Chapter 01

Market Economy
Market economy is an economy in which the questions of what to produce, how to produce and for whom to
produce are guided solely by the invisible hand of market forces of demand and supply without any external
intervention.

Market economy is one of the three ways in which a society can organize its economic system, the other being
a command economy and a mixed economy.

Admi smith:The most popular proponent of the market economy is Adam Smith, who famously coined the concept
of ‘the invisible hard’ which refers to the force that automatically allocates resources to production based on the
demand and supply. Under the market economy, the what, how and who are answered as follows:

 What to produce? Goods that generate the highest profit because they have the highest demand.
 How to produce? To maximize the profit by improving quality to be able to charge higher price, reducing
costs by adopting more efficient means, etc.
 For whom to produce? For consumers who have liberty to consume whatever they consume.

However, for the market economy to work, there must be no barriers to entry for producers and consumers and there
must be many producers and consumers of which no one is big enough to dictate the market price.

In a pure market economy, the extreme case called laissez faire (which literally means let go) economy, the role of
government is only to enact and enforce laws and regulations to ensure property rights. In such an economic
structure, there is no role whatsoever for government, i.e. there are no regulations, no taxes, no minimum wages, no
tariffs, etc.

Advantages
The major advantages of a market economy include:

 Resources are automatically allocated to their most efficient use because goods which the consumers want
are produced.
 The consumers have a wide range of choices of products depending on their preferences and no one
dictates them what to study, where to work, when to work, what to consume, etc.
 The profit motive and the self-interest of the market participants encourage innovation which fuels
economic growth.
 Competition ensures better quality products (because producers fear loss of customers), hard-working labor
(because they fear being laid off if not being productive enough) and hence high efficiency.

Disadvantages
Market economy in its pure form hardly exists anywhere, because it is not without its weaknesses which include:

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  Many economic activities result in negative externalities such as damage to the environment which is not
priced in the market economy automatically and hence government regulation is needed to save
environment.
 Breakthroughs in technology have the potential to results monopolies which are in many cases exploitative
in absence of effective anti-trust legislation.
 Where the return on capital is higher than the economic growth, it results in increase in income and wealth
disparity between different segments of the society which may destabilize the economy in the long-run. This
is the point made by Thomas Piketty in his book ‘Capital in the Twenty-First Century’.
 The automatic allocation of resources is a double-edged sword, it may result in certain not-very-profitable
yet vital sectors left-off without enough resources which might have serious consequences over the long-
run, for example education, health care, etc.
 The system is prone to crises due to several factors, for example, the profit motive may result in adoption of
automation and worker exploitation thereby dropping the disposable income and hence reducing
consumption and plunging the economy to a recession.

Positive vs Normative Economics

Positive economics deals questions of facts which can be answered with empirical analysis without taking sides. On
the other hand, normative economics addresses questions of fairness and ethics which are subjective.

Positive economics concerns itself only with uncovering the relationship between different economic phenomena i.e.
interest rates, inflation rates, unemployment rate, GDP per capita, etc. and providing conclusions based only on
objective analysis without offering any recommendation. Normative economics, on the other hand, offers value
judgements and makes recommendations on what policies should be adopted for ‘the greatest good of the largest
number of people’.

Both positive and normative economics may be based on empirical analysis, but positive economics stops short of
prescribing any course of action while the normative economics attempts to provide recommendations to redress the
situation. Conclusions of positive economics can be tested and verified because they are fact-based while the
recommendations offered by normative economics can’t be tested because they have a mix of opinion.

Examples
Positive Economics
Following are the issues/statements which positive economists may be interested in exploring:

 There is an inverse relationship between wealth and demand for inferior goods.
 Adopting protectionist policies results in shrinkage of the total global gross domestic product.
 An increase in tax rate ultimately decreases total tax revenue.
 Strict enforcement of property rights results in increase in GDP.
 Monopolies are inefficient.
 The required rate of return on gambling stocks in higher.
 Developing countries tend to have higher GDP during autocratic regimes.

