense has often divided different political parties.
• the availability of resources in a particular economy: in Manhattan, New York, for example, there is so little space that the government uses rent control to control the price of accomodation.

Disadvantages;

Disadvantages of a free market economy include the potential for market failure, such as the presence of externalities or the creation of monopolies; inequality, as some individuals or firms may have more resources than others; and the potential for a lack of investment in public goods and services.

Disadvantes of planned: Unable to respond to consumer preferences. Inefficient firms are protected and kept going; making it hard for resources to move to dynamic and efficient firms. A command economy creates a powerful government which limits individuals rights. Command economies tend to be very bureaucratic with decisions held up by planning and committees.

Advantages of a mixed economy include the ability to provide public goods and services, such as healthcare and education, that may not be adequately provided by the free market alone; the potential to regulate industries to prevent market failure; and the ability to redistribute income and wealth to reduce inequality.

Question 5

Economic efficiency

Answer 5

Efficiency is one of the most important terms in economics. Economic efficiency is a situation where an economic system achieves both allocative and productive efficiency.
- allocative efficiency is a situation where production matches consumer preferences. It is when supply (production) equals demand (consumer preferences)

• productive efficiency is a situation where all of the resources in society are being used to produce as much as possible. It is when no more could be produced