THE ALLOCATION OF RESOURCES

THE ALLOCATION OF RESOURCES

In this particular example, as a result of changing consumer demand,
the employment of a number of specific resources was affected.
Consider, first, the small corner of land occupied by a hamburger bar
that converts to a coffee shop.
Land and Transfer Earnings
Land in the centre of any market place is usually much in demand. A
fixed SUPPLY of land in a restricted area where many traders compete
to gain control of a given site means the price of this resource is forced
up and up. Though fixed in space, this land thus becomes extremely
OCCUPATIONALLY MOBILE – it can be bought up and employed in the
service of a cafe, a retail store, a solicitor’s office, an estate agents’ or a
bank – according to whichever business is prepared to pay the
highest price. (Ever wondered why the centres of the largest business
districts are dominated by banks?)
Geographers can map the employment of land in cities going out
in concentric circles from the highest earning inner ring to progressively
less and less economically productive sites. A coffee shop
with a rapid turnover selling an attractive product to high-incomeearning
inner city employees may well earn just enough to cover
its costly OVERHEADS. Typically, however, with high rents to pay
such enterprises are run on a financial knife-edge such that any
slight change in the quality of its product or in consumer preferences
will have an immediate knock-on effect on profits and thus
the business’s long term survival as indicated above.
Land in city centres can therefore transfer its employment relatively
rapidly if it does not earn enough – which explains why so
many stores do indeed close down and reopen transformed in a new
© 2004 Tony Cleaver
guise and under new management. The same fate may also apply to
people but since individuals, unlike land, have feelings about the
work they do and can express their opinions vociferously, the allocation
and reallocation of their labour supply embraces many issues
that are not solely economic.
Labour and Wages
Nonetheless, precisely because the price and employment of labour
is such an emotive issue, we can take time here to briefly analyse
and understand the economic forces that determine outcomes in
this particular market.
Economics is a seemingly cold and cruel science that, like it or
not, treats labour just as any other resource. People will be employed
only in so far as they are productive. Generally speaking, coffee shop
assistants will be taken on if they possess the necessary skills, attitudes
and enthusiasms at a competitive price. Employment is not a
right. In a market society, any resource will only find it is in demand
if it can help produce something that consumers are willing to buy.
If this is the case, then as above, the scarcer the resource, the more it
will command a high price.
Scarcity is a relative concept. There are millions of footballers
all over the world but the supply of footballers of the specific
talents of individuals such as David Beckham are very few, relative
to the demand for their services. Hence such talent can command an
exceptional price.
Mismatch Unemployment
People can become amazingly specialised in the occupations they
perform. The degree of talent and training required to become a
professional in one employment or another varies enormously and
this in part determines the speed at which newcomers can enter any
particular labour market. Labour as an economic resource, therefore, is
divided and sub-divided into many non-competing groups. Someone
whose abilities do not match those skills in demand will thus be
unemployed – unless and until either the individual re-trains or
the jobs on offer change. For example, there may be a shortage in the
supply of accountants to balance the books of our coffee shop and
employing someone to do so may be very difficult (and therefore
© 2004 Tony Cleaver
expensive) if access to this profession is restricted. There may be a
large pool of willing and able workers who can be taken on as shop
assistants but even extensive unemployment of such labour will not
necessarily increase the supply, and bid down the price, of those
with differently honed skills and attributes. Increased specialisation
reduces the occupational mobility of labour.
Demand-Deficient Unemployment
As mentioned above, the demand for a particular specialist service is
derived from the DEMAND for its product. In the extreme, in a severe
recession, a slump in consumer spending throughout the nation means
large industrial concerns may lay off all sorts of employees – whitecollar
workers of rare skill as well as some horny-handed manual
labourers – if there is no demand for their joint product. This is largescale,
demand-deficient unemployment. Governments may thus be
petitioned to provide support for those the market no longer requires,
but this can only be a short term palliative. If demand for one type of
product has moved on then the only long-term solution is for labour to
move likewise and produce something else. If rare skills are no longer
needed, the unemployed must learn others.
Technological Unemployment
The substitutability of a specific resource also affects its price and
employment and this in turn is affected by technological change. The
development of telecommunications technology, for example, has
enabled Indian skilled labour to compete away UK and US based
service jobs. Call centres in Delhi can now replace those in Detroit or
Swindon. Similarly, the technological revolution in robotics means
there is no employment now for many assembly-line manufacturing
workers. (Note this is hardly a new phenomenon: The substitution
of labour by machines has been infamous since the time of the
nineteenth-century Luddites.)
