Question

“How to allocate limited resources in an efficient way (as emphasized in an introductory economics course)?” [Hint: One useful starting point is the role of NPV (decision rule) in addressing the resource allocation issue.]

Answer 1

Allocation of limited resources in an efficient way:

Economics has always stressed on the need to judiciously utilise the limited resources that mankind has at their disposal. With multiple investment opportunities at hand, the amount of funds required by an investor can be huge if he wishes to invest in all profitable projects. Hence, to strike a balance between risk and return and at the same time, taking care of budget constraints, investors must implement resource allocation techniques and use capital budegting tools to effectively allocate the limited resources and earn maximum returns.

Net Present Value (NPV) technique is one way to select the investments for funds allocation. It refers to the difference between PV of cash inflows and PV of cash outflows. If the NPV is positive, then the project has positive investment ooportunities and hence should be taken up. If there is no scarcity of resources, then the Firm can take up all projects with positive NPV, whereas in case of limited resources, take up the highest NPV projects which can be financed via limited resources.

Payback Period is another method in capital budegting which does not use time value of money. It is the no. of yrs required to cover the initial investment in the form of annual cash inflows. Formula: Initial investment/Annual cash inflows. The lower the payback period, the better the project, however other factors like higher returns should also be taken into account. This method can also be used to rank projects and allocate limited resources.

Profitability Index is ratio of PV of future cash inflows to the initial investment. The higher the PI, the better the project. Again, investors can use this method to rank the projects and take them up as per resource avalability.