Normative Economics
Following are some statements which can be attributed to normative economics:

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  Wealth tax should be implemented to reduce the disproportionate distribution of wealth.
 No person should be entitled to any inheritance because inheritances belong to the society.
 Tariffs should be increased on imports from countries with poor human rights record.
 Investors should adopt socially responsible investment approach i.e. do not invest in vice stocks i.e. tobacco,
gambling, etc.
 Antitrust legislation does more harm than good.
 Developing countries should adopt democracy as a system only when they population is educated and
emancipated.

You might ask what use the positive economics is if it can’t offer a course of action. The fact is that positive economics
offers a diagnosis but leaves the prescription to government and other policy-makers.

Mixed Economy
A mixed economy is a type of economic organization of society which combines elements of both a market economy
and a command economy. Most of the economies today are mixed economies.

To understand a mixed economy, you need to what a market economy and a command economy are. A market
economy is a method economic organization in which economic decisions through the interplay of demand and
supply and the government’s role is that of an onlooker who just ensures no one breaks the rules. On the other hand,
in a command economy, the government is everything i.e. the producer of all goods, the owner of all means of
production (land and capital), the employer of all people and the CEO of all enterprises.

Features of mixed Economy

A mixed economy blends the features of a market economy and a command economy to keep their benefits and
avoid their pitfalls. The popularity of the mixed economies come from the fact that both pure market economies and
pure command economies are proven to be doomed economic structures. For example, in a laissez-faire economy,
lack of government oversight may mean severe environmental degradation, rampant employee exploitation,
excessive overproduction, very poor coordination, etc. Similarly, a pure command economy is a bureaucratic monolith
which kills all incentives for technological innovation resulting in stagnation, trespasses on people’s liberty,
concentrates power in hands of the very few, etc.

Example

United States is a good example of a mixed economy. On the one hand, it allows and enforces full private property
rights i.e. patents, copyrights, etc. On the other hand, it is the necessary environment, social security and anti-trust
legislation to ensure a level playing field.

Advantages and Disadvantages

Since a mixed economy blends the good features of both a market economy and a command economy, it is the most
popular because:

 It lets the market forces determine the question of allocation of resources for the most part without letting
anyone too big to be able to exploit the consumers or employees.
 It enables the government to enact legislation and promulgate regulations to make the companies pay for
negative externalities of their decisions thereby saving the mankind from ecological disaster and other
negative implications.

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  It gives the government tooth and nail (in the form of anti-trust laws) to stop companies from monopolizing
industries; and in some cases, even break up companies to encourage competition.
 It entitles governments to use tariffs and economic sanctions to encourage global well-being i.e. by
punishing regimes/countries who have child labor, poor anti-money laundering and anti-terror financing
frameworks, etc.
 It obligates governments to protect basic human rights of its citizens, i.e. their liberty, privacy, etc.
 It allows governments to raise taxes and adopt other policy measures to create a safety net for the
economically-vulnerable and in a way redeem the income and wealth disparity.
 The mixed economy allows the government to use fiscal policy and monetary policy as a tool to dampen
economic cycles.

Despite the significant flexibility allowed to both the private enterprises and government in a mixed economy, some
disadvantages do creep in, for example:

 The government’s attempt to redress the economic imbalances may result in excessive debt and
unsustainable budget deficits.
 If the taxes are two high, it may result in a flight of capital from the country to countries with low taxes or to
tax havens which in the long-run hurts the country’s economy by reducing production and employment
levels.
 Significant discretion on part of government may encourage lobbying by different segments of the society
to tilt the policies in their favor.
 Interventions by the government to avoid systematic crises may result in a too-big-to-fail syndrome where
companies take excessive risks knowing they will be bailed out.

Depression/ Trough 4th stage

Expansion (recovey)-Peak-Contraction(Recession) –Depression

Depression (also known as trough) is an economics term referring to the stage of

business cycle in which a regional or world economy operates at its lowest level.
Depression is one of the four stages of a business cycle. It is preceded by recession
stage and succeeded by recovery stage.

Depression is characterized by low trade and commerce, high rate of unemployment,

decline in real GDP, low incomes and investment, sovereign debt defaults, reduced
credit availability, bankruptcies including bank failures. In some depressions, price
deflation may also be observed.

