IGCSE | Economics | Notes | Unit 2
Allocation of Resources
1. Introduction
2. What is Economic System?
3. What is Free Market Economy?
4. The market system can fail in a number of ways?
5. What is Free Planned or Command Economy?
6. Mixed Economy
7. Why most of the country prefers Mixed Economies?
8. Comparisons of Planned, Market & Mixed Economy
9. Should the government intervene in the economy?
10. Conclusion

Unit 2: Allocation of Resources

1. Economic Systems (Introduction)

The study of economic systems includes traditional, market, command, and mixed economiesAll of these systems attempt to answer the same questions. What should be produced?  How much? How should goods be produced? And, for whom? 

The study of economic systems includes traditional, market, command, and mixed economiesAll of these systems attempt to answer the same questions. What should be produced?  How much? How should goods be produced? And, for whom? 

Tradition economies rely on farming and very simple barter trading. Examples include Neolithic farming villages and the first river civilizations. In a traditional economy, producers and consumers make choices based on what has been done in the past and often economic choices are handed down from generation to generation. For example, a person may be a farmer or a hunter because the members of the family have always farmed or hunted. Traditional economies may be observed in rural regions of less developed countries.

A market economy is controlled by the forces of supply and demand.  Market economies, such as those run by the Western European democracies have allowed these countries to grow large and strong.  In a market economy, decisions are left to businesses and individuals and the forces of supply and demand to determine what is produced and its value. The United States is mainly a market economy, but there are government constraints on some segments of the economy. For example, a government agency requires inoculations of children before they attend school and regulates the production of some vaccines to make certain there is an adequate supply.

A command economy is run by a strong centralized government and tends to focus on industrial goods.  The Soviet Union and Communist China in the 20th century operated under this economic system.  While short-term gains did occur, the majority of people suffered under system that paid little attention to food production or consumer goods.  In a command economy, the government controls the resources and the means of production and makes the decisions. Russia changed from a command to a market economy in 1990 and 1991 with the collapse of the Soviet Union. North Korea is now the best example of a command economy.

A mixed economy is a combination of market and command. The United States and many nations in the European Union operated under this system today. Many countries have a mixed traditional and market economy, and some components are run as command economies. For example, Cuba and China are largely command economies, but have street markets and privately operated restaurants and other businesses that use a market economy to set prices and attract customers. Instruct students to write four or five sentences describing how traditional, market, and command economies each respond to the three basic economic questions.

 

2. What is Economic System?

There are three main questions any economy has to answer:

  • - What is to be produced?
  • - How will it be produced?
  • - Who will get what is produced?

These three fundamental questions have to be answered by any economy, whether it is a highly developed economy, the poorest of countries, or a small group of people stranded on a desert island.

To answer these questions, different economic systems have developed. These systems revolve around how people in those societies allocate scarce resources to satisfy competing wants and needs. In other words, an economic system attempts to find ways of solving the basic economic problem.

 

3. What is Free Market Economy?

A free-market economy is an economy where all markets within it are unregulated by any parties other than those players in the market. In its purest form the government plays a neutral role in its administration and legislation of economic activity, neither limiting it (by regulating industries or protecting them from internal/external market pressures) nor actively promoting it (by owning economic interests or offering subsidies to businesses or R&D). Although an economy in this most radical form has never existed, efforts to liberalize an economy or make it "more free" attempt to limit such government intervention.

Features

  • - Private property: Individuals have a right to own, control and dispose natural and manufactured FOPs
  • - Freedom of choice: what to produce, how much to produce, what to buy or how to spend incomes.
  • - Self interest: Profit maximizing, income maximizing and consumer satisfaction are the driving forces. 
  • - Competition (price mechanism): Changes in the demand for and supply of goods result in changes in the price of goods. Prices bring supply and demand into balance or equilibrium.
  • - Limited role of government: as it has very few economic functions.
  • - What? How? For Whom? To produce is decided by the market
  • - Freedom to buy what they want and sell what they produce.
  • - Demand & supply determine the price & quantity offered for sale.

 

Advantages

1. Faster Economic Development: Because Every one works for the self interest.

  • - Self interest of Producer = maximize Profits
  • - Self interest of Consumer = maximize satisfaction
  • - Self interest of Workers = maximize income

2. More Choice : Because there is less Government restrictions. So, every producer, consumer & workers have many options available.

3. Competition : Due to Changes in the demand for and supply of goods result in changes in the price of goods. Which in turn finally leads to the competition in the economy.

4. Greater efficiency : Due to the free competition , the efficiency of the worker, producer increases. This will finally beneficial for all.

5. More Incentives : Every one works to earn maximum profit/satisfaction/income etc. All these encourage the productivity & output.

