Contents
Definitions
There are three types of economies:
- Free market economy – market forces determine the production and distribution of goods and services. There is little to no role for government intervention.
- Note the government may still have a minor role in a free market economy. It may set and enforce regulations for instance to ensure market forces can function.
- While no economy is a pure free market economy, some of the economies with the least government intervention include the US, Singapore and Switzerland. These economies have lower taxation for instance than many Western European economies but would likely still be regarded as mixed economies (see below).
- Mixed economy – some economic decisions are made by the government and others by the free market.
- Example: most European economies can be described as mixed. This includes the UK, France and Germany.
- In the UK for example, the UK Government provides healthcare through the National Health Service. However there are also private healthcare providers and most markets in the UK have private firms providing goods and services.
- Command economy – the government controls production and distribution.
- Government officials decide what to produce, how to produce it and the distribution of goods and services.
- An example of this is the North Korean economy.
Famous figures and their views on free markets: Smith, Hayek and Marx
Adam Smith coined the idea of the “invisible hand”.
- The “invisible hand” describes how the free market creates the incentives for everybody to work towards their own self interest, this supports the public interest. He was broadly in favour of free markets.
- Adam Smith did suggest the government should have a role in the economy, including in enforcing contracts and provide roads and bridges.
- Smith also saw the division of labour as a driver of growth and living standards.
Friedrich Hayek was in favour of free markets.
- Hayek argued that free markets reflects the information and preferences of all individuals.
- The role for governments was to provide law and order as well as welfare for people who could not work.
- According to Hayek, free markets encouraged innovation and entrepreneurship.
Karl Marx argued that free markets can lead to worker exploitation.
- Free markets incentivised firms to maximise profits.
- This does incentivise firms to raise productivity (output per unit of input), in order to increase output and raise profits.
- However, according to Marx, this is likely to lead to the exploitation of workers.
- Workers may be paid less and face worsening working conditions, while managers and shareholders received most of the profits from production.
Advantages of command economies (disadvantages of free market economies)
The advantages of a command economy (which are also disadvantages of a free market economy) include:
- Free market economies may underprovide merit goods.
- Merit goods are goods that are underconsumed in the free market – a type of market failure. This includes goods with positive externalities and where consumers undervalue the long-term benefits of consuming the good. For example, education and healthcare.
- The free market does not take into account the positive externalities associated with goods like education and healthcare. This leads to underconsumption of these goods in the free market relative to the socially optimal outcome.
- However in a command economy, the government can set the quantity at the socially optimal outcome. This may improve social welfare by eliminating the welfare loss associated with the merit good.
- Evaluation: in a command economy, the government may lack the information about the socially optimal quantity of the good. So the government may still underprovide or even overprovide a merit good relative to the socially optimal outcome.
- Free market economies may overprovide demerit goods.
- Demerit goods are goods that are overconsumed in the free market – another market failure. This includes goods with negative externalities and where consumers do not take into account the long-term health damage from consuming the good. For example, alcohol and cigarettes.
- The free market may not take into account the negative externalities associated with cigarettes, such as passive smoking. This leads to overconsumption of these goods in the free market relative to the socially optimal outcome.
- A similar argument can be made for when consumers do not account for long-term health damage from consuming cigarettes for example – the free market may lead to overconsumption.
- However in a command economy, the government can set the quantity of such goods at the socially optimal outcome, at a level lower than the free market outcome. This increases social welfare.
- Evaluation: in a free market economy, consumers may take into account the personal long-term health consequences of smoking a cigarette. It may be “paternalistic” – limiting individual freedoms instead of letting people take responsibility for their decisions. Consumers may know better than government about the effects of consumption.
- Alternative evaluation: in a free market economy, consumers may take into account negative externalities when deciding which goods to consume. For instance, environmentally conscious consumers may not buy goods that are produced using highly polluting methods. This may put pressure on firms to reduce pollution in their production process, without the need for government intervention.
