1.1.6 Free market economies, Mixed economy and Command economy Flashcards
What is a Free Market Economy?
Where governments leave markets to their own devices, so the market forces of supply and demand allocate scarce resources
What are the characteristics of a Free Market Economy?
- Private ownership of resources
- Market forces, i.e. supply and demand determine prices
- Producers aim to maximise profits
- Consumers aim to maximise satisfaction
- Resources are allocated by the price mechanism
Free Market Economy
Adam Smith 1776
He suggested that when individuals follow their own self-interest, they indirectly promote the good of society. Consequently, the Free Market Economy would result in an ordered market with producers responding to changes in consumer wants in such a way that there was a little waste. Smith believed that the role of the government should be limited to providing public goods such as defense and justice.
Free Market Economy
Frederich Hayek
In the 20th century he offered a strong defense of the Free Market along with support for private property. Further, he argued in his book “The Road of Serfdom” that attempts by governments to determine the answers to the questions;
- What to produce
- How to produce
- For home
were doomed to failure. State planning would require force and involve restrictions on freedom
What is a Command Economy?
Where the government allocates all of the scarce resources in an economy to where they think there is a greater need. It is also referred to as central planning
What are the characteristics of a Command Economy?
- Public (state) ownership of resources
- Price determination by the state
- producers aim to meet production targets set by the state
- Resources are allocated by the state
- There is greater equality of income and wealth than in a Free Market Economy
Command Economy
Karl Marx
In the 19th century, he thought that capitalism was inherently unstable because workers are exploited by the bourgeoisie (the owners of the factors of production). Ultimately, there would be a proletariat revolution in which communism would result
What is a Mixed Economy?
A mixture of the Free Market Economy and the Command Economy. In practice, there are no absolutely Free Market or Command Economies: most are mixed economies. In these economies, some resources are allocated by the price mechanism while others are allocated by the state. What differs between countries is the degree of that mix
Advantages of a Free Market Economy
- Consumer sovereignty – this implies that spending decisions by consumers determine what is produced
- Flexibility – the Free Market system can respond quickly to changes in consumer wants
- No officials are needed to allocate resources
- Competition and the profit motive help to promote an efficient allocation of resources
- Increased choice for consumers compared with a Command Economy
- Economic and political freedom for consumers and producers to own resources
Disadvantages of a Free Market Economy
- Inequality – those who own resources are likely to become richer than those who don’t own resources
- Trade cycles – Free Market Economies may suffer from instability in the form of booms and slumps
- Imperfect information – consumers may be unable to make rational choices if they have inadequate information or if there is asymmetric information
- Monopolies – there is a danger that a firm may become the sole supplier of a product and then exploit consumers by charging prices higher than the Free Market equilibrium
- Externalities – these are costs and benefits to 3rd parties which are not taken into account when goods are produced and consumed
Advantages of a Command Economy
- Greater equality – the state can ensure that everyone can enjoy a minimum standard of living and that no one is extremely rich
- Macroeconomic stability – the state can ensure that booms and slumps are smoothed out
- External benefits and external costs may be taken into account when planning production
- No exploitation – there is no exploitation of workers and consumers by privately owned monopolies
- Full employment – the state can ensure that all workers are employed
Disadvantages of a Command Economy
- Inefficiency – the absence of the profit motive and competition may result in an inefficient allocation of resources
- Lack of incentives to take risks – again the absence of the profit motive may reduce incentives for investment
- Restrictions on freedom of choice – people would be directed into the jobs deemed to be needed by the state
- Shortages and surpluses – if the state miscalculates supply and demand then there may be excess demand and/or excess supply of goods and services
The role of the state in a Mixed Economy
The states performs a variety of roles, many of which depend on the political priorities of the ruling party. However, in most economies, the state has a number of key roles which include the following to a greater or less degree:
- Defense and internal security
- Provision of public goods
- Provision of essential public services, e.g. education and health
- Redistribution of income from the rich to the poor
TEST YOURSELF - identify 4 characteristics of a Free Market Economy
- Private ownership of resources
- Profit motive
- Competition between firms
- Prices determined by the forces of supply and demand
TEST YOURSELF - what is meant by Consumer Sovereignty?
The power of consumers to determine what is produced by their preferences. Firms respond to consumer demand by producing the goods and services which consumers buy
