AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/1/1-2)
Unit 1 · Topic 1.2
1.2 Resource Allocation and Economic Systems
Every society has to answer the same three questions: what to produce, how to produce it, and who gets it. Economic systems differ in who answers those questions, the government or buyers and sellers in markets. Most real economies mix the two.
Key terms
- resource allocation
- command economy
- market economy
- mixed economy
- property rights
The three basic questions
Because resources are scarce, every society has to make three decisions:
- What to produce: which goods and services, and how much of each.
- How to produce: which combination of land, labor, capital and entrepreneurship, and which technology.
- For whom to produce: who gets the goods and services once they're made.
Command economies
In a command economy, the government owns most of the resources and central planners answer the three questions. They set production targets, assign workers and set prices. The goal is often to steer resources toward priorities like heavy industry or defense, or to spread goods more evenly.
The main weakness is information and incentives. Planners can't know what millions of people want or what every input costs, so they tend to produce too much of some things and too little of others. Long lines and empty shelves are common. Workers and managers also have less reason to work hard or innovate when they can't keep the rewards.
Market economies
In a market economy, individuals and private firms own most resources and make their own choices. Prices answer the three questions. If people want more of a good, its price rises, which tells producers to make more of it. Firms choose the cheapest way to produce because that raises their profit. Goods go to people who are willing and able to pay for them.
Markets rely on property rights: the legal right to own, use and sell things. If you couldn't be sure you'd keep what you earn or build, you'd have little reason to work, save or invest. Clear, enforced property rights are what make trade and investment worthwhile, which is why governments in market economies still run courts and enforce contracts.
The weakness of a pure market system is that it can leave some people with very little, and it can under-produce things like national defense or over-produce things like pollution. You'll study those market failures in Unit 6.
Mixed economies
No real country is purely one type. A mixed economy uses markets for most decisions but gives the government a role: enforcing property rights, providing public goods such as roads, regulating some industries and redistributing income through taxes and transfers. Countries differ in the mix. The United States leans heavily toward markets, while some other countries have larger government roles in health care or energy.
| Question | Command economy | Market economy |
|---|---|---|
| Who owns resources? | Mostly the government | Mostly individuals and firms |
| Who decides what to make? | Central planners | Buyers and sellers through prices |
| How are goods distributed? | By plan or rationing | By willingness and ability to pay |
| Main strength | Can direct resources to set goals | Prices carry information; strong incentives |
| Main weakness | Poor information and weak incentives | Inequality and some market failures |
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Identifying the system from a scenario
In Country Z, a government ministry decides how many tractors each factory will build next year and sets the price of bread. Farmers may sell any extra vegetables they grow at local markets at whatever price buyers will pay. What kind of economy is this, and which of the three questions does each part answer?
Show the solutionHide the solution
- Step 1: The ministry setting tractor output answers 'what to produce' by plan: a command feature.
- Step 2: Setting the price of bread decides 'for whom' by government rule instead of by market price: also a command feature.
- Step 3: Farmers selling extra vegetables at prices buyers agree to lets prices decide what is produced and who gets it: a market feature.
- Step 4: Since both features exist, the economy is mixed, leaning toward command.
Answer: A mixed economy that leans toward command; planners answer most what-to-produce and for-whom questions, while the vegetable market uses prices.
Common mistakes
- Saying a market economy has no government. Markets depend on the government to define and enforce property rights and contracts.
- Thinking a command economy avoids scarcity. Scarcity exists in every system; systems differ only in how they decide who gets what.
- Forgetting the incentive argument. A strong answer about why markets allocate well mentions both price signals (information) and the chance to keep profits (incentives).
On the exam
- Questions usually ask you to match a feature (central planning, price signals, private property) to an economic system, or to explain why secure property rights encourage investment.
- If a question asks how a market economy decides what to produce, answer with prices and profit: rising prices signal producers to make more.
Connected topics
Videos
Check yourself
4 questions on 1.2 Resource Allocation and Economic Systems. Pick an answer to see if you got it, and why.
In a market economy, the question of what goods to produce is answered mainly by
Which of the following is most characteristic of a command economy?
Most countries today are described as mixed economies because
Clearly defined and enforced property rights are important in a market economy mainly because they
0 of 4 answered