B Economics/Introduction to

Economics/Free Market vs Planned

Economy
< IB Economics | Introduction to Economics
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Rationing Systems

Basic Economic Questions

▪ The basic question of modern economics is that of scarcity.
Production is limited by entrepreneurial ability, natural resources,
capital, labor, and technology. Humans have basically limitless
wants in a world of limited resources. Economics is the question
of the allocation of those resources, as well as that of the output
produced.
▪ What goods and services should be produced with the
resources available?
▪ How can factors of production be used efficiently to produce
what is chosen?
▪ For whom should these goods and services be produced?
▪ Factors of production:
▪ Land/Natural Resources: not man made: land, minerals,
wood, fish
▪ Labour: human resources determined by population, age, skill
and training
▪ Capital: man made tools such as buildings, equipment, and
machinery
▪ Entrepreneurship: undertake the risk of organizing and
combining factors for production
▪ In order to maximize welfare we must produce in the most efficient
manner possible to get the most out of our limited resources: this
will put us on the production possibility frontier
▪ This point is defined when: Marginal Social Benefit = Marginal Social
Cost
▪ But how do we distribute production in such a way as to maximize
 utility for society as a whole?
▪ Marginal utility for rich people is low as they have the money to
afford to buy everything: in other words they are bored from
over consumption
▪ Marginal utility for poor people is high because they have only
limited income
▪ The problem is:
▪ If income is distributed from the rich to the poor, there is
less incentive for people to work; command systems
such as the Stalinist communist system was found to
lead to great inefficiency and unfairness
▪ Those who work hard in the market system are rewarded
so efficiency is achieved, but many become losers
and are marginalized
▪ What is produced is largely determined by the needs and wants of
people
▪ How it is produced depends on available resources and technology
▪ For whom depends on how goods are distributed: by traditional
systems, central planning (dictatorship) or the free market
Traditional Economies

▪ Resources and production systems are owned by the community

▪ Production takes place using traditional technology
▪ Allocation is based on long established patterns of community
sharing.
▪ The production possibility boundary tended to expand and contract
slowly as population grew, there were climatic changes, and new
tools were invented
▪ Advantages of traditional systems:
▪ Resources are protected and the systems have proven to be
sustainable over long periods of time
▪ Losses and profits are shared by the whole community, peer
pressure forces decision makers to be careful
▪ Disadvantages of traditional system: Growth is very slow
What are the basic economic questions?
▪ What to produce?
▪ How to produce it?
▪ For whom to produce?
Command Economy

A market where the government or some central authority decides

where to allocate resources
Advantages and Disadvantages of a Planned Economy
Advantages:
▪ The government can influence the distribution of income.
▪ The government can determine which goods are supplied.
Disadvantages:
▪ In order to function well, requires an enormous amount of information
which is difficult to obtain.
▪ No real incentive for individuals to be innovative. Goods are of poor
quality since there is a lack of profit motive.
▪ May NOT lead to allocative efficiency or productive efficiency due to
lack of competition and profit motives.
▪ Corruption - the government has the ability to abuse its absolute
power.
▪ The economy does not respond as well to supply and demand, firms
are simply told to produce a certain number of goods or services
Central planning:
▪ Resources and production systems are owned by the central
government which allows the government to determine what is
produced, how and for whom.
▪ Enormous information is required due to centralized planning and
control. Government planners must:
▪ Predict patterns of consumer demand
▪ Estimate technological possibilities and production capabilities
▪ Estimate the opportunity cost of resources in alternative uses.
▪ Producers are motivated to underestimate their capability
▪ Advantages of central planning:
▪ The govt. can make the distribution of income more equal
▪ The govt. determines what goods are produced and can
prevent production of socially undesirable goods.
▪ Initially higher growth rates for Russia and China would suggest
that as a system of organizing economic activity, central
planning is successful in the early stages of economic
development
▪ Disadvantages of central planning:
▪ Requires large amounts of information: forecasting people’s
desires is difficult and the lack of incentives have led to a
number of problems:
▪ Decision makers do not experience profits and losses and are not
strongly motivated to make the right decisions
▪ Incentives to falsify production information lead to poor production
decisions and massive pollution,
▪ A reluctance to change with the market in forecasting demand:
▪ There are queues when there are shortages (quantity rationing), and
stockpiles if there are surpluses.
▪ State owned enterprises are managed inefficiently.
▪ There is no incentive for individuals and firms to be innovative.
With no profit motive goods are often of poor quality and
choice is very limited.
Free Market

The forces of supply and demand decide the economic questions and
therefore where to allocate resources
Advantages and Disadvantages of the Free Market
Advantages
▪ Resources allocated more efficiently by the price mechanism.
▪ The profit motive is a great incentive, and forces producers to reduce
costs and be innovative.
▪ With no imperfections, the free market maximizes community surplus.
market system relies on a number of factors to ensure that it works
efficiently.
•The profit motive - the incentive for a reward for enterprise •Good
levels of information being available to both producers and consumers
•Price accurately reflecting the costs and benefits of consumption and
production •The ease with which resources can move to different uses
At the heart of the market system is the profit motive.
Disadvantages:
▪ Instability
▪ Market failure- see Chapter II.
▪ Monopolies and corruption - The natural goal of all firms is to attain
monopoly, as this eliminates competition, eliminating the
associated costs and thus maximizing profit. If the market
structure does not include limiting social forces, financial forces
will cause firms to externalize costs such as pollution to gain
monopoly. Union Carbide's gas leak in Bhopal is an example of
such an externalized cost.
Free market
▪ Resources and production systems are owned by individuals and the
allocation of resources, what, how and for whom, is left to the
forces of supply (production) and demand (consumers) operating
in a relatively free market.
▪ Producers attempt to maximize profits, but if they are poor at
predicting:
▪ They produce too much (surpluses) and will lose money.
▪ They underestimate (shortages), will miss the potential profit
and a competitor will make the profit instead.
▪ Only those firms which can predict most closely what consumers will
want will earn adequate money to stay in business.
▪ Advantages of free market:
▪ Resources are allocated by market forces and the price
mechanism without govt. intervention.
▪ Profits provide an incentive to reduce costs and be innovative.
▪ The free market maximizes community surplus if there are no
failures and imperfections.
▪ Disadvantages of the free market:
▪ Market failures and imperfections occur because of public
 goods, merit goods, externalities and lack of competitive
markets.
▪ The system of profits and losses is thought to be unfair,
substantial government intervention is needed to cope with
income redistribution problems.
▪ The wealthy are taxed to reduce profits
▪ Those marginalized by the system, are supported with tax money
▪ The system is incapable of controlling pollution and producing
sustainable growth, planning has been introduced to
correct for this problem.
Mixed Economies

An economy consisting of both free market and command economies -

some decisions are made by market forces while some other decisions
are made by the government or some central authority
▪ Most countries in the world have moved gradually toward a mixture:
▪ Free markets are used to allocate resources to achieve
efficiency.
Government planning is used where markets fail to operate
successfully, and to redistribute income to those who are marginalized
by the market system.