Resource allocation in different economic systems

Economists have recognised three main types of economic system:

the market economy, the planned economy and the mixed economy.
 In market economies, resource allocation decisions are largely driven by the market
mechanism,
 Whereby individuals and firms take these decisions without government intervention.
 In the market economy, resources are allocated by the forces of demand and supply through the
price mechanism.
 Decisions on how resources are to be allocated are regularly taken by millions of individuals and
thousands of firms. The government has little or no direct involvement in the process of resource
allocation.
 Households and firms interact as buyers and sellers. Price and the unrestricted operation of the
price mechanism are central to the way in which resources are allocated.
How the price mechanism works

Role of the government in a market economy

The government have no direct role in the market economy and should not interfere in the operation of
the price mechanism. As long as the price mechanism is working efficiently, the government’s role is to
watch what is happening and only intervene when the price mechanism does not provide the best
allocation of resources.
When the price mechanism does not work efficiently, the market ‘fails’. Examples of market failure are
where the government provides goods such as healthcare which would be underprovided, fire services
which would not be provided at all, and where it seeks to regulate situations to prevent firms using their
power to control the market for excessive gain. The true market economy is in certain respects an ideal.
No actual economy operates as a pure market economy.
Key features of the market economy
Main Actors Consumers
Producers
Owners of factors of production
Government (limited role)
Motivation Self Interest - actors are motivated by pure self-interest and their decisions are based
on private gains.
Consumers: maximum satisfaction / individual welfare
Producers: Maximization of profit
Owner of FOP: Wages, Rent, Profits and Interest
Government: Social Welfare
Ownership Private individuals own resources where the government has a duty to uphold
property rights, which is done through the legal system.
Free Owners of FOP have the right to buy and sell what they own, through the market.
enterprise
Competition Competition exists, as economic units are free to allocate their resources as they
wish. Producers compete for the spending of consumers. Workers compete for
the spending of the employers and so on.
Decision Decision making where individual are free to choose how they wish to allocate
making resources.
Allocation of Happens through the price mechanism where market forces of demand and supply
resources determine prices and quantity.

ADVANTAGES AND DISADVANTAGES OF FREE MARKET

ECONOMY
Advantages of the Market Economy Disadvantages of the Market
Economy
Free market economy functions automatically. Competition between firms is often limited. A few
large firms may dominate an industry. Lack of
competition may result in higher prices, large
profits and exploitation of consumers.
The economy can respond quickly to changes in Lack of competition and high profits remove
demand and supply conditions through the price incentive for firms to be efficient.
mechanism.
When markets are highly competitive, no one has Consumer sovereignty may not occur due to
market power. Competition between firms keeps unequal distribution of wealth.
prices down and acts as an incentive for firms to
become more efficient.
There is a strong incentive to innovate and produce The practices of some firms may be socially
high quality goods. undesirable. For example, chemical-producing firms
may pollute the environment.
Self-interest is the main motive for all economic Merit goods (health, education) would be under
actors/agents, which results in minimizing the provided by private enterprise, while demerit goods
economic problem of scarcity by encouraging the (cigarettes and alcohol) would be over-provided.
efficient use of resources in line with consumers’
interests.
Free market economy may lead to economic
instability. There may be periods of recession with
high unemployment and falling output, and other
periods of rising prices and increasing output.
By rewarding self-interested behavior, the free
market may encourage selfishness, greed,
materialism, and the acquisition of power.

PLANNED/COMMAND ECONOMY
An economic system where resources are owned collectively by the state and allocated by the
government is the economy.
Key Features of the Command Economy
Ownership All factors of production are owned and therefore allocated by the
state/government.
Motivation The government's key motivation is maximization of social welfare.
Decision making Centralized decision making where government is the sole decision
maker in terms of what, how and for whom to produce.
Price Prices are determined through the planning system.
Determination
Allocation of There is no price mechanism, as government plans the distribution of
resources resources through the planning mechanism.
ADVANTAGES AND DISADVANTAGES OF COMMAND
ECONOMY
Advantages of Command Disadvantages of Command
Economy Economy
The government could take an overall view of The larger and more complex the economy,
the economy and direct resources in the greater the task of collecting the
accordance with specific national goals. information
essential to planning, and the more complex
the plan.
National income could be distributed more If there is no system of prices, planning is
equally. likely to involve inefficient use of resources.
Shortages will occur if consumers decide to
buy more and surpluses will occur if they
decide to buy less.
Unemployment could be avoided if the It is difficult to devise appropriate incentives
government carefully planned the allocation of for workers and managers to be more
resources. productive without a reduction in quality.
The social effects of production and Complete state control over resource
consumption can be taken into account and allocation would involve a considerable loss of
avoided by the government. individual liberty of consumers, producers and
workers.
Government might enforce its plans even if
they were unpopular.

