Economic Systems Ms.A.

Cassar

✓ Production consists of all those activities that provide the goods and
services to satisfy wants.
✓ Human wants are unlimited but resources are limited. The resources
available to people are not enough to satisfy their wants.
✓ Therefore, people have to make a choice that means deciding between
various actions because we cannot have everything we want. Scarcity
brings the problem of choice!
✓ What we sacrifice when choosing something is known as opportunity cost
(producing more of one thing necessitates producing less of another.)

From the basic economic concepts of scarcity, choice, opportunity cost and
economic and free goods, we derive three basic economic problems that all
societies have to face, these are:

✓ What commodities to produce and in what quantities (What)

✓ How to produce (How)
✓ For whom to produce (For whom)

Are the various ways societies decided to answer the three basic economic
questions of what, how and from whom.

There are 3 systems: at one extreme, there is the free market economy, where
there is a very limited role of the government. At the other end, there is the
command economy, where the government takes virtually total control. These two
extremes are highly unrealistic. Just about every economy in the world is a mix of
the two, and is, therefore called a mixed economy. The question is what is the
degree of mix?

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Command M I X E D E C O N O M I E S Market
Economy Economy

Command economy and Market economy as extremes with Mixed economies in between.

1. A free market economy

Characteristics of this system

 Ownership: nearly all of the country’s factors of production are privately

owned. Although it might make sense to argue that firms own some of the
resources, it is private individuals, or groups of individuals, who own the
resources. They then rent them out to the firms so that they can produce
the goods and services. Richard Branson is in charge of Virgin, but primarily
he is a private individual who owns the majority of the shares. He could get
someone else to run the company. This brings into play one of the
government’s limited roles. Through the legal system, the government must
uphold the property rights of these individuals.
 Objectives: everyone in this system is motivated by pure self-interest.
Consumers maximize welfare, firms maximize profits and the private
individuals, who own the factors of production, aim to maximize rents (on
land), wages (on labor), interest and profit (on capital).
 Free enterprise: firms can sell anything they want. They effectively
respond to the consumers, who are allowed to buy anything that is old by the
producers. Workers can take any job they want.
 The level of competition: Very high. It is assumed that nearly every
market is a perfectly competitive one, with numerous buyers and sellers and
no barriers to entry or exit. Firms are competing desperately for
customers and the consumers are competing with each other for the goods
on offer.
 The pricing system: nearly all markets are perfectly competitive. You may
remember that in these circumstances, the price mechanism allocates the
economy’s resources. The reason why it is called the ‘price’ mechanism is
that the price acts as a signal and an incentive for producers to act in the

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required way to maximize their gain, which, in turn, optimizes the allocation
of resources in the whole economy.
 What will be produced? You might think that the firms decide what is
finally produced. In a free market economy, the consumer has all the power.
Consumer sovereignty exists. A firm will only produce a good if the
consumer is prepared to buy it. Through their purchases, consumers
effectively dictate to the firms what should be produced. If consumers, on
mass, stop buying shandy (perhaps they prefer drinking lager) then the
producers (the brewers) would stop making it. Therefore, the answer to the
question is, ‘whatever the consumers want’.
 How will it be produced? The simple answer is, ‘the firms’. However, there
is more to this question that that. ‘How’ also means ‘how well’. Due to the
highly competitive environment that exists, there will be pressure on firms
to produce goods as efficiently as possible and keep their process as low as
possible. As we said earlier, most industries will be perfectly competitive, so
in the long run firms should be both productively efficient and alloctively
efficient.
 For whom will it be produced? In other words, who actually ends up
consuming the goods that are produced? Well, we said earlier that
consumers’ money votes determine what is actually produced. However, it
will also determine what consumers can actually buy. Those with more money
will be able to consume mote of the goods produced. Who has the most
money? The rich, of course, but why are they rich? For some, it is
inherited wealth; earning high incomes form the sales of the factors of
production that they own (renting land and making profit and interest from
capital).
For others, who inherited nothing, their wealth may come from the
successful sale of their labor services. David Beckham came from nothing,
but he is able to sell his labor services (kicking a football) for tens of
thousands of pounds a week!
Of course, in this system, if you have nothing and you do not have
marketable labor skills (for most people this will be a good education), and
then you will remain poor. The free market system tends to create an unfair

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distribution of income. The wealthy consume a disproportionately large

share of what is produced.

