Part 2 The allocation of resources

Part 2 The allocation of resources

Assessment: Model answers
1 (a) 
The basic problem in economics is scarcity
of resources relative to human wants. That
is, there are just not enough productive
resources in the world to produce
everything humans want. This is because
human wants are limitless.
(b) 
In a market economy, the interaction of
consumer demand for different products
and producers’ decisions to supply them
will determine the prices at which they are
exchanged and the quantities exchanged.
Because private sector firms are motivated
by profit, they will choose to supply the most
profitable products depending on what goods
and services consumers want and what they
are able and willing to pay for them.

If consumer demand for a product is rising,
firms will be able to charge them a higher
price for the product and earn more profits.
A rising price therefore acts as a signal
to other producers that the product is
becoming more popular and more profitable.
As a result, they will allocate more resources
to the production of the product.

In contrast, if consumer demand for a
product is falling, firms will have to cut
their prices or will risk being left with
unsold stock. A falling price therefore
signals falling profitability. As a result,
producers are likely to reduce their
production of the product and reallocate
the resources they had used to produce to
other, more profitable uses.

It is this price mechanism and the profit
motives of firms that therefore determine
the allocation of resources in a free market
goods in a free market economy because
they are not profitable. A government may
also intervene in markets to regulate the
pricing and resource allocation decisions of
private sector firms.
(c) 
Because resources are finite and scarce
relative to human wants, we must
choose how best to use them. Devoting
more resources to the production of
one particular good or service therefore
means fewer resources remain available
to produce others. That is, every resource
allocation decision involves an opportunity
cost measured by what is given up or
foregone as a result.

For example, the diagram below shows
the production possibility curve (PPC) for
an economy. If it uses its scarce resources
as fully and efficiently as possible, it will
be able to produce any combination of
quantities of consumer goods and capital
goods along its PPC. At point A, it can
produce 200 units of consumer goods
each period and 100 units of capital goods.
However, if it wants to produce more capital
goods each period, it will need to move or
reallocate resources from the production
of consumer goods into the production
of capital goods. The PPC shows that it
will have to give up producing 80 units of
consumer goods in order to produce an
additional 50 units of capital goods. The
opportunity cost of 50 more units of capital
goods is therefore the benefit of 80 units of
consumer goods given up.
B
150
Capital goods

economy and also in many markets within

a mixed economy. However, in a mixed A
100
economy a system of government will also
make some resource allocation decisions.
These may include decisions to provide
public goods, such as street lighting, and
merit goods including public healthcare and 0 120 200
education. Private firms will under supply Consumer goods
these socially and economically desirable

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 Part 2 The allocation of resources

(d) An increase in resources allocated to the 2 (a) 

The equilibrium price of a product is the price
provision of healthcare could benefit an at which the quantity supplied exactly equals
economy in a number of ways. The most or satisfies the quantity consumers are willing
direct benefits will be the creation of and able to buy. The equilibrium price will
additional jobs in the healthcare sector. therefore remain unchanged over time unless
Increased spending on medical equipment the quantity demanded by consumers and/or
and medicines will also boost the sales the quantity supplied by producers changes.
and profits of firms making and supplying
(b) 
The market supply curve of a product
these products. In response, they are likely
shows how much producers are willing
to increase output thereby creating more
and able to supply of that product at every
employment opportunities. They may also
possible price. The amount of profit made
reinvest some of their increased profits
from the sale of each item will rise as the
in the research and development of more
price of the product rises so producers will
advanced equipment and medicines.
expand its supply as price increases.

