Resource Allocation

Supply and Demand Factors – Further Analysis

The previous pages have explored one way of examining the impact of supply and demand factors on the efficiency with which resources are allocated. A different approach may help us to clarify this even further. This time, instead of using supply and demand graphs, we will look at the Production Possibility Frontier.

Imagine that we have a country that is able to produce either goods or services. However, the resources available to this country are limited, and so they must make choices about how many goods they will make, and which services will be provided. For this country, the production possibility frontier may look something like this:

From this graph, we can see that each time the country “gives up” some goods, they are able to gain the production of some services. The goods given up will be the opportunity cost, but some new services will be gained. We can also conclude that if the country is producing at point A, then they are being inefficient – they could be producing more goods AND more services. At point B the country is efficient, but they could choose to CHANGE the mix of goods and services. And point C is not currently possible – there are not enough resources available to produce that many goods and services.

Now let’s imagine that something in the economy changes. For example, imagine that the economy finds some new resources. What would happen to the production possibility frontier in this case?

In this case, we can see that the curve has moved out to the right – with more resources this country is able to have more goods AND more services – point C is now possible, while point B would now be considered inefficient.

In fact, we can say that any increase in aggregate supply will lead to the production possibility frontier moving to the right. Therefore we can conclude that any increase in aggregate supply will lead to a more efficient allocation of resources.

We can also use this model to help us to understand the impact of a change in demand factors. Using our original model, let’s now imagine that there is an increase in the demand for services. Assuming that the economy was originally operating at point B, what would this do to the production possibility frontier?

The answer is that the curve would not move at all. However, we might move to a new point on the curve – in the diagram below, we may move from point B to point D due to the change in demand.

Does this mean that we are allocating resources more efficiently? Not really – we are just allocating them differently. That may mean that we are increasing our allocative efficiency, but only if we are responding to a market that is operating freely (as opposed to one that is enduring decisions that are being made by those who have too much market power). Inefficiencies could arise if the dynamic efficiency of the country is poor, and so the response to this change is slow. This would mean that pressure could be placed on the original level of production of services (leading to inflation), while those producing goods may become unemployed. As discussed earlier, these are signs of inefficiency within the economy.

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