There are no well-defined boundaries of depression in time. Some economists consider

depression simply an extreme form of recession. However, in context of business cycle,
these are two different stages. Recession morphs into depression and depression then
morphs into expansion (or recovery) stage. In some cases, depression is limited to a
region and in other cases it occurs worldwide.

Examples
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Notable examples of economic depression are the Great Depression (1929-1930) and
the Long Depression (1876-1896) (formerly known as the Great Depression)

There have been numerous other economic depressions which were either small in
magnitude or were limited to few nations. For example, Soviet Russia was hit by very
severe depression in 1990s. 2010s depression in Greece is one of the most recent
examples.

Production Possibility Frontier

Production possibility frontier (also called production possibility curve) is a plot that shows the maximum outputs
that an economy can produce from the available inputs (i.e. factors of production).

Since resources are scarce, deciding about what to produce is of pivotal importance for individuals, firms,
governments and whole economies. Production possibility frontier is a good tool that helps decision-makers imagine
their production choices and tradeoffs and determine whether they are producing at their full potential.

Let’s consider a country which can produce either 5 nukes or 5,000 megawatts of electricity using the available factors
of production i.e. land, labor and capital. The following table shows the different ‘production possibilities’ that
correspond to the available resources of uranium, trained metallurgists and scientists and capital:

Option Number of Nukes Electricity (Megawatts)

A 0 5,000
B 1 4,200
C 2 3,300
D 3 2,300
E 4 1,200
F 5 -
A plot of the above data is the production possibility frontier.

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It shows that country can either produce 5 nukes per year using the available technical knowledge or 5,000
megawatts of electricity or a combination but for each additional nuke, 1,000 megawatts of electricity must be
sacrificed i.e. producing nukes have opportunity costs. The choices made today have serious implications for future
i.e. if more resources are assigned to production of nukes, the country would have serious energy short-fall will
dampen growth and shrink the country’s overall production possibilities.

Inefficient Production and Infeasible Production

If an economy’s total production falls within the production possibility frontier, i.e. as in Point G in the PPF plotted
above, it is producing at below their potential. It is referred to as inefficient production.(inward shift) It is because
at Point G, the country is producing 2 nukes and 2,500 megawatts of electricity while it has the potential to produce 2
nukes and 3,300 megawatts of electricity. Many countries produce at a point inside their production possibility
fronteir due to business cycles because the market system is not able to correctly match the supply and demand.

Similarly, an economy can’t produce a combination of products outside their production possibility frontier. Point H in
the chart above is an infeasible production (outward shift)goal because it falls outside the PPF. The country can’t
produce 2 nukes and 4,000 megawatts of electricity at the same time. However, by investing in new technology and
thereby improving productivity, a country can shift its production possibility outwards and achieve the production
goal in future.

Factors that Shift Production Possibility Frontier

As we move along the production possibility frontier i.e. from A to B or B to C and so on, the total production
remains constant and we are just substituting one product for another. This happens when the available inputs and
technology is the same. However, there are certain factors that increases or decrease an economy’s total production
potential and they cause and inward or outward shift in the PPF.

Inward shifts in production possibility frontier means that the economy is shrinking i.e. its production potential is
decreases. Factors that can lead to this include:

 Natural disasters such as earth quakes, floods, etc. can have devastating effects on a country. It reduces the
production potential by decreasing the quantity of land, destroying infrastructure i.e. capital and decreasing
population i.e. labor.
 Wars, terrorism, violent protests and other political disruptions can stall the economic activity and shift the
PPF inwards.
 Outward immigration i.e. brain drain causes the skilled people to immigrate to other countries which reduces
over production potential.
 Spending too much on current consumption or unproductive pursuits (for example, engaging in an arms
race) decreases the creation of new capital which can cause PPF inwards shifts in future.

Outwards shifts in PPF causes an increase in an economy’s production potential. Factors that result in outwards shifts
include:

 New inventions i.e. improvement in technology: it increases productivity of other factors of production. This
happens when societies forego current consumption to save and invest in capital goods such as roads, etc.
 Population growth and inward immigration: it leads to an increase in the stock of skilled labor.
 Investment in education and other training opportunities: it increases the human capital of a society.

