Free Market Economies
As we saw in 1.1.3 (The Economic Problem), every economy has to find a way of addressing the three fundamental questions: What to produce? How to produce? For whom to produce?
No two societies go about addressing these questions in exactly the same way, but all rely on some combination of the market mechanism and the planning mechanism to allocate resources to different uses and distribute goods and services amongst the population.
Free Market Economies
Countries that rely to a large extent on the market mechanism are called free market economies. A market is any arrangement that enables buyers and sellers to trade. Some markets are physical places, such as street markets. Increasingly, markets are moving online. Examples include online shopping, travel, jobs and financial services.
Buyers seek to obtain the highest quality at the lowest price; whilst sellers try to get the highest price. The interaction between buyers and sellers establishes a market price. Free market economies involve a relatively limited role for the government.
Adam Smith was a great supporter of free market economics. He argues that the market allocates resources efficiently without government interference. The ‘invisible hand’ of the market operates through the forces of competition; consumers compete with each other to purchase scarce goods and resources, and producers compete with each other to win sales. Both groups are motivated by self interest; the former seek to maximise their welfare from consumption of goods, and the latter seek to maximise profit.
Producers and consumers both have freedom of choice to sell or buy what they want at the most favourable price. This is where the terms ‘free market’ and ‘laissez-faire’ come from. Government activity is mainly limited to providing a legal framework for markets to work efficiently. and making sure that competition is not restricted. The outcome, according to Smith is that resources are allocated in accordance with consumers wishes, as producers are competing with each other to win sales.
In the early 20th century, the Austrian economist Hayek was a radical proponent of free market economics. He argued that de-regulated markets and minimum government involvement in the economy maximised the freedom of the individual. His views were very influential during the Thatcher government of the 1980s, which saw a big sell-off of state owned businesses, a reduced role for the state in providing housing, and de-regulation of financial services.
- Freedom of choice for consumers forces producers to use resources efficiently in order to be competitive
- Consumer sovereignty__ –__ freedom of choice means producers have to satisfy consumer wants or go out of business
- Incentives to innovate and improve – the pressure of competition encourages firms to produce better goods at lower prices to win customers
- Vast inequalities of income and wealth. Taxes tend to be low in market economies, so governments do not have the resources to provide decent pensions and benefits, affordable housing and healthcare to those on low incomes
- Competition can break down – successful firms may drive weaker ones out of business, resulting in monopolies that charge high prices and provide poor service
- Risk and uncertainty – there is no guarantee of employment or profit. Market economies are inherently unstable and subject to booms and recessions
Planned or Command Economies
Under this system, the state owns and controls most resources and allocates them according to a government controlled plan. Communist countries in the 20th century operated according to 5 year plans, with governments deciding what goods are to be produced, and allocating workers, capital and natural resources accordingly. The government also determined levels of pay for workers in each industry.
Communism owes much to the thinking of the 19th century economist, philosopher and historian Karl Marx. He called the free market economy ‘capitalism’, because of the concentration of ownership of productive resources in the hands of a very wealthy and small minority. Marx believed this lead to the exploitation of workers, as capitalists try to drive down wages in pursuit of profit. He believed resources should be owned collectively, for the benefit of everyone.
- Much less inequality – governments, rather than markets determine people’s incomes and can provide housing, healthcare and pensions to everyone
- Greater stability – in planned economies there is much less risk of unemployment because governments control resources and can ensure jobs for everyone
- Little consumer sovereignty – consumers have to put up with whatever the state decides to provide
- Lack of innovation – without the profit motive or competition, state owned producers have little incentive to improve the quality of goods and services
- Inefficiency – without the profit motive or fear of bankruptcy, producers have no incentive to try to cut costs and use resources efficiently
There are no ‘pure’ free market or planned economies; all countries use a combination of the market and planning mechanisms, but some countries rely much more on one rather than the other. In Cuba, or China, for instance, the state still controls a very high percentage of economic activity. Countries like the USA or Hong Kong are much more oriented towards free enterprise, with much more of the economy in the hands of privately owned businesses.
Countries can be compared in terms of the percentage of GDP that is taken by the government in taxation. The higher the figure, the greater the involvement of the state, an vice versa. In Western Europe, governments typically take around 40% of GDP in tax, whereas in the USA it is less than 30%, so that the USA is more of a market economy than most West European countries.