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The fi nancial statements of limited companies

5 Prices and resource allocation

AS LevelPart 2: The price system and the microeconomy

Now that you are familiar with the use of the demand and supply model, it is time to take a wider view of the process of resource allocation within society. This chapter examines how prices can act as market signals to guide resource allocation, and introduces notions of consumer and producer surplus.

Key term

Free-market economy: one in which resource allocation is guided by market forces without intervention by the state.

5.1 The role of prices in allocating resources

The coordination problemAs Chapter 1 indicated, all societies face the fundamental economic problem of scarcity. Because there are unlimited wants but fi nite resources, it is necessary to take decisions on which goods and services should be produced, how they should be produced and for whom they should be produced. For an economy the size of the UK, there is thus an immense coordination problem. Another way of looking at this is to ask how consumers can express their preferences between alternative goods so that producers can produce the best mix of goods and services.

Some alternative possibilities for handling this problem will now be considered. In a free-market economy, market forces are allowed to allocate resources. At the other extreme, in a centrally planned economy the state plans and directs resources into a range of uses. In between there is the mixed economy. In order to evaluate these alternatives, it is necessary to explore how each of them operates.

Summary�

5.2 Prices and consumers

Prices and preferencesHow can consumers signal their preferences to producers? Demand and supply analysis provides the clue. Figure 5.1 shows the demand and supply for laptop computers. Over time there has been a rightward shift in the demand curve – in the fi gure, from D

0 to D

1. This simply means that consumers are placing a

higher value on these goods; they are prepared to demand more at any given price. The result, as you know from comparative

In a free-market economy, prices play the key role; this is sometimes referred to as the laissez-faire approach to resource allocation.

Learning outcomesAfter studying this chapter, you should:� have an overview of how the price mechanism works to

allocate resources� understand the meaning and signifi cance of consumer surplus� be able to see how prices provide incentives to producers� understand the meaning and signifi cance of producer

surplus� be aware of the effects of the entry and exit of fi rms into

and out of a market. � Societies face the fundamental economic problem of scarcity.

� In a free-market economy there needs to be a mechanism that coordinates the allocation of resources.

� Prices play a key role in this process.

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35

5.2 Prices and consumers

static analysis, is that the market will move to a new equilibrium, with price rising from P

0 to P

1 and quantity traded from Q

0 to Q

1:

there is a movement along the supply curve.

To that marginal consumer, P * represents the marginal benefi t derived from consuming this good – it is the price that just refl ects the consumer’s benefi t from a laptop, as it is the price that just induces her to buy. Thinking of the society as a whole (which is made up of all the consumers within it), P * can be regarded as the marginal social benefi t (MSB) derived from consuming this good. The same argument could be made about any point along the demand curve, so the demand curve can be interpreted as the marginal benefi t to be derived from consuming laptop computers.

The shift in the demand curve is an expression of consumers’ preferences; it embodies the fact that they value laptop computers more highly now than before. The price that consumers are willing to pay represents their valuation of laptop computers.

Consumer surplusThink a little more carefully about what the demand curve represents. Figure 5.2 again shows the demand curve for laptop computers. Suppose that the price is set at P * and quantity demanded is thus Q *. P * can be seen as the value that the last customer places on a laptop. In other words, if the price were even slightly above P *, there would be one consumer who would choose not to buy: this individual will be referred to as the marginal consumer.

In most markets, all consumers face the same prices for goods and services. This leads to an important concept in economic analysis. P * may represent the value of laptops to the marginal consumer, but what about all the other consumers who are also buying laptops at P *? They would all be willing to pay a higher price for a laptop. Indeed, consumer A in Figure 5.2 would pay a very high price indeed, and thus values a laptop much more highly than P *. When consumer A pays P * for a laptop, he gets a great deal, as he values the good so much more highly – as represented by the vertical green line on Figure 5.2. Consumer B also gains a surplus above her willingness to pay (the purple line).

If all these surplus values are added up, they sum to the total surplus that society gains from consuming laptops. This is known as the consumer surplus, represented by the shaded triangle in Figure 5.3. It can be interpreted as the welfare that society gains from consuming the good, over and above the price that has to be paid for it.

D0 D1

Supply

Q1Q0

P0

P1

Quantity of laptopcomputers per period

Pri

ce

0

Figure 5.1 The market for laptop computers

Quantity of laptop computers per period

Demand (MSB)

Q*

P*

Consumer A’s valuationConsumer B’s valuation

AB

Pri

ce

0

Figure 5.2 Price as marginal benefi t

Key term

Marginal social benefi t: the additional benefi t that society gains from consuming an extra unit of a good.