MIXED ECONOMY
In a mixed economy, both the private sector and public sector have a part to play in the
allocation of resources.
 Decisions involve an interaction between firms, labour and the government mainly
through the market mechanism.
 There is private ownership of most productive resources although there is some public
ownership.
 Mixed Economy is an economic system that takes into account the advantages of both,
free market and command economy.
 In a mixed economy a government can intervene in markets to correct market failures.
 It can organize resources to provide goods and services and can also introduce laws and
a legal system to control harmful activities.
 To finance public sector activities, governments levy taxes
PROBLEMS OF GOVERNMENT INTERVENTION
 High taxes on profits may reduce enterprise and high taxes on wages can reduce
people’s incentives to work.
 Regulations can impose significant costs on firms and as a result they will produce less
goods and services, increase their prices or lower the wages of their workers.
 Public sector provision may be inefficient and produce poor quality goods and services
because public sector organizations are not motivated to make profits.
 Government spending may be politically motivated instead of aiming to correcting
market failures and improving economic welfare.

SPECIALISATION, DIVISION OF LABOUR

Specialization is when we concentrate on a particular task.
The process of production to be broken down into a series of tasks. This is
called the division of labour. Example, in a garment factory where each
worker produces one part of an item of clothing such as a shirt sleeve, the
front part or button holes.
Advantages of DOL Disadvantages of DOL
For the Workers: 1. Doing the same job or repetitive tasks
1.Workers can make the best use of their can become boring and stressful. This
particular talents and skills. may eventually reduce
2.Workers can increase their skills and efficiency and increase unit cost as
experience by repeating tasks. unrewarding repetitive work lowers
3.Workers can produce more output and worker’s motivation and productivity.
reduce business costs if they concentrate 2. Individuals must rely on others to
on the same job or tasks. This is called produce goods and services they want but
‘learning by doing. cannot produce themselves.
4. More productive workers can earn 3. Computer-controlled machinery and
 higher wages. robots can now undertake many repetitive
For the Firms: manual tasks. This has led to many low
1. Low unit cost also allows firms to be skilled workers being made unemployed.
competitive in the markets in which they 4.Workers also begin to take less pride in
operate. their work, and quality suffers.
2. Firms can earn higher profits due to 5. The division of labor also runs the risk
lower costs. that if one machine breaks down, then the
For the consumers: entire factory stops.
Higher output at lower price and 6.Workers receive a narrow training due
therefore more wants and needs satisfied to division of labor and may not be able to
with a given number of scarce resources. find alternative jobs if they find
themselves out of work.
7. Mass produced, standardized goods
tend to lack variety.

Classification of goods and services

Private goods are rival and excludable while public goods are non-rival and non-excludable.
Non-rival: consumption by a person will not leave less for another person
Non-excludable: it is difficult to exclude payers from nonpayers.
Public Goods
Public goods are non-excludable and non-exhaustible (non-rivalry in consumption) and, most
times, non-rejectable as well.
- Non-excludable means no one can be stopped from the consuming the good if they are
available to anyone in the society.
- Non-exhaustible or non-rival means that they don’t exhaust when they are consumed.