Disadvantages

  • - Unemployment: Businesses in the market economy will only employ those factors of production which will be profitable and thus we may find a lot of unemployment as more machines and less labour will be used to cut cost.
  • - Certain goods and services may not be provided:There may be certain goods which might not be provided for by the Market economy. Those which people might want to use but don’t want to pay may not be available because the firms may not find it profitable to produce. For example, Public goods, such as, street lighting.
  • - Consumption of harmful goods may be encouraged: Free market economy might find it profitable to provide goods which are in demand and ignore the fact that they might be harmful for the society.
  • - Ignore Social cost: In the desire to maximize profits businesses might not consider the social effects of their actions.
  • - Inequality : rich get richer, inheritance rather than effort
  • - Instability : uncertainty, unemployment
  • - Dominant firm : small firms out of business, monopoly, high price
  • - Welfare :  poor, backward, less fortunate not given equal opportunities.

 

4. The market system can fail in a number of ways?

The provision of public goods - public goods are goods that could not be provided under a market system because it is not possible to charge a price for them. This is because it is not possible to exclude those who do not pay from getting the benefits. For example, how could the provision of a defence system that by definition protects all citizens be charged for individually? If just one person pays then it would not be possible to exclude all others from the protection - what reason do they have to pay if they are all being protected anyway?

The provision of merit goods - merit goods are goods and services that could be provided by a market system but if they were, there is a possibility that some people who need these services would either not be able to afford to pay for them or would not believe that they need them. There is a danger, therefore, that such goods and services would be under-consumed. Examples of merit goods are health and education.

Income inequalities - market systems tend to throw up individuals who become very very rich whilst there are others that struggle to survive. Such wide income inequalities may lead to a range of social and economic problems and tensions.

Existence of shortages and surpluses - imperfect information tends to lead to shortages and surpluses not being erased. A classic example is unemployment. In theory, unemployment should not occur because wages would adjust to get rid of the surplus labour; in reality, wages may not adjust in this way. In addition, there may be a number of factors preventing labour resources moving from one type of job to another.

The existence of externalities - externalities are the effects of decision making on third parties - individual and groups who are not involved in the initial decision.

 

5. What is Free Planned or Command Economy?

A command economy is one in which the government leaders decide the answers to economic questions. The government controls the use of natural, human, and capital resources. The government decides what is made. It decides how much is made. It decides where people will work, what they will produce, and how they will produce it. It decides who will be able to buy the goods and services that are produced.

Features:

  • All resources are owned and managed by the government.
  • There is no Consumer or producer sovereignty.
  • The market forces are not allowed to set the price of the goods and services.
  • Profit in not the main objective, instead the government aims to provide goods and services to everybody.
  • Government decides what to produce, how much to produce and for whom to produce.

 

Advantages

  • Prices are kept under control and thus everybody can afford to consume goods and services.
  • There is less inequality of wealth.
  • There is no duplication as the allocation of resources is centrally planned.
  • Low level of unemployment as the government aims to provide employment to everybody.
  • Elimination of waste resulting from competition between firms.

 

Disadvantages

  • Consumers cannot choose and only those goods and services are produced which are decided by the government.
  • Lack of profit motive may lead to firms being inefficient.
  • Lot of time and money is wasted in communicating instructions from the government to the firms.
  • Government agencies usually have poor information about what to produce. Centralization means that decisions are taken by people who may have no access to what is actually happening. Command economies, like the Soviet Union often produced goods that weren’t used.
  • Unable to respond to consumer preferences
  • Threat to democracy and liberty. A command economy creates a very powerful government which limits individuals rights to pursue economic objectives. This invariably creates a climate where governments can extend their control into other areas of people’s lives.
  • Bureaucratic. Command economies tend to be very bureaucratic with decisions held up by planning and committees.

 

6. Mixed Economy

It is an economic system where there is coexistence of both private sector & public sector.A mixed economy is an economic system that incorporates aspects of more than one economic system. This usually means an economy that contains both privately-owned and state-owned enterprises or that combines elements of capitalism and socialism, or a mix of market economy and planned economy characteristics. This system overcomes the disadvantages of both the market and planned economic systems.

Features

  • Resources are owned both by the government as well as private individuals. i.e. co-existence of both public sector and private sector.
  • Market forces prevail but are closely monitored by the government.
  • There is motivation for everyone (producer, consumer, workers).
  • Producer, consumer, workers have freedom of choice.
  • Govt. make provision for public & merit goods.
  • Social costs are controlled by govt. through taxation, ban, regulation etc.

Advantages

  • Producers and consumer have sovereignty to choose what to produce and what to consume but production and consumption of harmful goods and services may be stopped by the government.
  • Social cost of business activities may be reduced by carrying out cost-benefit analysis by the government.
  • As compared to Market economy, a mixed economy may have less income inequality due to the role played by the government.
  • Monopolies may be existing but under close supervision of the government.

