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the free market economy

Asked by Martinha | May 21, 2007 | AS Level > Economics > Coursework
Martinha asks:

could you help me to answer this question.
Compare the free market economy with the command economy as means of effectively allocating scarces resorces.
many thanks

etutor answers:

The free market economy is based on the principle of consumer sovereignty. The decisions made independently by millions of consumers determine market prices and the pattern of production, since producers automatically respond to signals. So no government coordination of the system is needed; Adam Smith described its operation as that of 'the invisible hand'.

Prices act both as a signalling device and a rationing device. The higher the price of a good, the fewer the number of consumers who will normally buy it, since they gain greater satisfaction (utility) from spending their incomes on other goods and services, and are thus excluded from the market. Similarly a lower price for a good causes an extension of demand. This is why demand curves, both for individuals and for the market as a whole, are normally downward sloping.

Changes in consumers' demand for a commodity (as a result of changes in income, changes in tastes or changes in the prices of substitutes or complementary goods) act as a signal to producers and bring about a reallocation of resources. So an increase in demand for a good will cause its price to rise; and existing producers in the industry will now supply more since it is profitable to do so. New firms, attracted by the prospect of profits, will enter the industry, and so more resources (factors of production) will be devoted to the production of the good. A decrease in consumer demand for a good will have the opposite effect - its price will fall; existing producers will cut back output to avoid losses; some firms will leave the industry; fewer resources are therefore devoted to the production of the good.

In all cases the market mechanism produces a situation of allocative efficiency - in other words, supply and demand are in equilibrium in all industries, and the price of each product (reflecting what consumers are prepared to pay for it) is equal to the marginal cost of production (the additional cost to the producer of producing the last unit of output). Thus resources are allocated across the economy in accordance with consumers' preferences.

Since there is competition between producers in each industry, they will all strive to produce their goods at the lowest possible unit cost, in order to be able to charge the most competitive price. This means that there will also be productive efficiency - i.e. each firm will be producing at the lowest point on its average cost curve. So no resources are wasted, and there is the greatest possible output for any given input.

All of this depends on a number of assumptions. Factors of production must be mobile and thus able to be reallocated from firm to firm, and from industry to industry. No individual producer should have exclusive control of a market - in other words, there must be no monopoly power. Consumers must be well informed, and not influenced by persuasive advertising. Even if these conditions are met, there might still be market failure. The market mechanism will produce insufficient quantities of merit goods (such as health and education) since some consumers will be unable to afford them, or else decline to buy them. It cannot produce public goods (like defence and flood control) since these can only be provided collectively by governments. The market mechanism may produce too many undesirable or de-merit goods (such as drugs or cigarettes). And there may be external costs as a result of private production and consumption decisions - i.e. negative effects on 'third parties' or society as a whole - for example, the pollution caused by many producers or the rubbish deposited by consumers outside local takeaways.

In sharp contrast, a command economy is based upon state ownership of resources and state direction of production. In a pure command economy there is no private ownership or production at all; in practice there are normally some examples of private enterprises in command economies, though they are given production targets by the state, and also government subsidies are common. All production is based on 'need' rather than private profit - in other words, resources are allocated (rationed) in accordance with what the state perceives citizens' needs to be. The price mechanism does not operate, since prices are fixed by the state, as are wages. In principle, such economies provide for a much 'fairer' distribution of resources and a more equal distribution of income. In practice, however, there is a lack of incentive for producers, since there is no profit motive and no ability to respond to the changing demands of consumers. The result is therefore often a lack of consumer choice, and standardised products that are often of poor quality. Since it is impossible to properly coordinate production on such a large scale from the centre, the result is frequently shortages of key goods and bottlenecks in production. This in turn tends to lead to the development of unofficial, black markets. The system is neither allocatively nor productively efficient.

I hope this is helpful.

1 student responses


Type your response here                  thank you so much


responded May 29, 2007 1:49:41 PM BST
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