Resource Allocation and Economic Systems: Study Guide (Microeconomics 1.2)

The problem every economy must solve

In Topic 1.1 you saw that most resources (land, labour, capital and entrepreneurship) are scarce: there are not enough of them to make everything people want. So every society has to choose. Resource allocation means deciding which uses the scarce resources go to, and who receives what they produce.

No society can avoid this choice. What differs is who makes the choices and how they fit together. That is what an economic system describes.

The three basic questions

Every economy, whatever its system, must answer three questions.

Question	What it asks	Example decision
What to produce?	Which goods and services, and how much of each?	More hospitals or more football stadiums? More rice or more cotton?
How to produce?	Which resources and methods to use?	Harvest by hand with many workers, or with a few workers and machines?
For whom to produce?	Who gets the goods and services that are made?	Who receives the new flats: the highest bidder, the family that has waited longest, or the family in most need?

The questions are linked: more hospitals (what) need builders and materials (how) and rules on who may use them (for whom). Each answer has an opportunity cost: resources used for hospitals cannot also build stadiums.

What an economic system is

An economic system is the way a society organises itself to answer the three questions. It has two parts:

1. Institutional arrangements: the rules and organisations of the economy. Who owns land, factories and businesses? Who is allowed to start a firm? Who sets prices? What laws protect property and contracts?
2. A coordinating mechanism: the way millions of separate decisions are made to fit together, so that what is produced matches, at least roughly, what is used. The two main mechanisms are a central plan and a system of prices in markets.

The course compares three systems: command, market and mixed.

Command economy

In a command economy (also called a centrally planned economy), a central authority, usually the government, makes the main decisions.

• Institutions: the state owns most land, factories and other capital. A planning agency collects information and writes the plan. Prices, wages and jobs are usually set by the state.
• Coordinating mechanism: the central plan. The planners give each factory and farm an output target (a quota) and an allocation of inputs.
• What? The planners decide, according to the government’s priorities.
• How? The planners decide which methods, machines and workers each producer uses.
• For whom? The planners decide, for example through rations, waiting lists, assigned housing or state-set wages.

A command system can move resources quickly towards one goal, such as building railways. Its main weaknesses are information and incentives. Planners cannot know the wants of millions of people or the true costs of thousands of products, so shortages and surpluses are common. Managers who are rewarded for meeting a target have little reason to cut costs, improve quality or invent new products.

Background, not required by the course: the Soviet Union ran most of its economy through central plans until it broke up in 1991.

Market economy

In a market economy (also called a free-market or capitalist economy), individuals and private firms make the main decisions.

• Institutions: private property (people and firms own resources and can sell them), freedom of enterprise and choice (anyone may start a business, choose a job or buy what they can afford), competition between many buyers and sellers, and a limited government that enforces contracts and protects property.
• Coordinating mechanism: prices in markets. Prices carry information and create incentives. When a good becomes scarcer or more wanted, its price rises. Buyers then use less of it, and producers, hoping for profit, make more of it. No one plans this; it happens through voluntary exchange. Economists often call this coordination the “invisible hand”, a phrase associated with Adam Smith.
• What? Consumers decide by what they buy. Goods that people pay for earn profits and are produced; goods that do not sell make losses and are dropped.
• How? Firms choose the methods that make the output at the lowest cost, because lower cost means higher profit. Input prices tell them which resources are scarce (see Worked example 2).
• For whom? Output goes to those who are willing and able to pay. Ability to pay depends on income, which comes from selling resources: wages for labour, rent for land, interest for capital and profit for entrepreneurship.

A market system uses information well and rewards effort, efficiency and new ideas. Its weaknesses: incomes, and so goods, can be shared very unequally; some goods that many people value, such as street lighting or national defence, are hard for private firms to sell; and some production harms people who are not part of the deal, such as a factory that pollutes a river. You will study these problems in Unit 6.

Mixed economy

A mixed economy combines the two coordinating mechanisms. Markets and private property answer most of the three questions, but the government also plays a significant part.

