What are the 3 basic economic questions ?
- What to produce ?
- How to produce ?
- For whom to produce ?
What’s a free market economy ?
A market economy is an economic system in which the decisions regarding investment, production and distribution are guided by the price signals created by the forces of supply and demand and is owned by the private sector.
What’s a command economy ?
A planned economy is a type of economic system where investment, production and the allocation of capital goods takes place according to economy-wide economic plans and production plans. It is usually controlled by a government.How
What’s a mixed economy ?
A mixed economy is variously defined as an economic system blending elements of a market economy with elements of a planned economy, free markets with state interventionism, or private enterprise with public enterprise.
What’s “ price mechanism” and what does it do ?
A price mechanism, part of a market system, comprises various ways to match up buyers and sellers. The price mechanism is an economic model where price plays a key role in directing the activities of producers, consumers, and resource suppliers.
What are the three important functions of price mechanism ?
Signalling Function
Rationing Function
Incentive Function
What are the features of a free market economy ?
- All resources are owned by the private sector.
- The objective of firms are profit maximisation, therefore firms will produce what customers demand.
- There is freedom of choice, producers are free to decide on what to produce and consumers are free to buy what they want.
- Consumer sovereignty prevails, as consumers have the ability to dominate the market.
- Resources are allocated by market forces ( demand & supply forces / price mechanism ) as Adam Smith termed “ invisible hand “.
What are the advantages of a mixed economy ?
- Unemployment will be minimized
- Government can provide public goods and raise money to to pay for them by taxing people’s income.
- Government may provide merit goods such as education, healthcare which are under provided by market economies.
- Government may stop consumption of demerit goods by declaring them illegal or imposing high taxes.
- Government could reduce negative externalities
- Government may ensure equality in distribution of wealth and income.
How does the signalling function operate ?
Price indicates consumer preference. Therefore, if the price of a product is increasing, it may be due to an increase in demand. Firms would enter the market in these times and allocate resources in that particular industry. On the contrary, when the industry is making losses the firms will leave the market, which indicates that losses are a “ signal “ to leave the market.
How does the free market economy solve the 3 basic economic questions ?
What to produce?
How to produce?
For whom to produce?
What to produce is determined by consumers as firms will produce what is demanded. They will produce more high priced goods and less of low priced goods.
How to produce - Consumers will buy from Producers who will offer the lowest price and therefore producers will produce at a low cost in order to survive. Therefore free market results in productive efficiency. If labour is cheaper than capital, labour intensive methods of production will be used.
For whom to produce- The amount of money consumers can spend, depends on their wealth and income. High income earners can acquire a large number of goods and services whilst low income earners can acquire less, therefore in this economy there is inequality in the distribution of goods and services.
How does the incentive function operate?
Price determines profits. Therefore when prices are increasing, sellers will be able to earn more profit and revenue by selling that product. Therefore the producer will allocate more resources for the product which is profitable.
How does the rationing function operate?
Is the practice of controlling the distribution of a good or service in order to cope with scarcity. Whenever resources are particularly scarce, demand exceeds supply and prices are driven up. The effect of such a price rise is to discourage demand, conserve resources, and spread out their use over time. The greater the scarcity, the higher the price and the more the resource is rationed.
What are the roles of a government in a free market?
- Some goods are underprovided by the private sector therefore government supply the rest. Ex; Merit goods
- Some goods are not provided at all due to free rider problem. Ex; public goods, defence and street lights. As it is difficult to implement a system to charge for public goods, users use it free of charge.
- Government is responsible for the issue of money and maintaining its value
- It implements rules and regulations to safeguard consumers from exploitation & to control activities of trade unions.
List a few advantages of a free market economy.
- Consumers have a variety of goods and services to choose from. ( More choices of goods and services)
- It encourages competition among firms. This compels firms to be efficient as less efficient firms will be driven out of the market. The role of profits in the market is to encourage efficient resource allocation.
- Successful firms can earn higher profits. This gives them the incentive to explore new products and implement better methods of production.
- Consumers are the kings ( Consumer Sovereignty) Customers determine what goods and services are produced and in what quantities .
- Since resources are allocated by market forces, there’s no need for government intervention, this can lead to developing international trade
How does a mixed economy respond to the 2 basic economic questions?
What to produce- In a mixed economy both the private sector and the state take part in decision making. Private sector will determine what to produce based on price. Consumers will be offered a a choice of goods and services. The public sector provides the other products such as as street lighting and defence.
How to produce - Private firms will select a method where cost of production is low. In a government sector method, production will be decided through a planning process.
