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How are resources allocated in a market economy? What is the advantage of price-based resource allocation?
In a free-market economy, resources are allocated by prices. In this way, a market economy is self-regulating, allowing real-time coordination across millions of goods and services, without any central authority knowing and setting all the prices.
In this article, you’ll learn how prices allocate resources and how supply and demand respond to prices.
The Economics of Resources Allocation
The most straightforward way to allocate resources across an economy is for a central authority to decide what to do. In a feudal economy, the lord tells people what to grow and how to sell it. The Soviet Union operated similarly, with the government determining how much steel to produce in Bulgaria and how much wheat to be grown in Ukraine.
The problem with this method is that economies are so complex, with many millions of products and services, that allocating resources optimally across millions of items is incredibly difficult. Counterproductive incentives also arise in these centralized systems which is why in modern economies, resources are allocated without a centralized authority.
How are resources allocated in a market economy? Market economies use prices to allocate scarce resources.
On a micro-level, each consumer and producer makes transactions with other individuals on whatever terms they can agree on. The terms often consist of prices. Even though a market economy has millions of goods with millions of prices, each party in the transaction just needs to keep track of the few prices relevant to their own decision-making, not the entire economy’s prices.
For example, a camera lensmaker doesn’t need to know the absolute specifics of her customer’s needs—for instance, that museum photographers can’t use flash and therefore need complex, expensive optics to take in low light – she can simply charge more for a more complex product, and let demand sort itself out. A complex reality is summarized in a single number—the price.
These transaction prices have ripple effects throughout the economy, with one price in one sector being transmitted to related sectors automatically, without passing through any central authority. These prices determine how much of each resource gets used where.
If someone else produces a better product, or a lower price for the same product, that fact gets conveyed through prices, not a central authority, and is acted on by consumers. Prices also mean that producers and consumers don’t have to know why things are getting cheaper or more expensive – they can simply make decisions based on prices alone. If a vast supply of rare earth elements is discovered in Zimbabwe, this may ultimately make smartphones cheaper, but consumers don’t have to know about this discovery to enjoy the benefits, and central authorities don’t need to control this pricing.
How Prices Allocate Resources
Prices provide financial incentives – profits and losses – to affect behavior in the use of resources and their resulting products. Profits motivate people to provide more of a product that people want, and profits are often the focus of popular press (“greedy capitalists!”).
But just as importantly, losses force the producers to stop producing what consumers don’t want. Losses prevent the inefficient use of scarce resources, allowing those resources to be used elsewhere where they will produce better output.
In general, a producer will try to maximize her profits and produce as many units as possible without incurring a loss per unit. She will bid higher for resources until she starts losing money per unit – when the cost to produce exceeds the amount people are willing to pay. As she bids up the price of resources, these resources become more expensive for other producers, which increases the cost of their products.
However, the producer will reach a ceiling in consumer demand when, beyond a certain supply, consumers are indifferent or unwilling to consume any more. The producer will not produce beyond this point. A natural equilibrium thus results when all producers bid for resources to meet their consumer demand.
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- Why we use money, rather than bartering our services with each other
- Why some nations prosper, while others stay poor despite vast natural resources
- How rent control might actually reduce housing supply and quality