• Institutions: mostly private ownership and markets, plus government that taxes, spends, regulates and sometimes owns firms.
• Coordinating mechanism: mainly prices, together with government decisions (laws, taxes, subsidies, public spending).
• What? Mostly consumers through markets, but government also chooses some output, such as roads, schools and defence.
• How? Mostly firms seeking low costs, within government rules on safety, pollution and working conditions.
• For whom? Mostly by ability to pay, adjusted by taxes, transfer payments (such as unemployment benefits or pensions) and free or low-cost public services.

Comparing the systems

It helps to think of the systems as points on a spectrum. The pure command economy and the pure market economy are the two ends. Real economies sit somewhere in between.

Feature	Command economy	Market economy	Mixed economy
Who owns most resources?	the state	private individuals and firms	mostly private; government owns some
Coordinating mechanism	central plan and output targets	prices in markets	mainly prices, plus government decisions
What to produce?	planners	consumers’ spending (profit signals)	mostly consumers; government chooses some
How to produce?	planners assign methods and inputs	firms choose the lowest-cost method	firms, within government rules
For whom?	planners (rations, assigned goods, set wages)	those willing and able to pay	ability to pay, adjusted by taxes, transfers and public services
Main strength	can direct resources quickly to a priority	uses information well; strong incentives	can combine market efficiency with public goals
Main limitation	poor information and weak incentives	unequal outcomes; some goods under- or over-produced	government choices can also be wrong or costly

Similarities, differences and limitations of the models

Command, market and mixed economies are models: simplified descriptions that help you compare real economies. You should be able to say how they are alike, how they differ, and where they fall short.

Similarities. All systems face scarcity and opportunity cost. All must answer the same three questions. All need some rules about ownership, and all need some way to coordinate decisions.

Differences. The systems differ in who owns the resources, who decides, and what coordinates the decisions: a plan or prices. They also rely on different incentives: orders and targets in a command economy, profit and income in a market economy.

Limitations.

• No pure case exists. Even strongly market-based economies have governments that provide defence, courts and roads. Even strongly planned economies have had some private trading. So a label such as “market economy” means “closer to the market end of the spectrum”.
• One label hides variety. Two mixed economies can differ greatly in how much government taxes and spends.
• The pure market model assumes working markets: competition, clear property rights and good information. When these are missing, markets can allocate resources badly (Unit 6).
• The pure command model assumes planners have the information and the will to serve people’s wants. In practice, they often lack both.
• The models describe how resources are allocated, not whether the result is fair. Judging fairness needs values as well as economics.

Worked example 1: identifying economic systems from evidence

Question. Three fictional economies are described below.

• Norvana: the state owns all factories and farms. A planning ministry sets each factory’s output target every five years. Workers are assigned to jobs. Flats are given out from a waiting list. The state sets all prices.
• Tallis Bay: almost all firms are privately owned. Prices are set by buying and selling. The government enforces contracts, protects property and runs the courts and a small army. There are no welfare payments.
• Selmira: most firms are privately owned and most prices are set in markets. The government runs free schools and hospitals, taxes higher incomes at higher rates, pays unemployment benefits, owns the national railway and sets safety rules for factories.

(a) Classify each economy as command, market or mixed, giving evidence. (b) For each economy, explain how the “for whom” question is answered. (c) Explain why Tallis Bay is not a pure market economy.

(a)

1. Norvana: command. Evidence: state ownership of resources, output targets set by a planning ministry, state-set prices. The coordinating mechanism is the plan.
2. Tallis Bay: market (very close to the market end). Evidence: private ownership, prices set by buying and selling, a government that mainly protects property and contracts.
3. Selmira: mixed. Evidence: private firms and market prices answer most questions, but the government also chooses some output (schools, hospitals, railway), sets rules for how firms produce, and changes who gets output through taxes and benefits.