It is also likely to improve the health of

If, however, producers increase the amount
many workers in other sectors, reducing
they are willing and able to supply at each
lost production during days off work
price then the market supply curve for
due to sickness and boosting their levels
the product will shift to the right. This
of productivity; both of which should
will happen if there is a fall in the cost of
contribute to increased output or GDP. In
producing the product, for example, due
turn, this will help to raise living standards
to technical progress or a fall in the cost of
as well as overall life expectancy.
materials. A fall in the costs of production

However, devoting more resources to means that firms can produce more at the
healthcare has an opportunity cost. For same price.
example, public spending on education or

Seasonal factors may also increase the
roads may have to be cut to pay for it. Or it
market supply of some natural products.
may have to be financed by higher taxes or
For example, good weather can boost the
higher health insurance payments, both of
amount of fruit, flowers, vegetables and
which will reduce the disposable incomes
arable crops grown and supplied to market.
of consumers.

(Other reasons include a reduction in indirect

Better healthcare may also reduce the
taxes; an increase in government subsidies;
death rate and increase the number of
a fall in the prices and profitability of other
people living longer into retirement. This
products; an increase in business optimism and
in turn will increase the cost of providing
expectations of profit; an increase in resources, for
pensions.
example, an increase in capital equipment.)

Further, there may be very few benefits
(c) 
All other things unchanged, a fall in
from expanding healthcare provision if the
product price will reduce the amount of
population is increasing at a faster rate.
profit from each item sold. Total profits will,
As a result, the quality of the service may
however, depend on how many units of the
actually fall, for example, if people have
product are sold at the new lower price.
to wait longer to see a doctor or undergo
surgery and medicines have to be rationed. 
The fall in price may increase sales of the
product significantly if demand for it is

If, in addition, hospitals and healthcare
price elastic. If so, the quantity demanded
practices in the public sector are badly
will increase by proportionately more
managed and run, then there is a risk that
than the fall in price. As a result, the total
additional resources may be wasted or
revenue and total amount of profit from
misallocated.
the sale of the product will increase even if

Whether or not increased provision the profit per item sold is lower than it was
of healthcare will benefit an economy before. If the farm is able to expand output
therefore depends on a large number of in response, it may also be able to reduce
factors. However, if the benefits of doing the average cost of each item produced
so outweigh the costs then it will be because it is able to use its land and
worthwhile. machinery more intensively than before.

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However, if demand for the product is
price inelastic, the fall in price may have
little effect on the amount consumers are
willing and able to buy. As a result, their
total spending on the product will fall as
price falls. Total revenue and therefore total
profit will be lower than before.
(d) It is difficult to predict what will happen
to food prices in the future because it
depends on a large number of factors, some
of which will affect the demand for food
products and others that will affect their
total supply. Any increase in demand for
food not matched by an increase in supply
will cause prices to rise.
3 (a) 

For example, the demand for food is likely
to continue to rise as the global population
expands. All other factors unchanged, the
increasing demand for food will cause food
prices to rise. Rising incomes will have a
similar effect.

However, rising incomes may also be
accompanied by variations in the pattern
of demand for different foods and also food
prices. Demand for some basic foods, such
as bread and potatoes, may fall as demand
for other ‘superior’ items and also many
processed food items increases.

Diets may also change over time due
to health and other concerns, and this
may also cause variations in the prices of
different food products. For example, more
people are giving up highly processed foods
and meat in favour of healthier vegetarian
or vegan diets, and also because of
increasing concerns over the mistreatment
and killing of animals.

The supply of food products is also likely
to change over time, both in response to
changes in the pattern of demand for food
and their effect on food prices, but also due
to other factors.

For example, advances in technology have
helped to improve crop yields by making
many more resistant to damage from
drought and insects. This means more
can be grown per area of farmland than
previously. The increase in supply will
help to reduce prices but not if demand
continues to rise at a faster rate.

Similarly, advances in technology may
also improve productivity and reduce the
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Part 2 The allocation of resources
costs of equipment, fertilisers and seeds. As
costs fall, food production becomes more
profitable and will attract more resources.
An increase in government subsidies may
also encourage increased food production.