Consumers now value laptop computers more highly than before

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36

5 Prices and resource allocation

Prices as signals and incentivesFrom the producers’ perspective, the question is how they receive signals from consumers about their changing preferences. Price is the key. Figure 5.1 showed how an increase in demand for laptop computers leads to an increase in the equilibrium market price. The shift in the demand curve leads to an increase in the equilibrium price, which encourages producers to supply more computers – there is a movement along the supply curve. This is really saying that producers fi nd it profi table to expand their output of laptop computers at that higher price. The price level is thus a signal to producers about consumer preferences.

Notice that the price signal works equally well when there is a decrease in the demand for a good or service. Figure 5.5, for example, shows the market for video recordings.

With the advent of DVDs, there has been a large fall in the demand for video recordings, so the demand for them has shifted to the left – consumers are demanding fewer videos at any price. Thus, the demand curve shifts from D

0 to D

1.

Producers of video recordings are beginning to fi nd that they cannot sell as many videos at the original price as before, so they have to reduce their price to avoid an increase in their unsold stocks. They have less incentive to produce videos, and will supply less. There is a movement along the supply curve to a lower equilibrium price at P

1, and a lower quantity traded at

Q1. You may like to think of this as a movement along the fi rm’s

production possibility curve for DVDs and videos.Thus, you can see how existing producers in a market receive

signals from consumers in the form of changes in the equilibrium price, and respond to these signals by adjusting their output levels.

Quantity of laptop computers per period

Demand (MSB)

Q*

P *

Pri

ce

0

Figure 5.3 Consumer surplus

Key term

Consumer surplus: the value that consumers gain from consuming a good or service over and above the price paid.

D0D1

Supply

Q1 Q0

P0

P1

Quantity of videosper period

Pri

ce

0

Figure 5.5 The market for video recordings

Exercise 5.1

Figure 5.4 shows a demand curve.

Quantity

C

A

B

EF

G

JH K

Demand

Pri

ce

0

Figure 5.4 Consumer surplus when price changes

a Identify the area that represents consumer surplus if the price of the good is OE.

Suppose that the price increases to OB.

b Identify the consumer surplus at this new price.c Which area represents the change in consumer surplus

between the two positions?d Which area shows how total welfare in the society has

changed?

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Prices and resource allocation

37

5.3 Prices and producers

The supply curve shows that, in the range of prices between point A and P*, fi rms would have been willing to supply positive amounts of this good or service. So at P*, they would gain a surplus value on all units of the good supplied below Q*. The total area is shown in Figure 5.7: it is the area above the supply curve and below P *, shown as the shaded triangle.

One way of defi ning this producer surplus is as the surplus earned by fi rms over and above the minimum that would have kept them in the market. It is the reason for which fi rms exist.

5.3 Prices and producers

Producer surplusParallel to the notion of consumer surplus is the concept of producer surplus. Think about the nature of the supply curve: it reveals how much output fi rms are prepared to supply at any given price in a competitive market. Figure 5.6 depicts a supply curve. Assume the price is at P *, and that all units are sold at that price. P * represents the value to fi rms of the marginal unit sold. In other words, if the price had been set slightly below P *, the last unit would not have been supplied, as fi rms would not have found this profi table.

Notice that the threshold at which a fi rm will decide it is not profi table to supply is the point at which the price received by the fi rm reaches the cost to the fi rm of producing the last unit of the good. Thus, in a competitive market the supply curve refl ects marginal cost.

Quantity supplied per period

Supply

P*

A

Q*

Pri

ce

0

Figure 5.6 A supply curve

Summary Key terms

Producer surplus: the difference between the price received by fi rms for a good or service and the price at which they would have been prepared to supply that good or service.

Marginal cost: the cost of producing an additional unit of output.

Quantity supplied per period

P*

A

Pri

ce

Supply

0

Figure 5.7 Producer surplus

Entry and exit of fi rmsThe discussion so far has focused on the reactions of existing fi rms in a market to changes in consumer preferences. However, this is only part of the picture. Think back to Figure 5.1, where there was an increase in demand for laptop computers following a change in consumer preferences. The equilibrium price rose, and existing fi rms expanded the quantity supplied in response. Those fi rms are now earning a higher producer surplus than before. Other fi rms not currently in the market will be attracted by these surpluses, perceiving this to be a profi table market in which to operate.

