Compare And Contrast Two Alternative Systems Of

Resource Allocation In The Economy Essay, Research Paper

Economics can be said to be the science which studies the relationship between scarce resources, with alternative uses, and consumers’ unlimited wants. Therefore the ‘problem’ of resource allocation can be seen to be central to the basic economic problem. In this way , how resources are allocated throughout an economy is of great importance and different types of economies employ different methods to achieve this allocation.

All economies have this same basic economic problem of ‘what’ to produce, ‘how’ to produce it, and ‘for whom’ to produce it. Deciding what to produce involves choosing a certain allocation of resources, in order to produce a particular combination of goods. The method of choosing the resource allocation varies, according to the economy in question. There is also the question of how to produce the goods which you require. ‘Any particular output can usually be produced by several different techniques, ranging from ones using a large quantity of labour and only a few simple machines, to ones using a large quantity of automated machines and only a few workers.’ (R.G.Lipsey; 1989) Different economies also vary in the way that national product is distributed throughout the individuals and groups within the society.

The methods which a society uses in order to tackle these questions determines the type of economy it is. There are various methods of resource allocation and the two most extreme cases are the contrasting methods of the ‘free-market’ and the ‘command’ economies.

‘In a market economy, the allocation of resources is the outcome of millions of independent decisions made by consumers and producers, all acting through the medium of the market’ (Lipsey; 1989)

The free-market economy depends upon the interaction of consumers and producers, all acting in their own self interest. The allocation of resources throughout the economy occurs via the ‘price system’ a system which sets the free-market economy aside from the command economy. This system works in conjunction with the theory of demand and supply, that is, price is a function of the demand and supply of goods and services.

An example of this could be illustrated using the markets for beef and pork. Let us say that, due to the recent British Beef crisis, the market demand for beef has fallen considerably while the market demand for pork has risen.

The diagrams above illustrate the effects of the changes in market demand. The demand for beef has shifted from to , this shift causes the quantity demanded at price to fall from to . This creates a surplus of unwanted beef which can only be sold if prices fall to . Also, the shift in demand for pork, from to causes quantity demanded at price to rise from to . This leads to a shortage of pork, which can combated by raising prices to to ration resources.

Pork will now become a relatively expensive, scarce commodity, in comparison with the glut of cheaper beef. Producers see this and so resources will be reallocated into the production of pork, because it has become a relatively profitable market, due to the change in its market price. At the same time, beef becomes relatively ‘unattractive’ to producers, because of the fall in price, leading to cuts in profits, which in turn urges producers to reallocate resources out of beef production. As less resources are allocated to beef production, so the glut will disappear, and its market price will begin to rise again. In the same way, as more resources are allocated to pork production, so the good becomes no longer scarce and prices and profits will diminish as more producers move into the market.

These price fluctuations and resource reallocations continue until beef profits have risen and pork profits diminished to a level at which it no longer pays the producers to reallocate resources from beef production to pork production. Therefore in the free-market, changes in consumer tastes and demands, cause the reallocation of resources within an economy, via the price system. Evidence of this occurred in the recent BSE crisis, when in the year of June 1996, amid fear of ‘mad cow disease’, the market demand for beef plummeted and led to beef prices to being slashed, while pork prices rose by 30 per cent, causing large scale resource reallocation. ( Begg, Fischer, Dornbusch; 1997)

Changes in the supply of good and services also cause the reallocation of resources within the free-market economy. If the supply of beef fell, maybe due to an increase in production costs with no change in market price, then producers would be less willing to supply beef, due to the cuts in profitability. At the same time an increase in the supply of pork would lead to a reallocation of resources into the production of pork. The fall in the supply of beef would therefore lead to a shortage as the market demand will not have changed and so the market price of beef would rise in order to ration a scarce good. On the other hand, the increased supply of pork would cause a glut and so prices would fall to clear the surplus.

This change in prices, however, makes beef more attractive because of the rise in market price, while pork producers’ profits are being cut. Therefore, producers begin to reallocate resources back into beef production and out of pork production. In this way, the price system removed the shortage of beef by increasing the price, therefore cutting demand, whilst also making beef more attractive to produce, therefore increasing the supply. The system also eliminated the surplus of pork by a fall in price, which increases demand and also urges producers out of the pork market due to dwindling profitability.