2. A command economy
As with the free market system, before we look at how the three questions are
answered, we must quickly look at some of the characteristics of a command
economy. Remember that, in complete contrast of the free market economy, a
command economy has a very powerful government sector (or ‘planners’) and the
workers and consumers are subordinate.

Characteristics of this system:

 Ownership: nearly all of the country’s factors of production are owned by
the government (or state). The only factor over which the government does
not have total control is labor, but as you will see, they certainly have
indirect control over the workers.
 Objectives: the complete opposite of the pure self-interest of the free
market system. No one (in theory) thinks of himself. Consumers, workers
and the government are all assumed to be working for the ‘common good’.
This system is often associated with communist Soviet Union (as it was
before 1989), but the fascist Hitler ran a ‘planned’ economy, albeit rather
dictatorially. Also, democratic countries often attempt a less severe form
of planned economy via socialism.
 Free enterprise: there is none.
 The level of competition: very little, certainly, in the former Soviet Union,
black markets used to develop because of shortages in the shops. But in
theory there was no competition.
 The pricing system: there is no competition, so there is no price mechanism.
The authorities set the prices. It is because they set prices at low levels to
make sure that authorities can afford the goods that excess demand occur
causing long queues for goods outside shops. Another inevitable consequence
is the creation of black markets.
 The planning system: this is an extra characteristic of the command
economy. The other five has tried to follow the five given in the ‘free

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market economy’ section. As the government runs the system, they have the
job of planning how all the resources should be used. They have to decide
what should be produced and in what quantities. They must decide how the
goods are to be made. What labor should be used and where? What
techniques of production shall we use? How will the completed goods be
divided between the workers (consumers)? The key point is that they
directly set the output levels and price levels.
 What, how and for whom? In a command economy the brief answer to all
three questions is, ‘It’s up to the planners’.
 What will be produced? The consumer no longer has any control. The
planners (or the government) decide what will be produced. The question is,
how do the planners know what the consumers want and need better than
the consumers themselves?
 How will it be produced? There are no such things as ‘firms’ in a planned
economy. The planners direct the resources into producing ‘units’. They are
not really firms. They have no autonomy. So, as we said above, the planners
decide on the quantities of output and methods of production.
 For whom will it be produced? In the free market, the richer you were,
the more you could buy. Of course, very poor people could end up with very
little. The planner tires to be fair in distributing output of the economy.
Wages are determined by the planners, as are the prices of the goods
produced. So the government is, effectively, determining how much each
consumer can consume.

3. A mixed economy
A mixed economy is one that is a mix of the two extremes above. Below is a
list of the characteristics of these economies. It should be noted, though,
that a ‘mixed economy’ could mean anything depending on the degree of mix.
For this reason, it is difficult to answer the ‘three questions’ specifically.

Characteristics of this system

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 Ownership: the government owns some of the country’s factors of

production publicly and some are owned privately.
 Objectives: Again, a combination of the two extremes. The market part of
the economy will be motivated by self-interest. Firms will profit maximize,
consumers will maximize their welfare and the factor owners will maximize
rent, interest and profit. The government, again, has the ‘common good’ goal.
We will see what that entails later.
 Free enterprise: only in the free market part of the economy (the private
sector)
 The level of competition: again, the private sector can be quite competitive.
It depends on the market structure that prevails in the various industries.
In the real world few industries are perfectly competitive. Governments do
tend to set up bodies, though, whose job is to make sure that industries do
not become too uncompetitive (The Competition Commission and the Office
of Fair Trading).
 The pricing system: the price mechanism operates in the private sector.
Its efficiency depends on how competitive the market structures are. The
government runs activities, like the health care and education; these tend to
be provided free at the point of use, although there are some charges even
in these areas (paying for prescriptions).

We shall look at the advantage and disadvantages of free market systems. As you
will see, the advantages of free market economies can be easily turned to become
disadvantages of command economies. Equally, the disadvantages of free market
systems often highlight advantages of command economies.

