Chapter 4
Allocation and
the market system
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-1
Learning objectives
• Show how the market system determines
what is to be produced
• Examine how markets organise production
• Discuss how markets distribute output
• Illustrate how markets accommodate change
• Evaluate the operation of the market economy
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-2
Operation of the market system
What is to be produced?
• Determined by competing buyers and sellers
in both resource and product markets
• How would a pure market–coordinated
economy decide on the types and quantities
of goods to be produced?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-3
Types and quantities of goods
produced
• Determined by the motives of firms to seek
profits and avoid losses
• Firms will produce those goods and services
that result in a profit
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-4
Profits (or losses)
Determined by:
• Total revenue received by the firm from
the sale of a product
• Total costs of producing that product
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-5
Economic costs and profits
• Economic costs — payments made to obtain
and retain the services of a resource, including
land, labour, capital and entrepreneurial ability
• Normal profits — the minimum cost payment
that is just sufficient to obtain and retain
contribution by the entrepreneur
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-6
Economic profit
• The total revenue of a firm less all its economic
costs (including the cost of entrepreneurial ability)
• Also known as pure profit
• Zero economic profit = normal profit
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-7
Profits and expanding industries
• Economic profits induce new firms to enter
the industry, resulting in an expanding industry
• Entry of new firms increases the market supply
of the product, resulting in lower prices until
normal profits are restored
• The market supply and demand situation
prevailing when economic profits become
zero determines the total quantity of a product
that will be produced
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-8
Losses and declining industries
• Below-normal profit induces firms to leave
the industry, resulting in a declining industry
• As firms exit, supply decreases, and prices
increase until normal profits are restored
• The market demand and supply that prevail
at this point determines the total output of
a product or service
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-9
Dollar votes
• Consumer demand determines the types
and quantities of product produced
• Ultimately determines whether industries
contract or expand
• Consumers register their dollar votes through
the demand side of the product market
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-10
Derived demand
• The demand for resources is a derived demand
• Demand for resources is ultimately determined
by the demand for the goods and services that
the resources help produce
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-11
Market restraint on freedom
• Firms are not really ‘free’ to produce what
they wish
• The demand decisions of consumers, restrict
the choice of businesses in deciding what
to produce
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-12
Organising production
Organising production in a market economy involves:
• How should resources be allocated among
specific industries?
• Which specific firms should do the producing
in each industry?
• What combinations of resources — what
technology — should each firm employ?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-13
Production and profits
• The specific firms remaining in an industry are
those employing the most efficient techniques
• Involves combining resources in the least-cost
production method
• The most efficient technique depends on
– Available technology
– The price of the needed resources
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-14
Least-cost production
• The combination of resources which results
in the lowest dollar-and-cents amount of cost
• Various techniques result in the employment
of varying quantities of resources and differing
costs
• Least-cost production or economic efficiency
entails obtaining a given output of product with
the smallest input of scare resources
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-15
Distributing total output
• Products are distributed on the basis of consumers
willingness and their ability to pay the existing
market price for a product
• Ability to pay is determined by income
• Willingness to buy is determined by consumers
preference for the product, availability of close
substitutes and their relative prices
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-16
Accommodating change
• Consumer preferences, technology and
resource supplies are always changing
requiring a reallocation of resources
• Market systems adapt through the guiding
functions of prices
• A change in relative prices act as a signal
to alter resource allocation or the distribution
of output
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-17
Initiating progress
• Competitive markets provide incentives for
technological advances — lower production
costs and economic profits
• Technological advances lead to capital
accumulation
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-18
Competition and control
• Competition is the mechanism of control
in a market-oriented system
• Forces business and resource suppliers
to respond to the wishes of consumers
• Firms and resource suppliers, seeking to further
their own self-interest and operating within the
framework of a highly competitive market system,
and guided by an invisible hand, promote the
public or social interest
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-19
A preliminary evaluation of the
market system
• A case for the market system
– Allocative efficiency
– Freedom of enterprise and choice
• A case against the market system
– Demise of competition
– Unequal income distribution
– Market failure and government intervention:
spillovers or externalities and public goods
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-20
The role of government
• The economic role of government in modern
capitalist systems has evolved, in part, to remedy
perceived shortcomings of the market system
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-21
Next chapter:
Organisation of business
in Australia
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Microeconomics 8e, by Jackson & McIver
By Muni Perumal, University of Canberra, Australia
4-22