However, reductions in subsidies and
increasing wages and other costs will have
the opposite effect, causing a reduction
in food supply and forcing up food prices.
Similarly, increasing demand for land for
housing and to grow crops for biofuels
could reduce the amount of land available
for agriculture if it is less profitable than
these alternative uses.
Demand is the willingness and ability of
consumers to buy a product. Consumers
demand different products to satisfy their
needs and wants.
(b) 
Bicycles are used by people as a form of
transport, for example as a substitute for
bus travel and also for leisure and exercise
to keep fit. The demand for bicycles may
therefore increase if there is an increase
in the price of other forms of transport,
for example if bus fares rise or if the price
of petrol rises making travel by car more
expensive. If a greater number of people
take up exercise and want to keep fit, then
there may also be an increase in demand
for bicycles.

(Other reasons include rising incomes, if bicycles
are a normal good; a rise in disposable incomes
due to a reduction in income taxes; increased
advertising of bicycles; an increase in the
population; a government ban on the use of
cars in certain areas; the provision of dedicated
cycling paths and good weather may encourage
more people to take up cycling.)
(c) 
The article suggests that the demand for
bicycles is quite low or price inelastic
in Asia Pacific countries compared to
countries in other regions. When demand
for a product is price inelastic, a small
change in its price will have relatively
little impact on the quantity demanded.
For example, in some countries a bicycle
may be essential for many people for travel
because they cannot afford to buy a car or
travel by bus or rail. Or perhaps there are
very few bus or rail services provided. The
absence of these alternatives or substitutes
for cycling therefore makes demand for
bicycles relatively price inelastic.
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However, in other countries the demand
for bicycles may be price elastic whereby
a small percentage change in their price
will result in a larger percentage change in
quantity demanded. This is likely to be the
case in countries where there are many bus
and rail services to choose from and fares
are relative cheap. Any increase in the price
of bicycles may therefore result in many
consumers switching their demand to these
transport alternatives instead.

Demand for bicycles may also be
relatively price elastic in countries where
they are considered luxury items because
average incomes are low and many
people cannot afford to buy them. Any
increase in the price of bicycles will make
them even less affordable and could cause
demand for them to fall sharply. This will
especially be the case if bicycle prices are
already very high.

In contrast, in countries where average
incomes are relatively high and the prices
of bicycles are relatively low, demand for
them may be price inelastic because many
people can afford to buy them even if they
are considered a non-essential item used
mainly for leisure. If so, an increase in
bicycle prices is unlikely to cause a dramatic
fall in demand because the proportion of
average income spent on them is low for
many households.
(d) Whether or not a government should
4 (a) 
increase the tax on cigarettes depends on
what it wants to achieve and how effective
any increase will be.

For example, if the aim is to raise
additional revenues to finance higher
public expenditures on, say, expanding
the provision of education or building new
public hospitals, then increasing the tax will
help. This is because cigarettes are addictive
and this makes demand for them relatively
price inelastic. Increasing the tax will raise
their price but is likely to have relatively
little impact on demand for them. As a
result, total spending on them, and therefore
tax revenues from their sale, will increase.

However, if the aim is to discourage their
consumption because of their negative
impact on health and air quality, then
a small increase in the tax is unlikely
to achieve this while demand is price
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Part 2 The allocation of resources
inelastic. The tax will therefore have
to increase significantly before it has a
big impact on demand. If this can be
achieved, then it should reduce public
spending on healthcare. It will also help to
boost labour productivity and total output.
This is because as cigarette consumption
falls, fewer people smoke, fewer workers
will suffer smoking-related health
problems and time taken off work due to
sickness should fall. Life expectancy should
also improve.

However, if many of the cigarettes
consumed by people in the economy
are manufactured in the economy then
discouraging their consumption could force
those firms to cut their production and their
workforces. Unemployment will rise unless
there are jobs in other sectors into which
the displaced workers could easily move.

The domestic industry may also be harmed
if the increase in tax on cigarettes results
in consumers switching their demand to
cheaper imported cigarettes. This will have
a negative impact on the balance of trade. It
may also encourage the smuggling of cheap
cigarettes from other countries.