The advantages of a free market economy (and the disadvantages of command

economies)

1. Efficiency: free market economies are very competitive. Most of their

industries are assumed perfectly competitive and so allocative and
productive efficiency will occur. It makes sense that free market economies
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allocate their resources are efficiently. Decisions about what to produce

are made by the people who actually consume the goods. Planners are less
likely to make the correct decisions across the whole economy.
2. Choice: firms will produce whatever consumers are prepared to buy.
Remember that the consumer is sovereign. Due to the free enterprise
factor, there are no restrictions on what the firms can produce. It is of no
surprise, therefore, that there will be a much larger choice of goods and
services in a free market economy compared with a command economy. The
planner will be more concerned with making sure there are enough essential
goods to go around rather than allocating resources efficiently between all
goods.
3. Innovation: firms will always be looking to produce something new to get
ahead of their competitors. We said earlier that, even though the
government’s role is limited, one of its jobs is to protect property rights.
This will include intellectual property rights through patents. Hence, there
are incentives in the free market system for firms to be innovative and
produce better quality products. Obviously, there is no incentive for the
planner to be innovative. As long as they produce the essentials, the
planners will be happy.
4. Higher economic growth rates: one does not have to be an expert economic
historian to see that countries whose economic system has been nearer to
the free market model have grown much faster than those with a command
economy since the Second World War. The most successful economy in the
world (in terms of size) has been the USA, and they have been one of the
freest economies in the world. Given the three factors above, it is not
surprising that this is the case. It should be noted that many mixed
economies have grown quite well, but certainly the post-war command
economies gad the worst record.

The disadvantages of a free market economy (and the advantages of command

economies)

1. Public, merit and demerit goods. Public goods cannot be provided

privately because of their two characteristics, non-diminish ability and

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non-excludability. These goods have to be provided publicly. Even in a

very free market, one of the governments’s few roles will be it provide
defense, for example. However, there may be a problem with merit goods
and demerit goods. Merit goods, like health and education, tend to be
under provided in a free market. Certainly in the USA the public health
system is a ‘last resort’ system. People are advised to buy health insurance.
Of course, the poor might not be able to afford this, and some people might
simply decide not to bother if they feel particularly healthy. Demerit goods
are bad for you. Government should ban a class drugs, and tax cigarettes
and alcohol heavily. A government with a limited role might not take enough
action in this area, causing health problem in the economy.
Of course, the advantage of a command economy is that the strong
government will make sure that public and merit goods are consumed at the
right levels and that demerit goods are banned or taxed heavily.

2. Unequal distribution of income: for many, this is the big disadvantage of a

free market economy. In a free market with very limited government,
benefits will be low, the health service poor and schools under funded. If
you start life with very little, and do not even get a good education, then
there will be very little protection from poverty. A command economy might
not have the efficiency and enterprise for the successful to make millions,
but at least the strong government will try to make sure that nobody falls
through the safety net. It will be a fairer economy, even though it is likely
to be less successful overall.
3. The environment: free market economies are likely to produce more
pollution, which is bad for the environment. Command economies can make
sure that the production processes that they chose are as environmentally
friendly as possible. They should be able to make sure that the level of
output is the socially optimal level of output.
Governments can try to force firms into producing the socially optimal level
of output with taxes, but governments with a limited role will not be keen to
use taxes. Although the tax on petrol is high in the UK, it still does not
cover the problems caused by the exhaust emissions (in health as well as the

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environment). Petrol prices have risen, but in real terms, the rise has not
been as high as for bus and rail fares. In the USA, petrol is ridiculously
cheap. The minimal tax on the good does not begin to cover the
environmental damage.

Having said all that, the command economies of the 80s had notoriously poor
records on the environment. In theory, they should have been able to
monitor pollution levels closely, given that they had control of production,
but this simply did not happen.

SO, WHICH SYSTEM IS BEST?

As you can see, both systems have advantages and disadvantages. As

extremes, neither of the systems work, but from the experiences of the
world economy over the last few decades, it appears that the free market
has won the argument.

It would be misleading, though, to say that the free market is the winner
without any provisions. Free markets with very limited governments would
fail in other ways: poor health and education services, low state benefits and
pensions and, perhaps the worst in a civilized society, an unfair distribution
of income. Most of these problems do not exist if you are one of the richer
members of society, but if you are poorer, you have nothing.
Hence, all economies in the world are now mixed.

Command M I X E D E C O N O M I E S Market
Economy Economy
Eastern Europe Western Europe &
North America

1989 after 1930s

Western European and American societies moved towards mixed economies away from market
economies after the Great Depression of the 1930s while Eastern European societies moved
away from command economies after the fall of communism in the late 1980s.