CIE IGCSE Economics 0455 Section 2 - Unit 4

Section 2

The Allocation of Resources: How the market works; market failure How an economy decides, how to allocate its resources determines its economic system. There are three kinds of economic systems: 1.

2.

3.

4.

Market Economy Command Economy Traditional Economy Mixed Economy

That means, how an economy answers the basic questions of what, how and for whom to produce determines its economic system.

If these questions are solved by automatic price mechanism or by private individuals freely (without any government control), then, it follows a market economy.

If these questions are solved by the Government alone, then it follows a command economy.

If these questions are solved by both private individuals and government, then, it follows a mixed economy.

Market Economy (Laissez faire Economy or Free market economy or Capitalist economy)

It is an economy where consumers determine what is produced, resources are allocated through price mechanism and land and capital are privately owned.

Characteristics of Free Market Economy ďƒ˜ Private Property - Individuals have the right to own, control and dispose of land, buildings, machinery and other man-made and natural resources. Owners are also provided with the right to income from property owned in the form of rent (land), wages (labor), interest (capital) and profits (enterprise). ďƒ˜ Freedom Of Choice - Producers are free to buy and hire any economic resources for the production of goods of their own choice. Workers are free to enter and leave any occupation for which they are qualified. Consumers are free to choose which firms to buy from and the goods and services they want to buy. ďƒ˜ Price Mechanism - It is one of the most important features in the free market economy.

Through the price mechanism, the consumers can inform producers about the goods they want to buy. Producers who are motivated by large profits will produce the goods that the consumer wants.

The price mechanism works as follows, if a good becomes popular among consumers, the demand for it would start to rise, which would lead to an increase in the price. This increase in the price would motivate the producers to make more of the good. However, if the consumers do not want a particular good, then its price would fall informing the producers not to make that good thus prices act as a signal telling producers to make or not to make a good.  Self Interest - Firms will try to maximize profits. Workers will tend to move to those occupations and locations which offer the highest wages. Consumers will spend their incomes on those goods which yield the maximum satisfaction.  Competition - Producers compete against one another for consumer spending. Workers compete against each other to get a better job.  Absence Of Government Involvement - The government plays little or no role in economy.

It does not decide what is to be produced, how it is to be produced and for whom it is to be produced in a free market economy.

Advantages of Free Market Economy 

Consumer Sovereignty - Consumers have the power to determine what is produced since they are the ultimate purchasers of the good. When the consumer’s demand for a good is high so the price will rise and so producers will make more of it.

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Quality and choice of goods - Due to competition, consumers have a wide range of goods to choose from and can, therefore, maximize their material welfare. Firms also try to compete with each other by providing the highest quality to consumers.

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Efficiency - Firms that use the cheapest method of production to produce goods are said to be efficient. Firms in the free market economy try to be efficient in order to make high profits. New methods of production and better machinery can help firms to reduce costs.

The profit motive and competition also promote efficiency.

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Automatic operation – The price mechanism act as a signal for firms, telling producers how much of a good they should produce. Firms can save the cost of employing planners as well as the time need to plan and decide which good should be produced.

Disadvantages of the Free Market Economy 

Unequal distribution of the income and wealth.

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Those who can own factors of production such as land and capital will be richer than those who don’t as they will have greater spending power. Thus, there will be an unequal distribution of income and wealth between people who have the money and people who don’t.

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Failure to provide certain goods and services - In a free market economy, production is only undertaken if there’s profit to be made. There are some goods that are not profitable as it is difficult to charge a price for it and restrict consumers from enjoying the benefits of these products without paying for them. E.g. street lightning defense, vaccination.

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Provision of harmful goods - Market economy may encourage the consumption of harmful goods. Since firms are motivated by profits, they can produce harmful goods for which people are willing to pay a high price such as cigarettes and drugs.

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Harmful effects of producing goods may be ignored - Firms in the market economy do not take the social costs to society of producing goods such as air pollution and noise.

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Monopolies - Since there is less or no government intervention in the market economy there is no restriction to stop firms from growing into monopolies.