- A free market economy may lead to a highly unequal distribution of income and wealth.
- In free markets, wages are determined by supply and demand. This results in some workers receive low pay (demand is low and/or supply is high), while other workers receive high pay (demand is high and/or supply is low).
- A family with high wealth may be able to give their children access to better education and networking for careers, compared to someone born into a poorer family. This may be viewed as unfair.
- There can be consequences if income and/or wealth inequality are too high. For example, poverty, homelessness, greater social unrest and the potential for those with high wealth to lobby politicians to change policies in their favour.
- However differences in incomes can be beneficial for a society. Income differences provide incentives to work or develop skills, which can increase productivity and output. This is likely to benefit everyone, as more goods are produced with the same inputs, lowering costs per unit and prices.
- Free market economies may lead to the formation of monopolies.
- A monopoly is when a market has a dominant seller of a good or service.
- Free markets can generate monopolies for several reasons. As firms grow, they can reduce their (long-run) cost per unit, which is known as economies of scale. This allows them to outcompete other firms.
- Other barriers to entry, costs that prevent competitor firms from entering the market, may include patents, regulation or the upfront investment required to start some businesses.
- One sector with several large companies is the technology sector. Over 80% of global internet searches occur through Google, for example.
- Monopolies may restrict the quantity sold and raise prices, decreasing consumer surplus. This means that, relative to a perfectly competitive market, monopolies lead to welfare losses.
- However monopolies can have advantages. For example, high profits may allow greater investment into improving the product.
Disadvantages of command economies (advantages of free market economies)
However the disadvantages of a command economy (which are also advantages of a free market economy), include:
- A command economy may lead to shortages (excess demand) and surpluses (excess supply) of different goods and services.
- Whereas in a free market, the price mechanism can eliminate excess demand by causing the price to rise. Similarly excess supply is eliminated with a fall in price.
- In the absence of market failures, the price mechanism allows the free market to maximise total welfare. In other words, market forces achieve allocative efficiency.
- However the price mechanism can fail to deliver the socially optimal outcome, when there is a market failure. For instance, when externalities or information gaps are present (see above on merit and demerit goods).
- A free market economy may provide greater incentives to innovate and faster improvements in product quality.
- Firms are incentivised to maximise profit. To increase profits, firms may improve their production processes to lower costs or improve the quality of their products to raise revenue.
- Profits may be invested back into the company to further improve the quality of the product.
- However this depends on how firms allocate their profit. Suppose firms allocate profits towards shareholders, rather than investment. In this case, free markets may not increase investment but inequality may rise instead.
- There is greater competition between firms in a free market economy.
- Firms compete to attract consumers to their product, in order to increase revenue and profit. Firms may compete by lowering costs in order to reduce prices and raise demand. This raises consumer surplus. Alternatively, firms may compete by improving the quality of their product to increase demand.
- However, free markets can also lead to the emergence of monopolies. Monopolies may lead to higher prices and lower quantities, creating a welfare loss [see above on monopolies].
- Firms compete to attract consumers to their product, in order to increase revenue and profit. Firms may compete by lowering costs in order to reduce prices and raise demand. This raises consumer surplus. Alternatively, firms may compete by improving the quality of their product to increase demand.
- Free market economies also create more choice for consumers. This is because consumers can choose products from multiple different firms. However in a command economy, the only supplier is the government, reducing choice.
The role of the state in a mixed economy
In a mixed economy, the government may:
- Subsidise merit goods.
- Tax demerit goods.
- State provision of public goods (or even some merit goods).
- Intervene where there is market failure using other methods. This could include minimum and maximum prices, regulations, information provision or tradable pollution permits.
- Implement policies to redistribute income, such as government spending on welfare benefits.
We’ll cover these types of government intervention in other posts. Government intervention in markets can either increase or decrease social welfare.
To return to Edexcel Economics A A Level notes, click this button below:
For more A-Level Economics Edexcel A style resources, click the blue button below:
About the author
