Micro Lecture 1: Scarcity and Allocation Mechanisms

Introduction
Every textbook begins with a definition of economics. While the precise words differ, all more or less recite the
following:
Textbook Definition of Economics: The study of how society allocates its scarce resources and the goods
those resources produce.
No doubt you understand the meaning of each individual word; nevertheless, I suspect that you are still not
certain about the real meaning of the textbook definition. The purpose of this lecture is to provide you with a
common sense understanding of the textbook definition.

A’s in Introductory Economics

Yesterday our college president visited our introductory economics staff meeting and issued the following edict
in an effect to fight grade inflation:
President Martin: “Only 5 A’s can be awarded in each introductory economics section.”
I want to report that each of us teaching a section of Economics 111 pleaded vehemently that 5 A’s per section
were far too few and in fact argued that each of you deserve an A. But the president is the president and we
have no choice but to follow her orders. What are the ramifications of this?

Well, there are about 30 students in our section.

Question: How many of you would like to have an A?
Answer: All 30 of you.
We have a problem, don’t we? More students want an A than the number that we can award, the number that
are possible. Economists call this problem scarcity.

30 A’s are wanted 5 A’s are possible

 
Wants exceed Possibilities

Scarcity exists
What we have just observed with A's is one small illustration of the pervasive phenomenon of scarcity.

The Economics Problem: Scarcity

It takes only a little imagination to illustrate how widespread the phenomenon of scarcity is. Just make a list of
all the things that you would like to have. I suspect that your dorm room is rather small. Wouldn’t it be nice to
have a larger dorm room? Or better yet, an apartment? Or even better, what about a house? Do you want a
small house with only one bedroom - no, wouldn't it be nice to have a large house perhaps a mansion with
beautifully manicured grounds would do, so that you could live in the luxury you deserve? Your mansion
would have a swimming pool. I suspect that you would want two swimming pools - one outdoor pool for the
summer and one indoor pool for the remainder of the year. Similarly, you would want both indoor and outdoor
tennis courts. Such a large estate demands care; you would certainly want a staff to maintain the property. You
would want housekeepers, gardeners, chefs, etc.

You also now want a car. Do you want a used Kia Rio? Not really, one of the new Porsche Boxsters would be
much better, won’t it? Perhaps a 911 Turbo S would be even better. But a Porsche only seats two. In addition
to the new Porsche, it would be nice to have a larger car also because I suspect that you will many friends who
will want to visit you. Perhaps a Mercedes SLS would do, or better still, why not a Rolls Royce? Of course,
you naturally will want a chauffeur because it is a little tacky to drive your own Rolls.

The point I am trying to make is that your list of wants, your wish list, so to speak, would be very, very long
indeed. When we combined the wish lists of all Americans, we would have an astronomically long list of
wants. Even though our economy produces trillions of dollars of goods and services each year, our factories
cannot begin to satisfy all the wants of every American consumer. Figure 1.1 illustrates this well. Scarcity
exists because our wants exceed the possibilities.
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Wish List – Wants Possibilities

Our collective wish list is __________ Resources
______________________ 
_________ Possibilities

Figure 1.1: Scarcity – Wants exceeds possibilities

Question: How do we resolve the problem of scarcity?

Coping with Scarcity: Allocation Mechanisms

Every economy, rich or poor, industrialized or developing, faces this problem of scarcity. It is impossible to
satisfy all consumer wants. Therefore, a mechanism must be devised to determine which particular wants will
be met and which will go unmet. Economists have a fancy term for such mechanisms; we call them allocation
mechanisms.

While every economy faces the problem of scarcity, different economies use different allocation mechanisms to
resolve the problem. For most of last century, the former Soviet Union used a method called central planning to
make many of their production decisions. The central planners in Moscow decided explicitly on the number of
automobiles, refrigerators, etc. to produce. As we will see in the upcoming week, our economy makes
extensive use of a different mechanism, markets.

But we are getting far afield. Let us return to the more immediate problem of scarcity that we face in
introductory economics. How are we going to decide which of you will receive one of the 5 A's? We need an
allocation mechanism  a procedure to decide which of you will receive the A you want which of you will not.
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Allocation Mechanisms

Allocation Mechanism: Performance – Average of Exams Scores, Quiz Scores, Assignments, etc.
Prior to yesterday’s meeting, I had assumed that we would use the traditional allocation mechanism. We
calculate a weighted average of everyone's performance on the exams, quizzes, assignments, etc. as
outlined on your course syllabus. The 5 students who have the highest 5 averages, receive the 5 A's.

