Resource Allocation

Free market economy

Decisions about production and consumption are left to those who are willing and
able to participate in the market place
1. Private ownership of economic resources
2. Profit maximization for consumers, maximum satisfaction for consumers
3. Price mechanism determines demand and supply

What to produce: Consumer sovereignty – Consumers have the purchasing power

to dictate what goods are produced

How to produce: Cheapest method of production

For whom to produce: Consumers with purchasing power gets the goods that
have been produced

Demand – Willingness and ability of consumers to purchase

Law of Demand – The quantity demanded of a good is inversely related to its price

Change in quantity demanded – Movement along the demand curve

Change in demand – Shift of demand curve

Factors Affecting Demand

1. Household income
a. Normal goods
b. Inferior goods
2. Taste and preferences
3. Prices of related goods
a. Substitutes
b. Complements
4. Speculations
5. Population structure and size
6. Government policies
7. Climate and weather

Types of Demand
1. Individual demand
2. Market demand
3. Complimentary demand (compliments)
4. Competitive demand (substitutes)
5. Derived demand (factors of production)
6. Composite demand

Supply – Willingness and ability of producers to produce goods

Law of Supply – The quantity supplied of a good is proportional to the price of a

good
Change in quantity supplied – Movement along the supply curve

Change in supply – Shift of supply curve

Factors Affecting Supply

1. Costs of production
2. Goals of firm
3. Technological improvements
4. Government policies
5. Speculations
6. Climate and weather
7. Number of producers
8. Prices of related goods
a. Competitive supply (substitutes in production)
b. Complementary supply (complements in production)

Types of Supply
1. Individual supply
2. Market supply
3. Competitive supply
4. Complementary supply

Market Equilibrium
1. Interaction of demand and supply
2. Neither surplus nor shortage arises
3. Conditions
a. No external benefits
b. No external costs
c. Perfect information
d. Perfect competition

Consumer surplus – The excess of what a consumer is willing to pay over what he
actually pays

Producer surplus – The excess of what a producer is actually paid over what he is
willing to be paid
Elasticity of Demand
1. Price elasticity of demand – degree of responsiveness of quantity demanded to a
change in price of the good
2. Income elasticity of demand – degree of responsiveness of quantity demanded to
a change in income
3. Degree of responsiveness of quantity demanded of a good to a change in price of
another good

Price Elasticity of Demand

1. Usually a negative value due to the law of demand

2. Price elastic demand – Elasticity < -1
a. A change in price of the good brings about a more than proportionate
change in quantity demanded
3. Price inelastic demand – Elasticity > -1
a. A change in price of the good brings about a less than proportionate
change in quantity demanded
4. Unit elastic demand
a. A change in the price of the good brings about a proportionate change in
quantity demanded
5. Perfectly elastic demand
a. A change in the price of the good will bring about an infinite change in
quantity demanded
b. Horizontal demand curve
6. Perfectly inelastic demand
 a. A change in the price of the good will not bring about any change in the
quantity demanded
b. Vertical demand curve

Factors Affecting Price Inelasticity of Demand

1. Availability of substitutes
2. Proportion of income spent on good
3. Necessities vs. luxury goods
4. Time period

Price Elasticity of Demand Affecting Total Revenue

1. Elastic

2. Inelastic

3. Unit elastic
a. Loss = gain
Income Elasticity of Demand

1. Positive income elasticity

a. Rightward shift of demand curve
b. Normal and luxury goods (inelastic)
2. Negative income elasticity
a. Leftward shift of demand curve
b. Inferior goods
3. Zero income elasticity
a. Basic necessities

Cross Price Elasticity of Demand

1. Positive cross price elasticity

a. Substitutes
2. Negative cross price elasticity
a. Complements
3. Zero cross price elasticity
a. Unrelated goods