(b)

• Norvana: planners decide. Flats go by position on the waiting list, and other goods go through state-set wages and prices.
• Tallis Bay: goods go to those willing and able to pay. Income from selling labour, land, capital and enterprise decides how much each household can buy.
• Selmira: mainly ability to pay, but adjusted. Higher taxes on higher incomes, unemployment benefits and free schooling and health care give more to some households than their market income alone would.

(c) Tallis Bay’s government still answers part of the “what” question: it provides courts and an army, which are not bought and sold in markets. It also sets the rules (property and contract law) that markets need. So Tallis Bay is near the market end of the spectrum, not at it.

Check. Each classification uses two kinds of evidence: who owns and decides (institutions) and what coordinates decisions (plan or prices). Naming only one is incomplete.

Worked example 2: how prices answer “how to produce?”

Question. In the fictional market economy of Velloria, a furniture firm can make 100 tables a week by either of two methods.

Method	Worker-hours	Machine-hours
L (labour-intensive)	300	20
K (capital-intensive)	100	60

Machine time rents for $40 per machine-hour. (a) The wage is $15 per worker-hour. Which method will a profit-seeking firm choose? (b) A neighbouring economy, where labour is plentiful, has a wage of $6 per worker-hour and the same machine rent. Which method will a firm there choose? (c) At what wage would the two methods cost the same? (d) In the low-wage economy, a planner orders every furniture factory to use method K. What does this cost, and what does it show?

(a) Total cost = (worker-hours × wage) + (machine-hours × rent).

1. Method L: 300 × $15 + 20 × $40 = $4,500 + $800 = $5,300.
2. Method K: 100 × $15 + 60 × $40 = $1,500 + $2,400 = $3,900.
3. K is cheaper by $1,400, so the firm chooses method K.

(b)

1. Method L: 300 × $6 + 20 × $40 = $1,800 + $800 = $2,600.
2. Method K: 100 × $6 + 60 × $40 = $600 + $2,400 = $3,000.
3. L is cheaper by $400, so the firm chooses method L.

(c) Method L uses 200 more worker-hours than K; method K uses 40 more machine-hours, costing 40 × $40 = $1,600. The costs are equal when 200 × wage = $1,600, so the wage is $8 per worker-hour. Check: L = 300 × 8 + 800 = 3,200; K = 100 × 8 + 2,400 = 3,200. Above $8, firms choose K; below $8, they choose L.

(d) Method K costs $3,000 per 100 tables instead of $2,600, an extra $400 per 100 tables. The order saves 200 worker-hours of plentiful labour but uses 40 extra machine-hours of scarcer capital. The same tables are made, but more valuable resources are used up.

Interpretation. No one told the market firms which method to use. The wage and the machine rent carried the information: where labour is scarce, wages are high, so firms save labour; where labour is plentiful, wages are low, so firms use more of it. This is how prices act as a coordinating mechanism. A planner can make the same choice, but only if they collect and use the same information.

Common misconceptions

• “A market economy has no government.” Even a market economy needs a government to protect property and enforce contracts. A pure market economy is a model, not a real place.
• “A mixed economy is half command and half market.” “Mixed” covers a wide range. Most real mixed economies rely mainly on markets, with government playing a smaller but significant part.
• “Command economies do not face scarcity.” Every system faces scarcity. A command economy changes who makes the choices, not the need to choose.
• “In a market economy, firms decide what to produce.” Firms make the goods, but consumers’ spending decides which goods earn profits. Firms that ignore what buyers want make losses.
• “‘For whom’ means who makes the goods.” It means who receives and uses the goods and services.
• “The systems are only about ownership.” An answer must also name the coordinating mechanism: a central plan or prices in markets.

Where this leads

The three questions and the idea of trade-offs lead straight to the next model, the production possibilities curve, which shows what an economy can produce with its scarce resources (Topic 1.3 study guide). The price mechanism you met here is developed fully in Unit 2 (supply and demand), and the limits of markets return in Unit 6. If you need to revisit scarcity first, see the Topic 1.1 study guide.

Test yourself with the practice questions, then use the revision notes and the checklist to consolidate.