If there are no barriers to entry, more fi rms will join the market. This in turn will tend to shift the supply curve to the right, as there will then be more fi rms prepared to supply. As a result, the equilibrium market price will tend to drift down again,

� If market forces are to allocate resources effectively, consumers need to be able to express their preferences for goods and services in such a way that producers can respond.

� Consumers express their preferences through prices, as prices will adjust to equilibrium levels following a change in consumer demand.

� Consumer surplus represents the benefi t that consumers gain from consuming a product over and above the price they pay for that product.

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38

5 Prices and resource allocation

until the market reaches a position in which there is no further incentive for new fi rms to enter the market. This will occur when the rate of return for fi rms in the laptop market is no better than in other markets.

Figure 5.8 illustrates this situation. The original increase in demand leads, as before, to a new equilibrium with a higher price P

1. As new fi rms join the market in quest of producer

surplus, the supply curve shifts to the right to S2, pushing

the price back down to P0, but with the quantity traded now

up at Q2.

If the original movement in demand is in the opposite direction, as it was for video recordings in Figure 5.5, a similar long-run adjustment takes place. As the market price falls, some fi rms in the market may decide that they no longer wish to remain in production, and will exit from the market altogether. This will shift the supply curve to the left in Figure 5.9 (to S

2) until only

fi rms that continue to fi nd it profi table will remain in the market. In the fi nal position, price is back to P

0, and quantity traded has

fallen to Q2.

D0 D1

S0

Q1Q0

P0

P1

Quantity of laptopcomputers per period

S2

Q2

Pri

ce

0

Figure 5.8 The market for laptop computers revisited

D0D1

S2

Q1 Q0

P0

P1

Quantity of videosper period

S0

Q2

Pri

ce

0

Figure 5.9 The market for video recordings revisited

Exercise 5.2

Summary

a Sketch a demand and supply diagram and mark on it the areas that represent consumer and producer surplus.

b Using a demand and supply diagram, explain the process that provides incentives for fi rms to adjust to a decrease in the demand for fountain pens in a competitive market.

c Think about how you could use demand and supply analysis to explain recent movements in the world price of oil.

� Producer surplus represents the benefi t gained by fi rms over and above the price at which they would have been prepared to supply a product.

� Producers have an incentive to respond to changes in prices. In the short run this occurs through output adjustments of existing fi rms (movements along the supply curve), but in the long run fi rms will enter the market (or exit from it) until there are no further incentives for entry or exit.

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Prices and resource allocation

39

Examination questions

Examination questions1 a Explain how an equilibrium price for a product is

established in the market and how it may change. [8]

b Discuss whether a fi rm’s revenue would increase, in response to price and income changes, if the price elasticity and income elasticity of demand for its product became highly elastic. [12]

Cambridge AS and A Level Economics 9708, Paper 2, Q2, November 2007

2 Elasticity of demand for air travel The Department of Finance of Canada examined 21 studies

of elasticity of demand for air travel. These were mainly based on behaviour in the USA. It produced a summary of what it thought were the most accurate estimates of elasticity for different segments of the market. Some of these fi ndings are given in Figures 1 and 2.

YED value

Total market �1.1

Figure 1 Income elasticity of demand (YED) for air travel

Market segment PED value

Long-distance international business fl ights �0.3

Long-distance international leisure fl ights �1.0

Short-distance business fl ights �0.7

Short-distance leisure fl ights �1.5

Figure 2 Price elasticity of demand (PED) for air travel

a i) State the formula used to calculate income elasticity of demand. [2]

ii) What can be concluded about air travel from Figure 1? [2]

b Using Figure 2, explain a likely reason for the different price elasticity values fori) business fl ights compared with leisure fl ights [3]

ii) long-distance fl ights compared with short-distance fl ights. [3]

c Explain the signifi cance of the price elasticity values in Figure 2 for an airline considering a policy of fare cutting. [4]

d Discuss the costs and benefi ts of an increased demand for air travel. [6]

Cambridge AS and A Level Economics 9708, Paper 21, Q1, November 2009

3 a With reference to the relevant type of elasticity of demand, explain the termsi) inferior good, andii) complementary good. [8]

b Discuss the importance of price in the effective operation of a mixed economy. [12]

Cambridge AS and A Level Economics 9708, Paper 22, Q3, November 2010

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