1.1.6 free market economies, mixed economies and command economy

What is a free market economy?

It refers to an economic system in which prices are determined by supply and demand with no government intervention where individuals are free to make their own choices and own the factors of production

What are the main characteristics of a free market economy?

* private ownership or resources
* market forces (supply and demand) determine prices
* producers aim to maximise profits
* consumers aim to maximise utility
* resources are allocated by the price mechanism

What is the invisible hand in free market economies?

According to Adam Smith, there was an invisible hand that allocated resources to everyone’s advantage, allowing the greatest good for the greatest number of people

What did Adam Smith say about free market economies?

* the free market would result in an ordered market with producers responding to changes in consumer wants so there is little waste
* competition in the market causing lower prices as firms wanted to be competitive
* believe the role of the gov should be limited to providing defence, justice and some public goods

What did Fredrich Hayek argue about state control/planning?

It leads to the loss of freedom and leads to what a small minority wanted being forced on the whole society

* although individuals don’t make supply and demand based on perfect information, they know best what they need in their situation

What are the advantages of free market economies?

* an automatic system due to the ‘invisible hand’ and production based on demand reduces waste
* consumer sovereignty - consumer spending decisions determine what is produced
* competition means firms will producers will produce goods at lowest cost (ensuring productive efficiency)
* political and economic freedom
* high motivation as people know working hard could lead to high potential rewards so initiative and enterprise flourish
* freedom of choice and increased choice for consumers

What are the disadvantages of free market economies?

* high levels of inequality - rich own more factors of production so they can grow richer
* may suffer from instability in the form of booms and slumps in the trade cycle
* imperfect information causes consumers to be unable to make rational choices
* danger of monopolies as one firm may become the sole supplier of a product and exploit consumers by charging higher prices than the free market equilibrium
* may be a lack of merit goods and little control of demerit goods
* problem of externalities

What is a command economy?

When all factors of production, except labour which is directed by the state, is owned by the state as all resources are allocated by them as well

What are the main characteristics of a command economy?

* public (state) ownership and allocation of resources
* state determines price
* producers aim to meet production targets set by the state
* greater equality of income and wealth

What did Karl Marx say about the command economy and capitalism?

He believed capitalism was inherently unstable because workers are exploited by the bourgeoisie

* he believed capitalist’s profit came from exploited labour as they underpaid workers
* ultimately, he believed there would be a proletariat revolution due to discontent of the WC where communism would result

What are the advantages of a command economy?

* greater equality - state ensures everyone can enjoy a minimum standard of living
* macroeconomic stability - the state ensures booms and slumps are smoothed out
* external benefits and external costs may be taken into account when planning productions
* no exploitation - privately owned monopolies are unable to exploit workers and consumers
* full employment - state can ensure all workers are employed
* less wastage of resources - no need for competitive services/advertising
* standardised products - produced cost effectively
* maximise social welfare - government are motivated by the wellbeing of the country

What are the disadvantages of a command economy?

* inefficiency - absence of profit motive and competition may result in inefficient allocation of resources
* lack of incentives to take risks - reduce investment and innovation
* restrictions on freedom of choice
* shortages and surpluses - if the state miscalculates supply/demand
* bureaucracy - vast army of officials is needed to allocate resources and to prevent the increase in bribery and corruption
* no consumer sovereignty - wastage of resources
* inflexibility - state may be slow to react to changes in consumer needs

What is a mixed economy?

Where both the free market mechanism and the government planning process allocate a significant amount of the total resources in the country

* mix of a free market economy and command economy

What is the government’s role in a mixed economy?

* creating a framework of rules - defence and internal security
* supplements and modifies the price system - public and merit goods are produced while demerit goods are limited
* redistributes income by tax
* provision of public services to allow the poor to have access to them
* stabilises the economy so the gov will attempt to manage the level of demand in the economy to prevent extremes of too much/little demand (through fiscal and monetary policy)