DEMAND, SUPPLY AND THE THEORY OF PRICE
Whether it be the price of coffee, the rent on land, a worker’s wages
or the profits of an enterprise, all are a measure of the demand
© 2004 Tony Cleaver
and supply of goods and services in a market society and these
prices signal to all and sundry the relative shortages and surpluses
that exist. Not only this, they also provide incentives for market
operators to respond and remedy any imbalances. Coffee in
demand? Its price will go up to ration out existing supplies and
meanwhile tempt new producers to enter the market. Falling profits
for hamburger bars? The least efficient will close down. Accountants
are earning high wages? More will take up the training. The price
mechanism is a ruthlessly efficient organiser.
Since prices are demonstrably at the heart of all economic organisations
it should be clear by now why economists focus so
repeatedly and relentlessly on the theory of price. If we can theorise
about what exactly determines price movements it enables us not
only to explain what has happened in the past, and why, but it also
gives us a basis for predicting what will happen in the future.
One comment on theorising before we begin: Milton Friedman,
probably the most famous economist entering the twenty-first
century, has said that no matter how abstract and seemingly unreal
the assumptions on which a theory is based, ‘the only relevant test of
the validity of a hypothesis is comparison of its predictions with
experience’. As you will see, though many assumptions in economics
make perfect sense (e.g. we assume consumers and producers
behave rationally) they are not necessarily true for all time. These
assumptions do not matter so much, however. In positive economics
we are most of all concerned about whether or not a theory’s
predictions are confirmed by hard evidence. So long as it produces
workable results, even the most unrealistic hypothesis must be
taken seriously. With that in mind, let us begin with analysing
demand.
Consumer Equilibrium
Assume that all consumers wish to maximise their UTILITY, their
‘level of satisfaction’. They are thus motivated to consume that
combination of goods and services which, given their income, yields
the most utility. Individual tastes differ such that your preferred
shopping list features items totally different from mine – you
may prefer coffee and ice cream and I access to public parks and
© 2004 Tony Cleaver
footpaths – but in both cases we opt for combinations that best
satisfy our particular wants. A change in relative prices between
some goods and others or a change in our levels of income will
affect our chosen purchases but factoring in these changes we will
always adjust our consumption to maximise our total utility or
satisfaction.
Considering the demand for coffee, we can assume for the
purposes of illustration, that an individual divides his purchases
between coffee and all other goods.
Given constant prices and incomes we can represent the choices
available to this consumer in the OPPORTUNITY SET given here.
Figure 2.1 shows that if a consumer spent all his fixed income on
coffee he could afford to buy amount A. Alternatively, if he spent it
entirely on other goods he could afford amount B. He thus has the
opportunity to buy any combination of coffee and all other goods
bound by the BUDGET CONSTRAINT triangle OAB. Given this opportunity
set, the individual thus chooses that combination of goods
which best maximises his utility. Let that be at point x where he
would consume a2 of coffee and b70 of all other goods. He could
have chosen any other point along his budget constraint AB, such as
y or z, but we have said that combination x represents the highest
level of satisfaction for this individual. At this point, the consumer
is at equilibrium in the sense that he cannot rearrange his
purchases to reach a higher level of utility (Box 2.1).
Coffee
A
z
y
x
a2
All other goods
0 b70 B
Figure 2.1 Consumption alternatives: coffee and other goods.
© 2004 Tony Cleaver
Box 2.1 Mapping individual preferences: indifference curves
Economists have invented a unique way to map an individual’s
tastes and preferences on a two dimensional diagram. It is
called an indifference map and it shows lines (similar to contour
lines on a topographical map) which illustrate higher and lower
levels of satisfaction and when taken together map out the
shape of a consumer’s preferences just as contour lines map out
the shape of the land.
Consider the Figure 2.2. The map of indifference curves or
preference lines shows increasing levels of utility as consumption
of both goods increases from zero. The closer together or
further apart are the lines, the faster or slower an increase in
consumption leads to increasing utility. Any one line, however,
joins places of equal satisfaction. That is, the consumer is indifferent
between all combinations of purchases along the same
line. (Just as going up or downhill is represented by crossing
contours on a geography map, so maintaining the same level
means moving along a contour.) Thus the combination of coffee
and all other goods represented by consumption point G is
preferred to combinations E, D and C (and all are clearly
preferred to zero). But the consumer rates the combination of
goods at point F at the same level of utility as point G. He is
indifferent between these two combinations of purchases.