Performance = Average of exams, quizzes, assignments, etc.

 Who would get the 5 A’s?
Those who earn the highest scores on the quizzes, examinations, assignments, etc. receive one
of the 5 A’s.
 Ramifications
You will have to take exams and we faculty would have to grade them.
 Incentives
It provides each of you with an incentive to study hard and master the material. Presumably,
this is why you enrolled in this course after all, to learn some economics.

At our meeting yesterday, Professor Honig suggested that we should explore other allocation schemes. He
argued that we have always used this scheme and he’s bored with it. Why not be more innovative? After
all, students do not like taking exams. Up to this point, no one found his argument very persuasive, but
then he reminded us how boring grading is. Reading a large number of answers to the same question
becomes extremely tedious. Suddenly, all of us became very interested in exploring alternatives.

Allocation Mechanism: Queue – First Students Arriving at the Economics Department Office
Professor Baisa was the first to offer a suggestion. He suggested the following. Keep all of you in this
room until the end of the class. After that time, you are free to leave as quickly as you like. The first 5
students to line up outside Converse 306, the economics department office, will receive the 5 A's.

Before you dismiss this allocation scheme as completely frivolous, allow me to point out that queues have
been used in the real world for goods far more important than A's in introductory economics. In particular,
the former Soviet Union made extensive use of queues to allocate consumer goods among households.
Soviet consumers had to wait in long lines to buy meat, vegetables, clothes, etc. Sometimes after waiting
hours, a Soviet citizen would finally arrive at the meat counter only to discover that there was no more
meat available. The long wait was in vain. Similarly, Soviet citizens had to sign up on a queue to buy a
refrigerator, washing machine, automobile, etc. It typically took months or even years get to the head of
the queue and receive the good. So do not make the mistake of dismissing this allocation mechanism as
frivolous.
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 Who would get the 5 A’s?

Those near the exits would have an advantage. Those who are familiar with the layout of
Converse; that is, those who know where the stairwells are would have an advantage. Also,
those who knew exactly where Converse 306 is located would have an edge. Those who can
run fast would also have an advantage during the mad dash.
 Ramifications
There would be some benefits with this approach. You would not have to take exams,
quizzes, etc. and we would not have to grade them.

Other people not associated with Economics 111 could also be affected: those people who
happen to be strolling casually up the stairs. Those poor souls would suddenly be faced with
a mass of humanity, you 30 frenzied Economics 111 students, stampeding toward the
department office. This could be dangerous.
 Incentives
Unfortunately, it would not give you an incentive to study hard and learn the material.
Consequently, when this flaw became apparent, Professor Baisa withdrew his proposal.

Allocation Mechanism: Random – A Lottery

Professor Sims then suggested a different mechanism. Write each student's name on a slip of paper. Place
the slips in a glass fish bowl. Thoroughly mix the slips and then draw them out one by one. The first 5
names drawn receive the 5 A's.

Before you dismiss this scheme as frivolous, let me point out that this mechanism is also used in the real
world. The most obvious examples are state lotteries. The lottery winner is chosen at random when a
series of numbers is drawn. Similarly, room draw at Amherst College uses this mechanism to decide who
gets which dorm rooms.

There are also other examples. Back in the dark ages, when I was a student in college, the Vietnam War
was raging. For some strange reason, the U.S. Army did not have enough volunteers to fill its ranks. So the
government drafted 18 year old men to fill the position of U.S. Army privates. A government agency, the
Selective Service Agency, was charged with the responsibility to draft 18 year old men. One method that
the Selective Service used went like this. On January 1, one slip of paper for each day of the year was
place in a large fish bowl. After thoroughly mixing the slips, they drew each slip of paper, one by one,
from the bowl. All 18 year olds with a birthday on the first date drawn would be drafted first. Then, the
Selective Service moved on to the second date drawn and so on. In the typically year, the Army received
the requisite number of privates after going through about 200 dates. In other words, the government used
a random draw to decide who would be drafted into the Army and who would not. I mention this just to
point out that this scheme is not as silly as it first sounds.
 Who would get the 5 A’s?
Those of you who are lucky receive the A’s.
 Ramifications
What are the benefits of this approach? You would not have to take exams and we would not
have to grade them.
 Incentives
But once again, it would not give you an incentive to study hard and learn the material. So, we
rejected this mechanism.
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Allocation Mechanism: Improvement

Professor Ishii then suggested another mechanism. He suggested that we give you an exam today and
record you score. Then in December, we would subtract the score on today’s exam from your weighted
average on the exams, quizzes, etc. This would measure your improvement:

Average of quizzes, Score on

Improvement = 
exams, etc. today’s exam

The 5 students who showed the most improvement would receive the 5 A's.
 Who would get the 5 A’s?
Those of you who improved the most receive the A’s.
 Ramifications
You would have to take exams and we would have to grade them.
 Incentives
After the exam today, each of you would have an incentive to study hard and learn the
material. By doing so, you would earn higher scores on your future exams, quizzes, etc.

