CHAPTER 1
THE PROBLEM AND ITS BACKGROUND

1.1 Introduction

The basic problem of an economic society is to allocate resources among the members of the society so as to maximize the welfare of the society as a whole. To achieve this welfare objective, each resource should be used to perform the functions by which it contributes most efficiently to society. In a market economy, the price system allocates these resources. That is, prices furnish the guideposts that indicate how resources should be used. Prices determine what products and services should be produced and in what amounts. Prices determine how these products and services should be produced. And prices determine for whom the products and services should be produced. Thus prices affect both incomes and spending behavior. For the consumer with a given income level, prices influence what to buy and how much of each product to buy. For business firms, profits are determined by the difference between revenues and costs, with revenues determined by multiplying price per unit sold by the number of units sold. Price changes also play a major role in a market economy. When the quantity demanded for a product or service is greater than the supply available, buyers bid the price up. If costs remain the same per unit sold, the higher price leads to greater profits and an incentive to invest in resources to produce even greater quantities of the product. Thus, the producers are able to bid more for raw material resources, thereby directing resources into their industry. In addition, higher prices may also stimulate a greater rate of innovation and the development of new technology. On the other hand, if available supply is greater than demand, pressures build to decrease prices and reduce output. These pressures lead producers to convert their resources to alternative uses. Thus, rising prices direct resources to the