Because indirect taxes are regressive, the
increase in tax on cigarettes will have a
disproportionate effect on people with low
incomes. However, they could easily avoid
the tax if they were to stop smoking.
Price elasticity of supply measures the
responsiveness of quantity supplied to
small changes in the price of the product.
If the percentage change in price exceeds
the percentage change it causes in quantity
supplied, the price elasticity of supply is
relatively price inelastic.
(b) 
The supply of apples may decrease because
of poor weather or disease. These factors
will destroy crops and reduce the quantity
harvested. Their supply will also decrease
if some of the land used to grow pears is
reallocated to more profitable uses, for
example, to grow other crops or to build
new homes or factories.

A rise in the costs of producing pears may
also reduce their profitability relative
to other crops or activities resulting in
a transfer of resources from banana
production to those other uses.
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(Other reasons include a reduction in resources
available to banana growers, for example, due
to a shortage of labour; technical failures, such
as mechanical breakdowns when harvesting
the fruits; poor expectations of future prices and
profits; a reduction in or removal of subsidies
paid to banana growers; the imposition of an
indirect tax on pears making their production
less profitable; any other relevant factors, such as
wars and natural disasters.)
(c) 
If apples are a close substitute for pears,
then an increase in the price of apples
could result in consumers switching their
demand from apples to pears. There will be
Short-run
S
D D1
P1
Price
Price
P P
D D1
0 Q
Pears
(d) Whether or not a government should only
impose indirect taxes on products with
price inelastic demand very much depends
on its objectives. If the main objective is
to raise public revenues, then it may be a
sensible thing to do. An indirect tax will
raise the market price of the product but
the impact on demand may be relatively
minor. This is because when demand is
price inelastic, any increase in price will
cause a smaller percentage contraction
in the quantity demanded. As a result,
total spending on the product, including
payment of the tax, will increase.

However, imposing indirect taxes on
products with price inelastic demand is
unlikely to be a very successful policy if the
aim is to discourage consumption of these
products because they are imported or they
are considered harmful or demerit goods.
The indirect taxes will only reduce total
spending on products for which demand is
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Part 2 The allocation of resources
an increase in demand in the market for
pears, shown in the diagram below as the
outward movement in the market demand
curve from DD to D1D1. As result, the
market price of pears will rise to P1 because
their supply will be fixed or price inelastic
in the short run at Q.

However, the rise in market price will
encourage more banana trees to be planted
so that over time the supply of pears
and, therefore, the quantity traded in the
market, will expand from Q to Q1 at the
new long run equilibrium price (Pe).
Long-run
D D1
S
Pe
S D D1
0 Q Q1
Pears
price elastic unless they are set so very high
on products with price inelastic demand
that people simply cannot afford to buy
them anymore.

Raising indirect taxes may conflict with
a government aim to keep price inflation
in the economy low and stable. This is
because indirect taxes increase the prices
of the goods and services on which they
are imposed. They are also regressive
in nature. This means that payment of
indirect taxes takes proportionately more
out of a low income than it does a higher
income. Imposing indirect taxes on goods
may therefore conflict with an aim to
reduce poverty. As many products with
price inelastic demand also tend to essential
items such as electricity and many basic
foods, imposing indirect taxes specifically
on these products will additionally affect
those on low incomes the most.
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 Part 2 The allocation of resources

5 (a) 
Regulations are legal rules introduced by a 
Conversely, private firms will under-
government to control the way something provide some socially and economically
is done or the way people or firms behave beneficial goods and services because it
to achieve more socially or economically is not profitable for them to do so. For
desirable outcomes. example, private sector firms are unlikely
to supply public goods such as street
(b) 
In a free market economy, all productive
lighting or national parks. This is because
resources are privately owned and market
it will be impossible for them to charge
interactions between consumer demand
individual consumers a price according
and producer supply determine how they
to how much they ‘consume’ and benefit
are used.
from them.