 

7. Why most of the country prefers Mixed Economies?

Most business and industry can be left to private firms. Private firms tend to be more efficient than government controlled firms because they have a profit incentive to cut costs and be innovative.

  • Mixed economies can reduce the amount of government regulation and government control prevalent in a command economy.
  • Mixed economies can enable some government regulation in areas where there is market failure. This can include:
  • Regulation on the abuse of monopoly power, e.g. prevent mergers, prevent excessively high prices.
  • Taxation and regulation of goods with negative externalities, e.g. pollution,
  • Subsidy or state support for goods and services which tend to be under consumed in a free market. This can include public goods, like police and national defence, and merit goods like education and health care.
  • A mixed economy can create greater equality and provide a ‘safety net’ to prevent people living in absolute poverty. At the same time, a mixed economy can enable people to enjoy the financial rewards of hard work and entrepreneurship.
Government can pursue policies to provide macro-economic stability, e.g. expansionary fiscal policy in times of a recession.

 

8. Comparisons of Planned, Market & Mixed Economy

  Market Command Mixed
Businesses and Private entrepreneurs produce goods and services. Individuals, other businesses, and the government purchase the goods and services with money. The price of the goods and services is determined by the demand for the good versus its supply.
Example: the black market, stock market
Individuals produce goods and services for the government. The government then distributes those goods and services to the population.
Example: the Soviet Union, Cuba, North Korea, Iraq
Businesses , Private entrepreneurs and the government produce goods and services. Individuals, other businesses, and the government purchase the goods and services with money. The government helps insure distribution of goods and services is fair, by regulating prices providing health care, etc
Example: Great Britain
Consumer usually has _____________options when purchasing a good or service. There are usually several businesses offering the same product. This ensures competition and fair prices, as businesses compete for the consumer’s money.
Example: Many types of soda
There is ________choice. The government distributes only one type of product for a given good or service
Example: There is only gov’t-issued soda. No other brands.
Consumer usually has multiple options when purchasing a good or service. However, the government may own basic utilities like water, and electricity.
Example: Washington Suburban Sanitary Commission, Public Education (you can not shoose the school you attend)
The main incentive of businesses. Forces them to set fair prices.
Example: Taco Bell would not be profitable if no one could afford it’s food.
Not a factor. The government collects all profit and distributes it amongst the population.
Example: Cuban government takes all the labor of the farmers, and distributes their work (crops) to the rest of the people.
The main factor of business. However, the government takes a large percentage of profit and distributes it among the people.
Example: A successful business in France pays high taxes, which the French gov’t spends on improved health care.
___________productive workers. If workers are not productive, then profit goes down.
Example: If farmers don’t harvest food quickly, they will have less food to sell.
___________productivity. Workers see little additional benefit in being more productive.
Example: A Soviet farmer may harvest food quicker, but he/she will not eat much more because of it.
__________productive. Profit is still an incentive, but goods are still distributed by the government. Gov’t acts like a safety net.
Example: A farmer harvests slow, may not profit much, but the gov’t will make sure he eats
_____________own natural and human capital. They sell the use of these to businesses, who own physical capital.
Example: A Giant employee sells his/her labor (human capital) to the store. The farmer sells the produce (natural capital) to Giant. Giant uses its refrigerators (physical capital ) to sell the goods.
______________owns all capital.
Example: Cuban farmer gives away his labor (human capital). Gov’t owns the farm he/she works on (natural capital). Gov’t owns the tractor (physical capital) used to harvest the goods.
________, businesses, and ________own capital.
Example: Tour guide sells labor (human capital) to Grand Canyon Expeditions company. Company owns the jeeps (physical capital) used on the tours. Federal Gov’t owns the land (natural resource) the tour takes place on.
Very high for some. Very low for more. Pretty good for most. Characterized by wide disparity: very rich and very poor. Low for most. Lack of incentive to produce good products. Good for most. Balanced. Less disparity.

 

9. Should the government intervene in the economy?

One of the main issues in economics is the extent to which the government should intervene in the economy. Free market economists argue that government intervention should be strictly limited as government intervention tends to cause an inefficient allocation of resources. However, others argue there is a strong case for government intervention in different fields.

Summary of whether should the government intervene in the economy.

Arguments for Government Intervention

•  Greater Equality redistribute income and wealth to improve equality of opportunity and equality of outcome

•  Market Failure Markets fail to take into account externalities and are likely to under-produce public / merit goods. For example, governments can subsidise or provide goods with positive externalities.

•  Macroeconomic intervention. intervention to overcome prolonged recessions and reduce unemployment.

Arguments against Government Intervention

•  Governments liable to make the wrong decisions influence by political pressure groups, they spend on inefficient projects which lead to inefficient outcome.

•  Personal Freedom. Government intervention is taking away individuals decision on how to spend and act. Economic intervention, takes some personal freedom away.