Price Mechanism In a market economy the prices are determined by the market forces of demand and supply. If the demand is more, price goes up and if demand is less, price comes down. If the supply is more, price comes down and if supply is less price goes up. These changes take place automatically in a market economy. This automatic adjustment is called price mechanism or market mechanism.

Command Economy (Planned economy or socialist economy)

A command economy is an economy in which all the resources are owned and controlled by the government.

Characteristics of Command Economy  Public ownership - In a command economy everything is under government ownership.  Welfare motive - The aim of production is the welfare of the people not making profit.  No individual freedom - Unlike market economy there is NO freedom of choice for people in a command economy.  Government fixes the prices for goods and services.

Advantages of Command Economy 

Provision of merit goods - Since government looks after the welfare of the general public, there will be provision of public and merit goods.

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Equal distribution of income and wealth - Since people do not have freedom to own resources everyone has more equal spending power to buy goods and services.

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Employment - Everyone works for the government.

Disadvantages of Command Economy  Wrong Goods - Since planners decide what to produce, the goods that consumers want may not be produced thus there is no consumer sovereignty.  Poor quality of goods - As there is no competition amongst firms and neither are they motivated by profits poor quality of goods might be produced.  Inefficiency - Planners are not only costly, but they also decide which production method to choose. This production method may not be the cheapest as profits play no part in the allocation of resources.  Shortages and surpluses - Planning failure might lead to resources wasted and consumers want not fulfilled.

Mixed Economy It is an economic system in which there exists both private sector and public sector together. It is a blend of both market economy and command economy.

Characteristics of Mixed Economy  Some firms are privately owned and some are owned by the government.  Some prices are determined by the market forces of demand and supply (price mechanism) and some are set by the government.  Both consumers and the government influence what is produced.  Since mixed economy combines the characteristics of both command and market economy. It also combines the advantages of the two systems.

Advantages from the private sector in mixed economy 

Consumer sovereignty

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Quality and variety of goods

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Efficiency

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Automatic operation

Advantages from the public sector in mixed economy 

Provision of public and merit goods.

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Government taxes people’s income in an attempt to bridge the gap between the rich and the poor.

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Government creates jobs for the employment.

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Encourage the consumption of goods that are beneficial for the consumers.

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Discourages the consumption of harmful goods by imposing taxes or passing legislation.

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Finance the production of merit goods.

The disadvantages of both the systems are minimized 

Provision of harmful goods is minimized.

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Drugs are made illegal.

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Taxes are imposed on cigarettes.

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Government can fine firms polluting the environment.

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Government also looks onto the functioning of the firms that are not behaving in the interest of consumers.

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Government also tries to prevent monopolies being built were necessary.

Why a mixed economy is better than a market system and a command economic system?

The market economy is strictly criticized for the existence of private ownership and thereby greater inequality among people. On the contrary, a command economy is criticized for lack of freedom for the people.

But a mixed economy solves these two problems in an economy by blending the advantages of both market and command economic systems and it tries to avoid the drawbacks of both market and command economic systems.

Why do we need a public sector?

We need a public sector because private sector provides goods and services only if its production is profitable. Private firms never consider the needs of the society. But in public sector, 1. It provides merit goods like education and health.

2. It produces for the welfare of the people.

3. It protects the country from the external attacks.

4. It considers social cost and social benefit.

5. It maintains law and order within the country.

6. It prevents the use of demerit goods like drugs and alcohols.

Merit goods - Those goods which government thinks that everybody ought to have, e.g. healthcare, education, social security.

Demerit goods - Those goods that government thinks that nobody should get it, e.g. drugs, alcohols, harmful products.

Social cost - The cost of an economic activity to society as well as the individual or firm.

Social cost = private cost + external cost (External cost is also called negative externalities) Social benefit - The benefit of an economic activity to society as well as the individual or firm.

Social benefit = private benefit + external benefit Private costs - The cost of an economic activity to individuals (consumers) and firms (production).

Private benefit - The rewards of an economic activity to individuals (consumers) or firms (producers)