Resource Allocation Answers Three Questions:
- What to produce?
- How to produce?
- For whom to produce?
How an economy decides, how to allocate its resources is its economic system. There are three kinds of economic systems:
- Free Market Economy
- Planned Economy
- Mixed Economic System
Free Market Economy:
It is an economy where consumers determine what is produced, resources are allocated through price mechanism and land and capital are privately owned.
- 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, wages, interest and profits.
Rent is earned from land
Wages are earned by labour
Interest is earned on capital
Profits are earned through enterprise
- 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 the goods and services they want to buy.
Consumers can choose which firms to buy from.
- 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 in the following way if the 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.
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 The Market System:
- 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.
- 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.
Firms that produce goods using the cheapest method of production 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 promote efficiency also.
- Automatic operation:
The price mechanism helps to reduce the need for making decisions through the large administrative bureaucracy as prices act as a signal telling producers get to know whether they should make more or less of a good.
Time is not wasted on planning and deciding which good should be produced and also the cost of employing planners is avoided.
Disadvantages Of The Market System:
- Unequal distribution of the income and wealth:
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.
- 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
- 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.
- 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.
- Monopolies :
Since there is less or no government intervention in the market economy there is no restriction to stop firms from growing into monopolies.
Command / Planned Economy:
It is an economy which is controlled by the government.
- Public ownership – Government owns the factors of production.
- No freedom of choice
- Social interest
- Government decides
- What to produce?
- How to produce?
- For whom to produce?
Through the help of planners
Advantages Of The 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.
- 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.
- Employment :
Everyone works for the government.
Disadvantages Of The Command Economy:
- Wrong Goods:
Since planners decide what o 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?
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 is one that combines the characteristics of both command and free market 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
- Quality and variety of goods
- Automatic operation
Advantages from the public sector in mixed economy:
- Provision of public and merit goods
- Government taxes people’s income in an attempt to bridge the gap between the rich and the poor.
- Government creates jobs for the employment
- Encourage the consumption of goods that are beneficial for the consumers
- Discourages the consumption of harmful goods by imposing taxes or passing legislation.
- Finance the production of merit goods
The disadvantages of both the systems are minimized:
Provision of harmful goods is minimized
- Drugs are made illegal
- Taxes are imposed on cigarettes.
Government can fine firms polluting the environment.
Government also looks onto the functioning of the firms that are not behaving in the interest of consumers.
Government also tries to prevent monopolies being built were necessary.