1.4 - resource allocation in different economic systems

Economic system

the way in which production is organised and choices are made in an economy. 

• It is the system that determines how resources are allocated - how an economy decides what goods and services to produce, how to produce them, and who to produce them for.

Market economy

an economic system where resources are allocated by the market mechanism. 

• also known as the price mechanism, resource allocation decisions are taken by individual producers and consumers with no government intervention. 

• Households and firms interact as buyers and sellers. Producers’ aim is to maximise profit, and the consumers' aim is to maximise their utility, thereby giving rise to the idea of consumer sovereignty. 

  • What to produce? = determined by consumer sovereignty - consumer preferences are signalled to producers through the price mechanism.

  • How to produce? = determined by firms seeking profits

  • For whom to produce? = determined by the purchasing power of consumers.

• Prices and the self interest of individuals and businesses act as a guide to the allocation of resources

• The government has little or no direct involvement in resource allocation

• Examples - USA, Singapore, UK

Market mechanism

also known as the price mechanism, resource allocation decisions are taken by individual producers and consumers with no government intervention. 

Role of the government in a market economy

• As long as the price mechanism is working efficiently, the government’s role is to watch what is happening and only intervene when the price mechanism does not provide the best allocation of resources 

  • When the price mechanism does not work efficiently - the market fails

    • Market failure leads to the government intervening

      • e.g. provision of public goods such as fire services 

      • e.g. merit goods such as healthcare 

      • e.g. regulation of monopolies 

• The true market economy is in certain respects an ideal. No actual economy operates as a pure market economy. 

  • In the US, federal and state governments have important roles to play in providing some limited public services.

  • Hong Kong SAR provides an interesting case of a near perfect market economy. All businesses are privately owned and Hong Kong’s bus, rapid transit rail service (MTR) and road tunnels are operated by private companies. The economy is dominated by local, US- and European - owned MNCs. Since 1997, a ‘two systems, one country’ structure has been in place, retaining many of the benefits of a market economy.

Planned economy

an economic system where resources are state owned and allocated by the government.

• Government has a central role in all decisions that are made

  • The choices of what to produce, how to produce and for whom to produce are all centralised

• Central government and its organisations are responsible for the allocation of resources

  • Production targets are set for main sectors of the economy 

    • e.g. agriculture

  • Prices of most essential items and wage determination are controlled 

  • State ownership of most property and productive resources - resources that are available to be used. 

• Goal of planned economies tends to be a high rate of growth 

• Nowadays, there are very few PEs, including Cuba and North Korea, which are close to planned economies as the theory suggests. 

  • Albania and Vietnam could be mentioned as socialist economies rather than full planned economies.

Mixed economy

an economy in which both market forces and government are involved in resource allocation decisions. 

• Decisions involve an interaction of firms, labour and the government mainly through the market mechanism

• There is private ownership of most productive resources, with some public ownership

  • Over the past 30 years or so, there has been an increase in privatisation - change in ownership from the public to the private sector

    • This has been the case in many emerging economies of Central and Eastern Europe and Pakistan. The previously planned economies in Europe have had to move along this path towards a mixed economic system prior to becoming full members of the EU.

• Increased emphasis on market forces has resulted in some benefits and some problems

  • Benefits - e.g. Poland - inflows of foreign investment, opportunities for private sector businesses to be developed

  • Problems - e.g. the UK - many jobs have been lost in manufacturing as factories close and production is moved to lower-cost locations, mainly in China.

  • Elsewhere, there have been similar trends. One of the most dramatic has been in the former Soviet Union where the economy has been restructured (perestroika). This has been the case in its former satellites such as Poland, the Czech Republic, Slovakia, Hungary, Lithuania and Estonia. Opening up the economy in this way has resulted in huge inward flows of foreign investment, particularly in the manufacturing and retail sectors. There have been opportunities for private sector businesses to be developed - cafés, small shops and garages as well as the local ownership of productive resources are now the norm. In some cases, such as where former state-owned companies have been sold to the private sector, the new owners have made vast sums of money in a very short period of time through adapting the businesses to make the most of the opportunities of the market mechanism. Even in Albania, once seen as one of the few remaining planned economies, the government has recently decided to allow limited privatisation and a greater emphasis on the market mechanism.

  • The experience of the Asian Tiger economies varies. Singapore and Hong Kong, for example, have always focused strongly on the market to allocate resources. Their governments have created an economic situation where free enterprise is encouraged. The rewards can be high. Other economies have placed more emphasis on central planning, such as Malaysia, the Philippines and Indonesia. The extraordinary continual growth of China over the past 15 years or so is linked to the controlled management of the economy but with very clear opportunities for foreign investors as well as domestic companies to influence the allocation of resources.

Scarcity and choice apply in all economic systems.

How choices are made in an economic system depends on __ ?

the relative importance of government and the market mechanism