How Markets Allocate Resources

Do you know how did Adam Smith's famous idea of the ‘invisible hand’ for resource allocation transform into a modern market theory? Did you know that prices are crucial for determining how resources are allocated within a market? Let’s talk about how markets allocate resources.

How markets allocate scarce resources

Due to the fact that resources are finite, it is necessary to decide which goods and services should be produced to ensure productivity and efficiency.

Different economic systems use different mechanisms to determine the allocation of resources in the market:

• In a planned economy, the mechanism for resource allocation is dictated by the state.

• In a market economy, the price mechanism dictates the allocation of resources evidenced in consumer spending and producer investing.

• In a mixed economy, a mixture between state planning and the market mechanism determines resource allocation.

The role of the market in resource allocation

As we mentioned before, resource allocation answers several questions. Let’s explore them in detail.

What to produce and how much to produce?

Resources in the economy are limited. So it is necessary to choose what goods and services should be produced. Producers and consumers decide which goods and services are in the market through the signaling role of price and self-interest.

A demand curve demonstrates how much of a product consumers are willing and able to buy (demand), whilst the supply curve shows how much of a product producers are willing and able to produce (supply).

How to produce?

The prices of resources are used to address the question of how various goods and services should be produced. This would require the economy to carefully consider the various factors of production such as labour and capital, as firms would usually try to reduce the cost incurred in production. Therefore, price is an important factor in deciding how to allocate resources against competing uses.

For whom to produce?

The price mechanism also helps in deciding who to produce for. The demand curve demonstrates this by showing what consumers are willing and able to buy. In a way, this represents the consumers’ vote on what they want producers to produce more of by indicating to them where to allocate their resources.

Market resource allocation and the price mechanism

The markets use prices as signals to allocate resources to their highest-valued uses. This is evidenced in various market scenarios:

• Consumers will pay higher prices for goods and services that they value highly (influenced by personal taste and trends).
• Producers will devote more resources to the production of goods and services with higher selling prices (as there is an incentive for profit).
• Workers (as owners of the resource of labour) will provide more hours of labour to jobs that pay higher.

• Price plays a very fundamental role in the allocation of resources in the economy as it guides the ‘invisible hand’ in the correction of market failures caused by an inefficient allocation of resources.
• The role of price in resource allocation starts with the transmission of information to the agents in the market. Changes in demand and supply are caused by changes in price signals. For instance, if a product has low demand at a high price then this would signal to firms to reduce the price.
• The role of price extends further to giving agents in the market direction in terms of how they should ration their scarce resources. This also helps to distribute scarce resources to those customers who value them the most.
• On the producer side, price gives them an incentive in regards to how they spend and invest their resources. This is particularly relevant when faced with the economic dilemma of ‘what to produce and for whom?’. For instance, in a market where producers know that demand is inelastic, they would be willing to produce for those consumers as they are able to price their products higher and still be able to make sufficient sales and profit.

Advantages and disadvantages of the price mechanism in market resource allocation

Let’s explore some advantages and disadvantages of the price mechanism as a tool for market resource allocation.

Advantages of the price mechanism

• Resources are allocated efficiently to satisfy consumers’ wants and needs.

• The price mechanism can operate without the cost of employing people to regulate it.

• Consumers decide what is and isn't produced by producers.

• Prices are kept at their minimum as resources are used as efficiently as possible.

Disadvantages of the price mechanism

• Inequality in wealth and income is likely.

• There will be under-provision of merit goods and overproduction of demerit goods, as the supply and demand for these goods won't be at the socially optimal level.

• People with limited skills or ability to work will suffer unemployment or receive very low wages.

• Public goods will not be produced.

Resource misallocation and market failure

The price serves a number of useful functions in resource allocation: signaling information, creating incentives to influence people’s behaviour, and rationing the demand for goods and services. However, it’s still possible that these functions would not ensure the maximisation of resources for the social and economic welfare of agents in the economy.

This is the case of pure public goods and the production of goods with negative externalities, which the price mechanism allows. Therefore, there is a risk of market failure when we rely on the price to allocate the resources in an economy. Furthermore, due to unequal income and wealth distribution in society, relying on price to effectively balance demand and consumer preference may be deemed as unfair.

Another case of market failure is a monopoly, which leads to resource misallocation. Resource misallocation occurs in a monopoly as compared to a competitive market as it restricts output and increases the price. This can lead to underconsumption whilst in a perfectly competitive market goods are sold in accordance to the ruling market price.

Prices play a fundamental role in resource allocation in the markets. The price mechanism has advantages and disadvantages. The disadvantages sometimes lead to resource misallocation and market failure, which can be corrected by government intervention.