Explain how economic systems attempt to allocate and make effective use of resources. Because we live in a world where resources are scarce economic systems make use of market structures such as the perfectly competitive market model as a benchmarking tool in order to better understand consumer behaviour and recognise areas of their market structures that require improvement and how they could possibly achieve this in the most efficient and effective way.
The theory of perfect competition is based upon five pre conditions namely: Homogenous product. All the firms within a industry sell the same product. Consumers have no reason to prefer one seller’s product to that of another seller. For example: Farmers selling peas on a weekend market. Absence of artificial constraints. Any new firm is free to enter the industry and start producing/offering services, just as existing firms are free to stop producing/ offering services and exiting the industry. No legal barriers fixing prices within the industry exist and existing firms also have no power to fix prices either. For example: The existing pea farmers could not prevent new farmers from planting peas and selling them in the market. Perfect knowledge. Customers have perfect knowledge regarding the products being sold and the prices being charged by all the firms in the industry. For example: Customers know that all the peas the farmers sell on the market are of the same kind, quality and how much each of them charge for it. Many buyers and sellers in the market. No seller or buyer is able to affect prices within the industry. If one seller exists the industry the total supply would not decrease enough to cause a price change. Single buyers also do not have the power to affect prices with their purchase quantities. For example: If one of the pea farmers in the industry decides to start planting and selling corn instead of peas the price of peas within the industry would not be affected. The same when on of the members of the Brown family develop a pea allergy and the family decides not to buy peas anymore. The buyer is so small relative to the size of the market that there is no affect on the pea prices of the industry whatsoever. Mobility. Sellers can sell their products or provide their services wherever it is the best suited for their particular product or service and they could get the best prices for it. For example: If the pea farmer knows that there exists a higher demand and the opportunity to sell his peas for a higher price in a different town from the one he lives in he may sell his peas in that market.
The studying of the above mentioned structure provides a logical starting point for economic analysis of their market structures. A mechanism for determining resource allocation is the supply and demand curve. The graph below shows the quantity of a product/service that is demanded as the price of that product/service changes, the quantity of that product/service that sellers place on the market, the equilibrium point and where there is a shortage or surplus in the market. [pic]
The concept of price elasticity of demand is also an important factor in the process of determining the effective usage of resources and allocation thereof. The price elasticity of demand measures the responsiveness of the quantity demanded to changes in price charged for the product/service. If the demand decreases severely when the price changes, the product/service is highly elastic. An example of this would be chocolate. If the price of ordinary milk chocolate would rise from 2 euros a slab to 7 euros a slab, the quantity demanded would decrease drastically. If the demanded quantity of a product/service remains more or less the same when prices are changed that product would be inelastic. An example of an inelastic product is petrol. No matter how much the price changes people still need to buy it and will continue doing so. Price elasticity of demand...
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