Price Elasticity of Supply

1. Price elastic supply

a. E.g. Manufactured goods
2. Price inelastic supply
a. E.g. Agricultural goods
3. Unit elastic supply
a. Straight line from origin
4. Perfectly elastic supply
a. Horizontal supply curve
5. Perfectly inelastic supply
a. Vertical supply curve

Factors Affecting Elasticity of Supply

1. Time period
2. Existence of spare capacity (short run)
3. Storage and perishability
4. Availability and mobility of factors of productions
5. Number of firms

Labour Market
· Diagrams plotted with Wages vs. Number of workers employed

Demand for Labour

1. Graphically, Demand = Marginal Revenue Product
2. Marginal Revenue Product = Marginal Physical Product x Marginal Revenue (MRP
= MPP x MR)
3. MRP – Increase in total revenue contributed by the employment of an additional
worker
4. MPP falls, MR constant

Factors Affecting Demand for Labour

1. Productivity (MPP changes)
2. Price of good (MR changes)
3. Demand for goods and services using skills offered by labour market
4. Market value of product

Elasticity of Demand for Labour

1. Degree of responsiveness of the level of employment to a change in wage levels
2. Effect of wage increase on the employment level

Factors Affecting Elasticity of Demand for Labour

1. Time period
2. Proportion of wages to total cost
3. Price elasticity of demand of products
4. Supply of substitute factors
5. Strength of economy
6. Ease of substitution of resources (e.g. labour and capital)

Supply of Labour
1. Upward sloping as more labour supply at higher wage rates

Factors Affecting Supply of Labour

1. Ease of entry of new labour
2. Population structure
3. Wages and working conditions in alternative industries

Elasticity of Supply of Labour

1. Degree of responsiveness of quantity of labour supplied to a change in wage
levels

Determination of Equilibrium Wage Rate

1. Wages paid to workers will depend on their contribution to employers’ revenue

Other Determinants of Wages

1. Minimum wage laws
2. Racial/gender discrimination
3. Influence of trade unions
4. Imperfect information

Money Market (Loanable Funds)

· Diagrams plotted with Interest Rate vs. Quantity of Loanable Funds

Demand for Loanable Funds

1. Downward sloping
a. More demand as lower interest rate → Lower cost of borrowing

Supply of Loanable Funds

1. Upward sloping
a. More savings as higher interest rate → Higher rate of returns

Currencies Market (Foreign Exchange)

· Diagrams plotted with (eg.) Price of S$ in US$ vs Quantity of S$

Demand for Currencies

1. Downward sloping
a. Lower exchange rate causes greater demand of the country’s currency to
purchase goods and services
2. Generated by:
a. Exports
b. Foreign direct investments
c. Capital inflows

Supply of Currencies
1. Upward sloping
a. Lower exchange rate causes dearer foreign goods and hence lower supply
of domestic currency to import the goods
2. Generated by:
a. Imports
b. Investment overseas
c. Capital outflows

Purpose of Indirect Taxes

1. Improve resource allocation and achieve social efficiency
2. Government revenue
Graphically, tax will cause a leftward shift of the supply curve

Burden of Tax
Supply is elastic → Burden of the tax falls more on the consumers
Supply is inelastic → Burden of the tax falls more on the producers

Purpose of Subsidies
1. Encourage consumption and production (of goods which generates positive
externalities)

Graphically, subsidy will cause a rightward shift of the supply curve

Price controls → market at disequilibrium level → persistent shortages or surpluses

Price ceiling → price below equilibrium price

Purpose of Price Ceiling

1. Prevent overcharging and allow equitable distribution of scarce product
2. Release more resources for urgent needs

Effects of Price Ceiling

1. Shortage of good
2. Black market may result

Price floor → price set above the equilibrium price

Purpose of Price Floor
1. Protect workers’ wages
2. Stabilize prices

Effects of Price Floor

1. Surplus of good produced
2. Guaranteed higher wage for employed
3. Inflated production costs and consumption prices
4. For agricultural products, surplus is bought by the government, and is an
inefficient allocation of resources