1.1.6 Free market economies, mixed economy and command economy

What is a free market economy?

• individuals are free to make their own choices and own the factors of production without government interference.

• resources are allocated through the price mechanism.

• the consumer determines what is produced by their willingness to spend their money on a good. Consumers make decisions based on satisfaction and producers based on profit.

Advantages of a free market economy:

● The system is automatic due to the invisible hand; resources are moved out of production of a good when people stop wanting it or costs are too high.

● Consumers have freedom of choice, called consumer sovereignty.

● There is high motivation as people know working hard could lead to high potential rewards, creating conditions where initiative and enterprise flourish.

● There is political freedom.

● Because firms are in competition, they will produce goods at the lowest cost they can, ensuring productive efficiency.

● In general, freer market economies tend to have higher growth

Disadvantages of a free market economy:

● There tends to be high levels of inequality, since the rich own more factors of production and so can grow richer.

● There may be a lack of merit goods (goods considered as intrinsically good) and little control of demerit goods (intrinsically bad).

● Resources could be wasted on unproductive expenses such as advertising, switching the factors of production and providing competitive services

● If competition disappears then there may be monopolies, who charge high prices and offer low quality of service.

● There is the problem of externalities.

What is a command economy?

Command economy advantages:

Command economy disadvantages:

What is a mixed economy?

The government’s role in a mixed economy:

● Creating a framework of rules: They can protect customers / property rights, ensuring whatever a person owns cannot be taken away by someone else. Also, they ensure safety standards, protecting employers and employees.

● Supplements and modifies the price system: They produce public and merit goods, such as emergency services and transport, and limit the production of demerit goods like child pornography. Government action ensures the consideration of externalities

● Redistributes income: They move income from one group of people to another, from the rich to the poor. This is in the form of benefits for those who are out of work or on low incomes, and in the provision of services for all, such as education and the NHS, allowing the poor to access these services when they might not have been able to afford to.

● Stabilises the economy: The government will attempt to manage the level of demand in the economy to prevent extremes of too much or too little demand. They do this through fiscal and monetary policy, which is looked at in Theme 2.

What did Adam Smith believe?

(1723-1790)

• believed in the free market economy and the laissez-faire approach by governments.

• ‘invisible hand’ in the market which allocated resources to everyone’s advantage, allowing the greatest good for the greatest number of people.

• believed competition in the market caused lower prices as firms wanted to be competitive and so this benefits the consumer as they can get goods cheaply.

• Smith concluded that each individual’s self-interest managed to produce and purchase the goods and services that society needed.

• However, he did argue that the state needed to provide goods/services which free markets wouldn’t such as. the laws, property rights and goods such as bridges and roads.

What did Friedrich Hayek believe?

(1899-1992)

• argued that state control of the economy leads to the loss of freedom.

• believed that the poor in free market (or freer market) countries were better off than those in command economies because at least they had personal freedom.

• said that central planning by governments led to what a small minority wanted being forced on the whole of society.

• individuals they best know what they need in their own situation i.e. a consumer knows how much bread they need and a manager knows how many raw materials they need.

What did Karl Marx believe?

(1818-1883)

• believed in the command economy and criticised capitalism.

• Marx believed that capitalist’s profit came from exploiting labour as they underpaid workers for the value that they actually created.

• wanted remove the difference between the incomes of owners and workers and believed that capitalism would collapse leading to communism.

• saw businesses growing and workers getting poorer, creating a two class system with a few wealthy capitalists and many underpaid workers.

• He thought more firms would fail because of competition causing unemployment, lower wages and higher prices and this would lead to discontent amongst the working class.

• His theory stated that these workers would inevitably rise against property owners and seize control of the means of production. This would lead to a democratic society where everything would be owned by everyone i.e. the fall of capitalism to begin communism.