Resource Allocation in the Competitive Market

Resource allocation in a competitive market system is based on the principle of consumer sovereignty. Consumer sovereignty is where consumers, through their effective demand, determine the composition of output. In other words, what consumers want, producers will supply.

Reallocation of resources begins in the product market (the market for a good or service). If there is a change in the conditions of demand, for example, an increase in disposable income, there will be an increase in effective demand for the product. As a result, there will be an increase in the derived demand for the resources that make the product. The market for the resources is known as the factor market. As the derived demand in the factor market increases, price in the factor market will increase. As price in the factor market is the reward for employing the resources (profit), it signals to producers that producing more of the product can make supernormal profit. As a result existing producers and new producers will allocate more resources into this industry. Resources will, therefore, be allocated away from areas with low consumer demand toward areas of high consumer demand.

Many markets are related and what happens in one market can affect the actions of buyers and sellers in other markets. There will be a structure of relative prices established throughout the economy, which can be affected by changes in related markets.

If demand increases for a product, as discussed before, it has the potential to alter the allocation of resources in many associated markets.