N.B. This topic stands alone from the others in the ‘Nature of Economics’ content. To develop a full understanding, it could be advised that one should study the ‘How Markets Work’ and the ‘Market Failure’ material beforehand.
Learning Objectives
Students will understand:
- The distinction between free market, mixed and command economies: reference to Adam Smith, Friedrich Hayek and Karl Marx.
- The advantages and disadvantages of a free market economy and a command economy.
- The role of the state in a mixed economy.
Content
Free Market Economies
Free Market Economies: In a free market the fundamental economic choices of what to produce, how to produce and for whom to produce is solved by market forces (Supply & Demand)
Workings: The forces of supply and demand work together to determine what price and quantity of goods and services are traded. The Price Market Mechanism.
- Customers will demand what is supplied if it is at a price that they can afford (What?).
- Businesses will supply what is demanded at a price that allows them to make a profit (How?).
- The Wealth of individuals will determine how much and of what they consume (For Whom?).
Examples: USA, Hong Kong, Singapore (although are perfect examples).
Free market stakeholders (with an interest or concern):
- Consumers act to maximise their personal welfare.
- Producers act to maximise their profits.
- Owners of FoP act to maximise personal gain (wages, rents, dividends, interest).
- Government’s act to maximise benefits to society (limited government intervention).
Classical Economics
The Invisible Hand (Adam Smith): The self regulating behaviour of the free market.
The ‘invisible hand’ is a metaphor for the unseen forces that move the free market economy.
Individuals seeking to maximise personal gains will lead to an efficient allocation of resources.
This self-interest benefits society as a whole.
“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”
Adam Smith, describing how letting the free market work leads to socially advantageous results
Limited Government Intervention (Friedrich Hayek): The state shouldn’t interfere in the free market and that its role should be to maintain the rule of law.
Reasoning: Too much central planning of economic activity eventually led to totalitarian rule with a one party government restricting freedom and undermining democracy.
He advocated decentralisation and decision making be left with individuals and groups of individuals e.g. businesses.
He argued that the state’s role should just be as a ‘safety net’ such as social insurance (e.g. National Health Service), or limited support for workers in times of need (e.g. unemployment).
Too much intervention makes problems worse and distorts the smooth running of the free market mechanism.
Classical economics: Suggests a laissez-faire (to leave alone) approach by the government towards markets. This will provide the greatest good for the greatest number of people.
“Let the market decide!”
A popular phrase, informally the mantra of capitalism
Advantages and Disadvantages of Free Market Economies
Advantages
Competitive markets. Leading to increased consumer choice and lower prices.
Rewards entrepreneurship. Business owners keep their profits, which also helps to incentivise innovation.
Productive efficiency. Firms are motivated to keep costs low to maximise profits.
Economic growth as private firms seek to increase their outputs to generate profits.
Disadvantages
Inequalities in wealth. Ownership of the factors of production determines distribution of income.
Limited regulation can lead to market failures and suboptimal allocations.
Provision of demerit goods and negative externalities are not controlled.
Under provision of merit and public goods, as the optimal level of output is not as profitable.
Linked Post
Command Economies
Definition: Where resources are owned by the state and allocated by government planners in order to achieve output targets and an equal distribution of resources.
Workings: The state decides what, how and for whom to produce.
Examples: Cuba, the USSR, 20th century China
Marxism
Marxism (Karl Marx): The belief that labour is exploited by capitalists, the owners of the means of production e.g. factories.
Marx suggested that labour was underpaid by the owners of businesses which enabled them to make profits.
The inevitable inequality & exploitation that results creates a historically unavoidable class struggle
To escape, there needed to be a formation of a socialist government, eventually creating a communist utopia
“Workers of the World, Unite! You have nothing to lose but your chains.”
Advantages and Disadvantages of Command Economies
Advantages
A fairer distribution of income and wealth. There is equality in consumption of G&S.
Provision of merit goods & public goods, avoiding market failure.
Control of negative externalities through strict regulation.
Disadvantages
Lack of profit motive. Thus there is: no competitive pressure on price (productive inefficiency) or quality; a lack of consumer sovereignty, meaning G&S desired by citizens are not necessarily produced; and a lack of rewards for entrepreneurship rewards which discourages innovation and lessens long run economic growth.
Inability to centrally plan all the complexities of human needs and wants.
Risks of missing markets and government failures.
Linked Article
Mixed Economies
Definition: Resources are allocated by a combination of both the market mechanism (free market) and the government (command economy).
Workings: Enterprise is encouraged and markets are mostly free to answer the three fundamental choices (What, How, For Whom), but government will act to:
- Reduce negative externalities and demerit good e.g. pollution & smoking.
- Provide public goods & merit goods e.g. infrastructure and defence.
- Control macroeconomic variables e.g. inflation.
- Provide a legal framework e.g. intellectual property rights.
- Encourage free trade e.g. restrict monopoly power and reduce consumer exploitation.
Keynesian Economics
Keynesian Economics (John Maynard Keynes): Keynes questioned the idea that the free market would automatically correct itself to achieve maximum welfare.
In particular, he thought that periods of high unemployment would persist for a long time as workers are inflexible with regards to taking a pay cut.
Thus, the government has a role to control markets to ensure maximum welfare as the market won’t achieve this by itself.
Advantages and Disadvantages of Mixed Economies
Advantages
The state provides essential services for all, ensuring even the poorest in society can survive.
Profit motive in private sector encourages growth.
Competition keeps prices low and maintains consumer choice.
Wage differentials increase productivity.
Inefficient business behaviour is controlled by the government.
Disadvantages
Heavy taxes to fund public sector act to reduce the incentives to work hard or make profits.
Public sector provision is less efficient than private sector.
Excessive control over business activity can add costs and discourage enterprise.
Transition Economies
Transition Economies: Economies which is changing from a command economy to a market economy.
They undergo a set of structural transformations to develop market-based institutions. These Include:
- Economic liberalization (prices are set by market forces rather than centrally planned).
- The removal of trade barriers.
- State-owned enterprises and resources are increasingly privatised and restructured as businesses.
- The birth and growth of a financial sector to facilitate macroeconomic stabilization and the movement of private capital.
Examples: China, ‘Eastern Bloc’ countries, Vietnam.
