Question below?

Question

Suppose the demand for bagels rises dramatically while the demand for breakfast cereal falls. Briefly, explain how the competitive market economy will make the needed adjustments to reestablish an efficient allocation of society’s scarce resources.

Answer 1

You are taking about demand, supply and prices. Price is the mechanism used by the market economy to allocate resources efficiently.

If the demand for bagels rises that means the demand curve for bagels shifts outwards to the right. This means it will now cut the supply curve at a higher point implying a higher equilibrium price and quantity. A higher price means larger profits (other things remaining constant)

At the same time the demand for breakfast cereal falls. This means the demand curve for breakfast cereal shifts downwards to the left, thereby cutting the supply curve at a lower equilibrium price and quantity. Lower price means smaller profits.

The higher profits in the bagel market will now attract some suppliers and resources from the cereal market where profits have fallen. In other words some of the resources formerly used to produce cereal will now be used to produce bagels.

The result will be that the supply of bagels will increase and the supply curve will shift outwards intersecting the demand curve at lower and lower prices. The price of bagels will fall to the point where profits are normal once again although the equilibrium quantity would have increased.

As suppliers and resources leave the cereal market, the supply curve for cereal shifts leftwards cutting the demand curve at increasingly higher equilibrium prices until normal profits are restored. The equilibrium quantity however would have decreased.

The changes in the respective prices therefore caused resources to be re-allocated from producing cereal to producing bagels in accordance with the changes in demand. Remember the price mechanism is what Adam Smith called the "invisible hand" in the market economy that is responsible for the allocation and the re-allocation of resources.

Answer 2

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