Command Economy
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A command economy (also called a planned economy) is a type of economic organization of a society in which the
government owns most of the means of productions and makes all the major decisions regarding production.

Inherent in the philosophy behind the command economy is the premise that free market capitalism is doomed to
create imbalances in the economy in the form of income and wealth disparity, environmental degradation, worsening
of class struggle, economic crises, political turmoil and corruption, etc. The objective of a command economy is very
noble, i.e. emancipating the general population from insecurities related to their most basic needs i.e. food, clothing,
shelter, etc. In a command economy, no one can accumulate wealth (in the form of land and capital) because it is
owned by the government and belong to the whole society.

Examples of countries whose economic organization is predominantly based on command economic structure include
the erstwhile Soviet Union, North Korea, China, Cuba, etc.

Advantages
Even though command economies have faced significant failures, some of their features have positive appeal in
certain situations:

 During extraordinary times, such as war, etc., command economies can ensure allocation of resources to the
most vital sectors.
 It can help countries who are stuck in the vicious circle industrialize themselves rapidly; however, such rapid
expansion can’t be sustained indefinitely.
 A command economy can benefit from immense economies from scale; however, this advantage is severely
restricted from lack of innovation.
 Because the government employs all the people, it can maintain a low level of unemployment thereby
helping the poorest people meet their most acute needs i.e. food, clothing, etc.

Disadvantages
Command economy is (rightly) despised by many people because:

 It makes the human being a cog in the giant economic machine by infringing on his personal liberty, culture,
likes and dislikes to assign him a robotic role from which he can’t escape. This point is illustrated by Friedrich
Hayek in ‘The Road to Serfdom’.
 Lack of proper incentives deter the innovative spirit because people don’t see any benefit accruing to them
from their invention of new technologies.
 Planning is hard even for a single enterprise let alone for millions of people. This results in inefficient
allocation of resources i.e. forcing people to do jobs at which they don’t excel at and producing goods which
they don’t like.
 Black markets pop up because people’s consumption patterns can’t be met through the planned and
regimented production.
 Significant red tape exists in command economies because the managers become risk averse and may prefer
to ‘look busy do nothing’.
 Democratic principles don’t work in executing such a mammoth plan and hence power must be
concentrated in hands of the very few people which can lead to widespread abuse.
 The choice of products would be severely restricted because centralized planners would tend to harvest
economies of scale.

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Command Economy vs Market Economy vs Mixed
Economy
A command economy is the exact opposite of a market economy. It is also significantly different from the mixed
economy.

The market economy is an economic structure in which the government acts as a referee while the interplay of
demand and supply settles the question of allocation of resources. Market economy is generally more efficient than a
command economy and stimulates innovation and economic growth; however, it can potentially result in income and
wealth disparity, monopolies, wastage of resources, etc.

A mixed economy, which is the third type of economic organization, attempts to offer the best of both worlds i.e. it
adopts the free market mechanism for the allocation decision (a feature of market economy) while also allowing the
government a greater role in trying to stop the market forces from running amok (a feature of command economy).

Business Cycle
Business cycle, also known as economic cycle, consists of a alternating and irregular
fluctuations in economic activity in a region. The economic activity is measured by real
GDP.

Phases
Expansion (recovey)-Peak-Contraction(Recession) –Depression

A business cycle is commonly classified into four phases:

 Recession: A recession is period in which the total income, output and

employement declines. Many sectors of economy show contraction in business
activities such as buying, selling and production. Both consumers and producers
start to face hardships in this stage of business cycle.
 Depression(Trough): In this phase, the contraction in business activities which
started in recession phases reaches minimum level. THe level of output and
unemployment stands still for some duration at the lowest level.
 Expansion: The output and employment level starts to rise again and economy
continues to expand beyond the maximum level achieved in past and thus the
long-term trend of real GDP is positive.
 Peak: The expansion phase ends with economic activity at peak. In peak phase,
business activity reaches the maximum potential of an economy at which it

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 operates at or near full capacity. Unemployement reaches minimum level and
prices are likely to rise.

Business cycles are irregular both in duration and intensities. This is also true from
individual phases in a business cycle. There have been recessions which were only few
months to a number of years in duration.