4-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Chapter 4

Allocation and the market system

4-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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?

4-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Profits (or losses)Determined by: • Total revenue received by the firm from

the sale of a product• Total costs of producing that product

4-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Organising productionOrganising 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?

4-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Initiating progress• Competitive markets provide incentives for

technological advances — lower production costs and economic profits

• Technological advances lead to capital accumulation

4-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

4-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Next chapter:

Organisation of business in Australia