For whom to produce - Goods produced by the private sector will be distributed according to purchasing power. Goods which are not adequately produced by the private sector will be provided by the government. Ex- Merit Goods
List a few disadvantages of a free market economy.
- Under provision of merit goods. Ex; Education
- Inequality in the distribution of goods and services.
- Competition drives out less successful firms. This will lead to a small number of large firms remaining in the market. These firms would have great market power and charge higher prices.
- It does not provide public goods for which a price cant be charged. Ex; defence
- It encourages consumption of harmful goods, if they are profitable.
What are the features of a command economy?
- All resources are owned by the government.
- Resources are allocated by the central planning committee rather than market forces.
- Prices are fixed by the government and if there is a shortage, a process of rationing or queuing is followed.
- The objective of the state is social welfare and not profit
- No freedom of choice
List a few disadvantages of a mixed economy.
- Since welfare of society is important in a mixed economy, it leads to lower the optimum use of of the resources because the government uses resources to produce goods and services which are beneficial for the society as a whole than those which are profitable.
- Private enterprises will have to face various loopholes like favouritism and bureaucratic nature.
- Mixed economies are mostly closed economies discouraging international trade and globalisation, preventing citizens from enjoying international trade.
How do command economies solve the basic economic problems?
What to produce- This is decided by the central planning committee on behalf of the government. Production is carried out according to a national plan.
How to produce- In the production plan the method of production is decided. They decide whether to follow labour intensive or capital intensive methods.
For whom to produce - This is not solved according to purchasing power, whether it produces products for all the customers, education & Health care are provided free or at a subsidised rate.
List a few advantages of a command economy
- Less inequality in the distribution of income.
- Unemployment is relatively low.
- Goods which are harmful to the society are not produced.
- Negative externalities are considered
- All economic activities are long term oriented, more investments are made on capital goods.
- Wastage of resources are minimized
List a few disadvantages of a command economy.
- Limited choice- there are no varieties of the same product as consumers have less choice
- Shortage of goods lead to rationing or queuing
- Firms maybe inefficient as there are no incentive schemes
- The economic system maybe very bureaucratic, because the government intervenes in many areas, it makes the system inflexible and unresponsive to consumer demand changes.
- Goods are in low quality as firms & workers are not provided incentives., workers have low productivity.
Whats a transition economy?
It is an economy which was previously a command or planned economy which is now allowing a greater degree of scope for market forces to operate.
Advantages of transition
Price liberalization- Allow prices to be determined through demand and supply and freeing prices from state control rather than a central planning committee
- Encourage International Trade - Market economy will build new relationships with other countries, Domestic productions can expand the market and citizen’s living standards will increase.
-Privatization - State owned enterprises will be turned into profit motivated private sector firms. State firms are sold to private sector.
- Trade liberalization - Trade liberalization doesn’t
exist without price liberalization. In the command economy most of the industry is monopolized by state owned enterprises. Liberalizing trade can create competition.
-Reformation of the financial sector- Transition requires a fully functioning financial sector which include 1) A central bank to control money supply and interest rates and to act as lender of last resort. 2) Commercial banks to collect savings and grant loans.
What are the costs involved in transition?
- Decline of output (GDP) - Due to uncertainty in the market a firm would produce less. In the meantime, as producers have the freedom to decide what to produce, they might change from one product to another thereby causing a decline in the overall output in the initial stages of transition. Furthermore, small firms do not have the government’s protection, which might cause them to exit the market.
- Unemployment - Planned economies maintain low unemployment rates , but moving towards market economy, unemployment may increase. Private producers may lay off some workers to maximize their profit.
- Inflation- In a command economy, the state controls prices and keeps them down, but when prices are determined by free market forces, it is difficult to control prices, causing inflation to rise.
- Industrial unrest- Trade unions have very limited powers in a planned economy, once the control has been lifted, TU will demand wage rises to match the increased prices, backed by industrial actions.
Less welfare - Planned economy provides facilities to everyone, with the introduction of market forces , there may be a fall in welfare provision. - Due to development in international trade, there can be an imbalance between imports and exports, BOP could become a deficit.
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Micro & Macro economics39
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Economic systems26
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GDP9
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Economic Growth3
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Production Possibility Curves PPC25
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Classification of good and services11
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Demand16
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Supply14
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Market equilibrium9
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Principles of International Trade24
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Government Aims and Types of Policies33
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Elasticity41
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Protectionism10
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Maximum Prices and Minimum Prices13
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Taxes and subsidies15
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AD and AS19
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Balance of payments11
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Exchange rate16