Consumers will buy those products that

Similarly, private firms will only supply
give them the most satisfaction while
merit goods such as education and
producers will allocate resources to the
healthcare to those consumers able to pay
production of those products that earn
a profitable price for them. Many will not
them the most profit. In this way, those
and so consumption of these goods will be
consumers willing and able to pay the
less than what is socially and economically
highest prices will get the products they
desirable.
want. The prices and profitability of
different products therefore determine the 
Other goods with significant external
allocation of resources in a free market benefits, such as vaccinations against
economy. infectious diseases, will also be under-
consumed if people have to pay the full

If consumer demand for a product is rising,
market price for them because private firms
firms will be able to charge them a higher
will only supply these goods if they can sell
price for the product and earn more profit.
them at a profit.
A rising price therefore acts as a signal to
other producers that consumers want more 
In contrast, the provision and consumption
of the product and are willing and able of harmful demerit goods, such as guns,
to pay more for it. This will increase their cigarettes and alcohol, is likely to exceed
profits and as a result they will allocate what is socially and economically desirable
more resources to the production of the because they can be produced cheaply and
product. because consumers are not always aware of
the harm their use can cause to themselves

In contrast, a falling price signals falling
or others. The prices of such products need
consumer demand and profitability. As
to be much higher to reduce demand for
a result, producers are likely to cut their
them.
production of the product and reallocate
their resources to other, more profitable uses. 
The desire to maximise profit among firms
may also result in the creation of large
(c) 
Market failures occur when free markets
monopolies able to restrict the market
fail to produce socially and economically
supply of the goods or services so they are
desirable market outcomes. Market failures
able to charge high prices for them. Many
therefore reduce social and economic
of these products may be essential items
welfare. This means alternative resource
such as water and electricity supplies. In
allocations will be more efficient and
the absence of any alternatives, consumers
desirable.
will therefore have no choice but to pay

Because private sector firms want to high prices for them.
maximize their profits, they will only
(d) A decision to cut down forests will benefit
be concerned with the private costs and
an economy only if the social benefits
benefits of their activities and not the
of doing so exceed the social costs of the
external costs or benefits they impose on
decision.
others. For example, products that create
pollution, cause damage to the natural 
A number of firms and employees may
environment and wildlife and result in benefit from the decision in terms of higher
other external costs will be over produced if profits and wages. These will include firms
it is profitable to do so. and their employees hired to cut down the

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 Part 2 The allocation of resources

trees and firms who will benefit from a fall 

The act of cutting down trees may cause
in the price of wood due to the increase significant noise and dust pollution. This
in its supply. Manufacturers of wooden may be a short-term cost but clearing
furniture, paper and other wood-based the forests will destroy the natural
products will benefit from falling production environment and wildlife habitats forever.
costs and will expand their production. This in turn could reduce tourism to
Their prices can be lowered without a loss these areas and reduce the trade and
of profit margin and this should encourage profits of firms that provide services
higher sales. The balance of trade will to tourists. Conserving the forests will
improve if many of these additional sales enable future generations to enjoy
are to consumers in other countries. them and benefit from the income they
generate, including from the sale of

In turn, the cleared land could be used
wood. If the forests are cut down and not
for housing or to build factories. This will
replanted, then there will be no future
help to create additional business and
domestic supply of wood. This will increase
employment opportunities, increasing
both the price of wood and the need to
total profits and wages further. These
import it in future thereby worsening the
will contribute to higher GDP and living
balance of trade.
standards.

On the plus side, clearing of the forests

However, the additional sales, profits
may release land for farming to grow much
and wages of private sector firms and
needed food and may also make travel
individuals will reflect only their private
easier. Trees also soak up a significant
costs and benefits. Cutting down forests
amount of groundwater that could instead
may also give rise to external costs and
be used to irrigate crops for food if the trees
benefits that should also be taken into
were cleared.
account before a final decision is made.

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