Non-rejectable means that the consumer does not have a choice of whether to consume the
commodity or not. An availability of public goods to one person does not infringe upon the right
of others to consume the same product.
Public goods are non-rival and non-excludable.
Non-rival means that consumption of a good or service does not prevent another person from
consuming that good. For example, streetlight is non-rival because if one person uses the light
provided by it, it does not prevent another person from also benefitting.
Non-excludable means that once a good is provided it is impossible to exclude payers from
non-payers of the goods.
Few examples of pure public goods exist. A lighthouse, national defense and traffic lights are
typical examples. If a lighthouse is built and maintained on some island no fisherman can be
excluded from its benefits. If the lighthouse is ‘used’ by one boat the amount of its service
available to other boats is the same (the marginal cost of one more boat using the service is
zero).
A different example of a pure public good is broadcast television and radio. Both public good
properties are satisfied. A broadcast television program is normally available to any household
with a television (a private, separate good). Also, if one person watches the program there is no
less of it available for others to watch.
Interestingly, television and radio broadcasting, despite its public good features, is produced
and offered by private, for-profit companies. This is possible because broadcasters are not
selling the programs but the advertising time, which is both excludable and rival. If the
provision of public goods were left to the market mechanism, there would be a market failure;
this is because of the free rider problem, as these goods are non-rival and non-excludable,
making people to have no incentive to pay for it. The only way these goods are provided, is
through direct provision by the government which is funded through raising tax revenue.
Quasi-public goods
Some goods are purely public (e.g. lighthouse or national defence) and other are to certain
extent also known as quasi-public goods (e.g. public beach or public park). These are the goods
that have some but not all of the characteristics of public goods.
A good example might be a sandy seaside beach. Such a beach is available to all those who
wish to use it. It appears non-excludable. However, it is possible to think of ways of excluding
consumers. Privately owned beaches do this. Equally, the beach is non-rival up to a point. If you
are the first person on a pleasant beach on a warn sunny day, it does very little to diminish your
enjoyment of that beach as a few more people arrive to enjoy the benefits themselves.
However, there may well come a point at which that is no longer the case. As the beach
becomes crowded, space limited and other people’s conversations and music become ever
more audible, enjoyment may perceptibly reduce. Thus, the each has something of the
characteristic of non-rivalry, but not the full characteristic. It is a quasi-public good.
Merit and Demerit Goods
Merit good
Merit goods are a special class of goods that are defined in terms of [external benefits] positive
externalities generated and in terms of information failures involved. If the consumption of a
good creates very significant [External benefits] positive externalities then it is referred to as a
merit good. As a result, it is under provided by the market mechanism. Education and health
care are prime examples which not only have positive effect on people who consume them but
they can benefit others.
Also, individuals may not be aware of the benefits arising from the consumption of the good
because of lack of information as costs occur today but the benefits received come only in the
future (time lags). Government would like all members of society to consume in adequate
quantities independently of their income or even their preferences.
Demerit good
Demerit goods are a special class of goods that are defined in terms of negative externalities
[External cost] generated and in terms of informational failures involved. If the consumption
of a good creates very significant [External cost] negative externalities then the product is
referred to as a demerit good. Alcoholic drinks and tobacco products are good examples.
Not only do they have a negative effect on people who consume them in excessive amounts
but they can also harm others, for example, through passive smoking. Also, individuals may not
be aware of the costs arising from the consumption of the good because of lack of information.
They are unable to stop consuming them because these goods are addictive. It can therefore be
said that consumers of these goods are not the best judges of their own interest. Hence,
governments would like to limit consumption.

Knowledge and understanding

 Free goods
 Merit goods
 Demerit goods
 Public goods
Analysis
How does information failure apply in the provision of healthcare?
Explain whether the provision of healthcare services by the private sector is a private
good.
Evaluation
Q. Explain why demerit goods are only provided by the private sector and
consider whether the private sector alone should provide merit goods.
Q. Explain why higher education is a merit good and consider whether in a
free market the price charged reflects the true value to higher education
students.
Ans: A public good is something that is provided by the government for the
benefit of the people. It has to be paid for out of taxation. An example is the
army in my country. Other examples are street lights and public libraries [K].
There are two characteristics as to why the above examples are public goods.
These are called non-rival and non-excludable [K].
Let us now explain what each means.
Non-rival means everyone benefits. Nobody can be excluded from benefiting
from the army or street lights. Everybody can benefit in the same way. Non-
excludable means that even if you have not paid any taxes towards paying for
the public good, you are still able to benefit from it [A]. Such people are
called free-riders.
A quasi-public good is not the same as a pure public good. This type of public
good is one where neither of the characteristics is fully applied [K]. An
example is a pay road. You cannot use the road if you have not paid the
charge. It is non-rival as once you have paid to use a road, you have the same
use of it as other drivers [A].