But what are your incentives for today’s exam? By answering a question correctly today, you
will be making it more difficult for yourself to get an A because today’s score is subtracted.
After a few moments of thought, I believe that each of you would realize this. If you
answered a question correctly today, it would hurt your ability of getting 1 of the 5 A’s. This
allocation mechanism provides you with perverse incentives.

The only sensible thing for you to do today would be to turn in a completely blank answer
book. Each of you would score a zero and in effect this would be the same allocation
mechanism as the first.
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Allocation Mechanism: Market – Supply and Demand

Professor Rabinovich then made one last suggestion; he proposed that we use a market. After all, in the
U.S. we use markets extensively to cope with the scarcity problem. Furthermore, in the last couple
decades, markets have become increasingly popular. The former republics of the Soviet Union have
embraced markets, as well as China and Eastern Europe.

So let us investigate the consequences of using a market to allocate the 5 A's among Economics 111
students.

We often illustrate a market with a diagram: Price ($ per A)

The price is placed on the vertical axis and the quantity S
on the horizontal axis. There are two parts of every
market: supply and demand.

Supply is easy in this case. As a consequence of the

President Martin's directive, there are 5 A's available.
The supply curve is vertical at the quantity of 5 as
illustrated in figure 1.2.

5 Quantity (A’s)
Figure 1.2: Supply curve for A’s

What about demand? To determine what the demand

Price ($ per A)
curve looks like, allow me to ask you a few questions.
How many of you would buy an A,
if the price were $1? ______
if the price were $10? ______
if the price were $100? ______
if the price were $1,000? ______
if the price were $10,000? ______

What do we observe? As the price increases, the quantity

demanded decreases. As shown in figure 1.3, the demand
curve is downward sloping.

Quantity (A’s)
Figure 1.3: Demand curve for A’s
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Figure 1.4 illustrates the equilibrium by superimposing Price ($ per A)

the two curves on a single graph. Whenever the price is at S
its equilibrium, the quantity of A’s demanded equals the
quantity of A’s supplied. From counting your raised
hands, I believe that the equilibrium price would be about
$100. Exactly 5 of you would purchase an A, if the price 100
were $100; hence, $100 would be the equilibrium price of
an A.
 Who would get the 5 A’s?
Those who are willing to pay $100 or more:
exactly 5 of you would receive an A.
 Ramifications
You would not have to take exams and we D
would not have to grade them.
5 Quantity (A’s)
Those who have higher incomes would have Figure 1.4: Market for A’s
a clear advantage.

Other factors would also play a role, however. Those who value an A highly would be
more likely to purchase one:
o Those of you who plan to major in economics would probably be willing to pay
more than those who were not planning to major.
o Those taking the course pass/fail would probably not be willing to pay much for
an A because a B or C or even a D is just as good for a pass/fail student.
 Incentives
This would not give you an incentive to study hard and learn the material.

Of course, I trust it is clear that my description of our staff meeting was fictitious. I hope, however, that our
discussion of A’s in Economics 111 makes the notion of scarcity and markets a little less abstract, a little less
“textbookish.” Hopefully, you now have a more concrete notion of what economists mean by the scarcity.
Every economy faces the problem of scarcity and every economy addresses the problem by using an allocation
mechanism.

In the U.S., we primarily use markets as the allocation mechanism. In the next few weeks, we will begin our
study of markets by focusing on demand and supply curves. We will see how the notions of demand and supply
allow us to gain insights into how the U.S. economy works.

Summary
 Scarcity exists in all economies; that is, wants exceed possibilities.
 Different economies have used different allocation mechanisms to cope with scarcity.
 Allocation mechanisms affect incentives and incentives are important.
 Our economy relies extensively on markets.
 There are two parts to a market: supply and demand.
 In equilibrium, the quantity supplied equals the quantity demanded.