As the countries try to allocate their resources, they are faced with the questions of what, how and for whom to produce. The answer to these questions determine what type of an economic system a particular country has.
Market Economies is also known as capitalist economies. In this type of economic system, the questions facing the economy is answered by the forces of demand and supply.
What to produce – What the customer demands.
How to produce – By private companies, the companies decide the most efficient method and competes with each other to win customers.
For whom to produce – The production is done for those who demand. It is for the customers willing to pay money to buy the produced goods and services.
Price/ market mechanism which manipulates the allocation of resources or tries to resolve the three fundamental questions of what, how and for whom to produce. In other words, resources are allocated through changes in relative prices. Adam Smith referred to it as the “invisible hands” of the market.
Producers aim at profit maximisation and rely on higher prices as a “green signal” to higher production. The foundation is the profit motive. Evidently, the production of those commodities will be more profitable which are demanded more by consumers. There is freedom of choice for producers and consumers.
Everyone in a market economy acts in self-interest. The factors of production are owned by private individuals and companies. Government has a very minimal role in the production.
Advantages of market system
- Market system automatically responds and adjusts to the people’s wants
As we know, in a market system, the price of goods and services are determined by the forces of demand and supply. If consumers want a particular good or a service, they simply demand for it and the prices go up, which gives signal for the producers to produce more of that good. If producers can produce the required amount of that particular good, the price automatically comes down to normal. Likewise, if people no longer wants a particular good, they simply stop demanding for it, so that it is no longer profitable for producers to produce that good, so producers stop producing that good.
- Wider variety of goods and services
In a market system, producers compete with each other by offering wider variety of goods, therefore consumers have more choice, this may even lead to lower prices.
- Competition pushes businesses to be efficient: keeping costs down and production high.
The aim of firms in a market economy is to make as much profits as possible. In order to do this, the firms need to be more efficient. Therefore they often use new and better methods for production, this leads to lower costs and higher output.
- Government does not have to take decisions on basic economic questions
The market system relies on producers and consumers to decide on what, how and for whom to produce. Therefore it does not require the government to employ a group of people to take these decisions
The disadvantages of market system
- Factors of Production is not employed if it is not profitable
In a market system, producers do not produce a good or a service if it is not profitable. But sometimes it may be necessary to produce some goods even if it is not profitable. Therefore Market system will fail in this aspect.
- Market system may not produce certain goods and services
Private firms in a market system will not be willing to provide certain public goods like street lights because it is almost impossible to charge any payment from the consumers.
- Free market may encourage harmful goods
If there are people in the market who wish to buy dangerous goods like narcotic drugs, the market will be ready to buy it since private firms will be willing to provide anything that is profitable
- Production may lead to negative externalities
When firms are always trying to maximize their profits, they may ignore external costs like damages to the environment.
- Free market economy may increase the gap between the rich and the poor
When firms and individuals are able to produce and consume freely, it may make the rich even richer because they have more decision making power, and the poor may become poorer because they have less decision making power in the market. The market system allocates more goods and services to those consumers who have more money than others.
- Cyclical fluctuations
Cyclical fluctuations are caused by the ever-changing demand and supply conditions. Sometimes, when producers anticipate a rise in demand for certain goods, they raise investment to produce more. But if demand actually does not rise, a general glut will occur, that is, stock accumulation. Consequently, the affected producers will have to reduce investment, dismiss workers toreduce costs. Both of these have an adverse effect in the economy as a whole. Less investment meanslower production while lower employment means less consumption, lower prices and profits. These cumulative effects lead to a lower national income.
Conclusion: It can be concluded that price mechanism determines allocation of resources as per what consumers want more, which initially sounds right. However, this system cannot be left to itself because of its various imperfections which undoubtedly necessitate government intervention.
In this type of economic system, the government answers all the basic economic questions. Let’s see the typical answers to those questions by the government:
What to produce – The government decides what will and must be the needs of the citizens. The ans could be to produce only ‘Dettol’ soaps and no other variety of soaps. Citizens have no choice but to accept it.
How to produce – The government decides the method of production. A typical answer by a command economy could be to produce it in a labour intensive factory owned by the government.
For whom to produce – Again the government decides who will consume the products. Yes the answer is that the production is done for the people, so the people will use it and everyone gets the same price. Welfare is supposedly maximized.
Government controls everything. The factors of production are all owned by the state and production is done for the welfare of the state. And of course the choice of goods available to the people is much less, the people have to accept what is produced. This type of economic systems are also known as ‘planned economies’.
Advantages of command economic system
- Since this system is centralized and directly under the control of the government, it is stable and safe for investors. There are standards laid down by the government which have to be followed by every investor and thus, it helps to establish more control.
- All individual efforts are focused towards a certain goal, which means that all the efforts can be concentrated towards achieving social and economic goal of the government.
Since this system is stable, long term financial projects and infrastructure can be made without the fear of market downturn.
- Citizen welfare (at least in theory) is the main agenda of the government. Thus this kind of economy looks forward to maximizing citizen welfare. Gap between the poor and the rich are lower than any other type of economic sytem
disadvantages of command economic system
- In planned economy, planners are not always aware of consumer preferences, shortages, and surpluses with accuracy and therefore, cannot manage production accordingly.
- This type of economy requires many planners and administration to run the system which results in slow decision making, less progress, and corruption.
- There could be unemployed labour and other resources which leads to waste of labour and resources that could have otherwise been used to fulfill other needs of the society.
- As the system allows very little freedom, there is not much room for innovation. If the state allocates employment, then people are left with very fewer options to choose from.
- The government companies are highly bureaucratic and inefficient in operation.
Sometimes there is under-production of certain products while over-production of unnecessary products.
In a mixed economy, there are features of both the market and command economies. Some of the factors of productions are owned by the government, while others are owned by private sector. Almost all the economies today are mixed economies, however the degree of mixing varies. Some are more market oriented, while some are more towards government planning.
The price is primarily determined by the market. The government can regulate the market to correct the market failures.
- This system overcomes the disadvantages of both the market and planned economic systems.
- Producer and consumer sovereignty: Both consumers and producers can choose what to produce and what to consume.
- The government can always correct the market in case of the market failure
- Best and efficient allocation of resources takes place due to the resources being allocated by the market forces, with the government doing the necessary regulations. Government will provide those goods and services which the market forces will fail to provide (public and merit goods)
- The monopolies and other practices can always be regulated.