•  Market is best at deciding how and when to produce.

Arguments for Government Intervention to improve equality

In a free market, there tends to be inequality in income, wealth and opportunity. Private charity tends to be partial. Government intervention is necessary to redistribute income within society.

Diminishing marginal returns to income . The law of diminishing returns states that as income increases, there is a diminishing marginal utility. If you have an income of £2 million a year. An increase in income to £2.5 million gives only a marginal increase in happiness / utility. For example, your third sports car gives only small increase in total utility.

However, if you are unemployed, and surviving on £50 a week. A 10% increase in income gives a substantial boost in living standards and quality of life. Therefore, redistributing income can lead to a net welfare gain for society, therefore income redistribution can be justified from a utilitarian perspective.

Fairness.   In a free market, inequality can be created, not through ability and handwork, but privilege and monopoly power. Without government intervention, firms can exploit monopoly power to pay low wages to workers and charge high prices to consumers. Without government intervention, we are liable to see the growth of monopoly power. Government intervention can regulate monopolies and promote competition. Therefore government intervention can promote greater equality of income, which is perceived as fairer.

Inherited wealth . Often the argument is made that people should be able to keep the rewards of their hard work. But, if wealth and income and opportunity depend on being born in the right family, is that justified? A wealth tax can reduce the wealth of the richest and this revenue can be used  to spend on education for those who are born in poor circumstances.

Rawls Social Contract . Rawls social contract stated that the ideal society is one where you would be happy to be born in any situation, not knowing where you would end up. Using this social contract, most people would not choose to be born in a free market because the rewards are concentrated in the hands of a small minority of the population. If people had no idea where they would be born, they would be more likely to choose a society with a degree of government intervention and redistribution.

Government Intervention to Overcome Market Failure

1. Public Goods . In a free market, public goods such as law and order and national defence would not be provided because there is no fiscal incentive to provide goods with a free rider problem (you can enjoy without paying them). Therefore, to provide public goods like lighthouses, police, roads, e.t.c it is necessary for a government to pay for them and out of general taxation. see: public goods

2. Merit Goods / Positive Externalities . Goods like education and health care are not strictly public goods (though they are often referred to as public goods). In a free market, provision tends to be patchy and unequal. Universal education provided by the government ensures that, in theory, everyone has the opportunity to gain an education, which has a strong social benefit.

see: Government subsidy for goods with positive externalities

3. Negative Externalities . The free market does not provide the most socially efficient outcome, if there are externalities in consumption and production. For example, a profit maximizing firm will ignore the external costs of pollution through burning coal. This leads to a decline in social welfare. By contrast other forms of energy production, like solar power, are environmentally friendly and have a positive externality. By taxing production which causes pollution costs and using the subsidy to encourage other forms of energy production, there is a net gain in social welfare.

see: Tax on negative externalities

4. Regulation of Monopoly Power . In a free market, firms may gain monopoly power, this enables them to set higher prices for consumers. Government regulation of monopoly can lead to lower prices and greater economic efficiency.

See:  Regulation of monopoly power

Macro Economic Intervention.

In recessions, there is a sharp fall in private sector spending and investment, leading to lower economic growth. If the government also reduce spending at the same time, there is an even bigger fall in economic growth and collapse in confidence. In a deep recession, governments can borrow from the private sector and spend the money to employ unemployed resources. If there is a collapse in the money supply, there maybe a role for Central bank or Government to print money. Similarly, the government may need to prevent an economic boom and explosion of credit. Keynesian economists argue that the government can positively influence the economy through  fiscal policy . Monetarists believe monetary policy can help encourage economic stability, though an independent Central Bank may not be considered government intervention.

More on  government intervention in the macro economy

 

Arguments against Government Intervention

•  When governments spend on public goods and merit goods, they may create excess bureaucracy and inefficiency.

•  State owned industries tend to lack any profit incentive and so tend to be run inefficiently. Privatizing state owned industries can lead to substantial efficiency savings.

•  Politicians don't have the same market discipline of seeking to maximise the use of limited resources.

•  Government intervention causes more problems than it solves. For example, state support of industries may encourage the survival of inefficient firms. If governments bailout banks, it may create moral hazard where in the future banks have less incentive to avoid bankruptcy because they expect a government bailout.

•  Real business cycle theorists argue that at best government intervention makes no difference to the length of a recession, but may just create additional problems, such as the accumulation of public sector debt.

 

Conclusion

There is no real model of a society run in the absence of government intervention. Even the most extreme libertarian economists would accept there needs to be some state protection of property rights and spending on national defence. The debate comes on the extent of government intervention. This needs to take place on each aspect of government intervention. The arguments for and against government intervention in macroeconomic stabilization are very different to the arguments for and against providing universal health care. It is not satisfactory