Figure 2.2 An indifference map.
Coffee
G
E F
C
0
All other goods
D
© 2004 Tony Cleaver
Note that another individual might have a completely different
map of preferences between the two dimensions shown. It all
depends on individual tastes.
The combination points of goods, C to G, remain unchanged
here. However we are now illustrating, in Figure 2.3, the preference
map of a coffee lover who is indifferent between points C and D.
Only by increasing coffee consumption to point E or F (again he is
indifferent as to which) does his level of utility rise. G in this case
represents the highest level of satisfaction illustrated.
Returning to the original case discussed here, where the
consumer has an opportunity set constrained by his budget to
0AB, of all the possible combinations of goods that the consumer
can choose between, which one will the individual choose?
Figure 2.3 A coffee lover’s indifference map.
Figure 2.4 Consumer equilibrium.
Coffee
A
z
y
x
a2
0 b70 B
All other goods
Coffee
G
E F
C D
0
All other goods
© 2004 Tony Cleaver
What happens now to this individual’s demand for coffee if its
price falls? Given his income, if he chose to spend it all on coffee he
could clearly buy more (represented by a move from A to C given
in Figure 2.5), though if he chose to buy no coffee at all then since
the price of no other good has changed he is still constrained to
point B. This consumer’s new set of choices made possible by the
price change is thus illustrated by the budget line CB.
Which consumption point will the consumer move to? It will be
that point which maximises his utility somewhere along the line
CB. Let that new equilibrium be point p. Note that although this
consumer’s nominal income has not changed, since the price of
Given his fixed income, he will choose that combination which
maximises his utility – that which allows him to reach the highest
level of satisfaction. That is, the combination of a2 and b70 represented
by point x, which we can now see, courtesy of this
individual’s map of preferences, in Figure 2.4 is clearly higher
than the levels of satisfaction represented by points y and z.
Coffee
C
A q
z
y p
x
a2 r
All other goods
0 b70 B
Figure 2.5 A price change.
© 2004 Tony Cleaver
coffee has fallen his REAL INCOME has risen such that he now has the
opportunity to increase his purchases of all goods as illustrated by
the additional sector ABC. According to this consumer’s preferences
he could equally choose point q or even r.
Different people have different preferences. A real coffee lover,
given the fall in price of coffee represented earlier, may choose to
Box 2.2 Diminishing marginal utility
If the price of coffee falls, exactly how much more would you buy?
Think about it. Doesn’t it depend on how much you have already,
and how much you value a bit more coffee compared to the cash
you would sacrifice in buying that bit extra? Generally speaking, if
you have already bought a lot of something, the increase in total
utility you would gain by buying more of it would be relatively
little. That is, your marginal utility has diminished. The more you
have something, the less you want more of it.
This important principle is true for all goods and services
consumed. Some people’s marginal utility diminishes more
slowly than others, however. A chocoholic, for example, will no
doubt be keener to consume more and more chocolate bars than
I will, but even an addict will find that the first item consumed
increases his total utility by more than that gained from the last
item consumed.
Given a price fall for a given product, an individual will
increase consumption until his marginal utility diminishes to
just equal its price – that is, the value of the cash that could be
spent on all other goods. Suppose this week, King Size Deep
Pan-fried Pizzas are on special offer: each one for £1. Assuming
you like these things, wouldn’t you buy more . . . up until the
point where the sacrifice of £1 (which you could spend on all
other things) is not worth it? The extra or marginal utility to be
gained from one more pizza purchase is now adjudged to be
less than the value of its price. Whether you knew it or not, you
have just reached ‘consumer equilibrium’ – where the marginal
utility per pound (or MU/£) on one item in your shopping list is
equal to that for all other items.
© 2004 Tony Cleaver
move from consumption point x to point q. That is, he or she may
choose to consume much more coffee and actually buy less of all
other goods. Alternatively at point r there is illustrated the option
of buying the same amount or even less coffee and buying more of
other things. Point p represents the choice to buy more coffee as its
price falls, all other purchases remaining the same.
The analysis in Box 2.2 illustrates all the options open to one
consumer. Summarising, we can say that a price fall of any one
good that features in an individual’s regular shopping list represents
not only the opportunity to increase purchases of that good
itself but also, since it represents a marginal change in REAL INCOME,
it opens the opportunity to alter purchases of other goods as well.
The more a certain good takes up an important slice of a person’s
budget, however, the more its price change will affect that individual’s
overall pattern of purchases.