It is through this price system that resources are allocated throughout the free-market economy, through the interaction of consumer and producer decisions within the market.

The command or ‘centrally planned’ economy allocates its resources in a completely different way.

‘In a command economy a government planning office decides what will be produced, how it will be produced, and for whom it will be produced. Detailed instructions are then issued to households, firms and workers.’ ( Begg, Fischer, Dornbusch; 1997 )

In a command economy there is little or no role for the price system, profitability, or the market. All decisions are made by some central authority who decide on a resource allocation which they feel will be for the overall good of the economy.

This method of resource allocation completely contrasts the whole concept of the free-market which is based around the capitalist concept of self interest. It has been said that the attitude of those in the free-market economy is ‘individualist’ rather than the ‘collectivist’ attitude of those within the centrally planned economies. ( C.Weststrate: 1963 ) The allocation of resources in a free-market economy is governed by the individual’s decisions, within the market, guided by self interest whereas the method of planning by a central authority could often be found in communist countries, such as Cuba or China. The attitude of the centrally planned economy is that the ‘economy’ is more important than the individual, which contrasts the general individualistic attitude of the capitalist, free-market economies.

.The command economy, although closing the gap between the rich and poor, often lacks consumer luxuries and the variety of goods and services available is limited in comparison with the free-market who are striving to win customers in the market. Planning resource allocation for all sectors is a near impossible task and so command economies can often be seen in shortage or surplus of goods. Unlike in the free-market, when the consumers ‘decide’ what is to be produced by choosing which goods to buy and which not, the government must make assumptions about what they feel should be produced, which is why there are few luxuries and many resources are allocated to sectors such as industry and defence. However if the planning is accurate the command economy has the potential to be near perfect, stable, in equilibrium and without the worry of macro economical problems such as unemployment or inflation.

The free-market may be seen to be inequitable when completely free from government intervention. The distribution of goods and services will be purely determined by the individual’s to meet the market price and also based solely on ‘consumer wants’ rather than ‘consumer needs’. There is no guarantee of full employment or low inflation rates and the economy is often plagued by market failures, which occur often when the ‘invisible hand’ does not function or when certain factors affect the market system. Monopolies are a perfect example of market failure and the disadvantage of the free-market system. Barriers to entry prevent the price system from operating smoothly, as firms cannot enter a profitable market, allowing the monopolist to retain super normal profits and also exploit consumers through high pricing with no worry of cheaper competition.

However, the defence of the free-market is that it allocates a nation’s resources in a better way than any alternative because relative prices reflect relative cost, and also the allocation requires no prior complex planning but seems to function automatically. Perfect competition, in theory, leads to an optimal allocation of resources, at which no reallocation of resources will make one party better off without making some other party worse off, pareto efficiency.

We have discussed the two alternative methods of resource allocation, command and free-market economies. They answer the basic economic questions stated earlier in contrasting ways. What to produce in a free-market economy is determined by the price system, how to produce it depends upon the most efficient method as producers strive for profit maximisation, those who are able to pay the market price of a good, are those for whom the goods and services are produced. In a command economy the central authority decides what, how, and for whom to produce in order to create the best economic situation. In practice, however, there are no purely command or free market economies, all economies are mixed with a tendency towards either extreme. The U.K may be said to be free-market, yet the government intervenes in order to combat the inequitable free-market attitude by monitoring resource allocation through benefits, taxation, subsidies and other policies.

There are arguments or and against both free-market and command economies, however the modern trend of former planned economies moving towards the free-market attitude, despite problems during transition, seems to indicate that perhaps the advantages of the free-market outweigh the disadvantages and that the ‘free-market based’ modern mixed economy is more attractive than command based economies.

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Beggs, Fischer, Dornbusch (1997) : Economics 5th Edition.

R.G.Lipsey (1989) : An Introduction to Positive Economics.

C.Weststrate (1963) :Types of Economy.

A.Eckstein (1973) : Comparison of Economic Systems.