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

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.

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.

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

  1. 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.

  1. 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.

  1. 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.

  1. 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

  1. 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.

2. 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.

3. 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

4. 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.

5. 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.

6. 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.

Ownership of property:Private ownershipGovernment  ownershipPrivate + Public (government) ownership
Motive or objective:Profit maximizationCollective social welfarePrivate Sector:   Profit maximization. Public Sector:    Social welfare.
Allocative mechanism:Price mechanism ( demand and supply)Rationing mechanism (central planning & quotas )Private Sector: Price mechanism. Public sector: Rationing                                                       mechanism.
Freedom of choice :YesNoPrivate Sector:     Yes. Public sector:        No.
Competition:YesNoPrivate Sector:    Yes. Public sector:       No.
The role of the government :Minimum government intervention in economic affairs. Only limited to maintaining law & order in the country.All economic & noneconomic affairs are in the hands of government.The government limits its role to the provision of necessary goods & services & to regulate the private sector for social welfare.
Variety of goods &  services:YesNoPrivate Sector:     Yes. Public sector:       No.
Quality  of goods &  services:High qualityUsually poor qualityPrivate sector:  High quality. Public sector:   Usually poor                         quality.
Response to changes in demand (Consumer sovereignty):Quick response to changes in consumers’ preferences.Slow or no response.Private Sector:  Quick response. Public sector:    Slow response.
Efficiency :*Usually efficient allocation of resources because of existence of profit motive *Sometimes inefficient, e.g., in the case of private monopolies.Inefficient allocation of resources because of the absence of a profit motive.The inefficiency of the private sector is minimized by government policies.
Shortages & surpluses :The price mechanism clears the market and there are no shortages or surpluses.Central planning is unable to guess exact quantities demanded; shortages & surpluses are present.Private sector: No shortages and surpluses Public sector: Shortages and surpluses are present.
Merit goods :Under-production & under-consumption.Socially optimum*private sector    under-provides *Missing markets of merit goods will be supplied through government provision.
Public goods :Non-marketable and, therefore, missingProvides public goods through government expenditure.The public sector provides public goods.
Demerit goods :Over-production & over-consumption.Fewer or no demerit goodsThe government discourages consumption by applying high taxes and other imposing other legislative actions.
Distribution of income & wealth:Unequal distributionEven distributionProgressive taxation and welfare payments to the poor will reduce the disparity between the rich & poor.
Useless duplication of goods & services:YesNoMay occur in the private sector, but not in the public sector.
Negative externalities :More than socially optimum levelSocially optimumThe government will regulate negative externalities through taxes and legislative impositions.
Necessities  & luxury goods:Fewer necessities & more luxury goodsMore necessities & fewer luxury goodsThe public sector will provide necessities, even to those who can’t pay for them.
Private monopolies:Develop and exploit consumers by setting high prices No private monopolies are exist in a command economy.The government regulates private monopolies and protects consumers from exploitation.
Existence in real world:No pure market economy.No pure command economy.All economies are mixed, but their proportion of private & public sectors vary from country to country.
Other terms:Free economy, Capitalism, free market economy, laissez faire.Communism, socialism, planned economy, centrally planned economy.

Issues of Transition

Eastern European countries, such as Poland, Ukraine, or those forming the Soviet Union, etc., were command economies throughout the 1940s and the 1950s. However, during the 1990s these economies started transforming themselves into market-oriented economies. These countries, while they were in a process of transition, were known as transition economies. This transition created a lot of problems for the people living in these nations, and also for the government itself. 

Transition economies undergo a set of structural transformations intended to develop market-based institutions. These include economic liberalization, where prices are set by market forces rather than by a central planning organization. In addition to this trade barriers are removed, there is a push to privatize state-owned enterprises and resources, state and collectively run enterprises are restructured as businesses, and a financial sector is created to facilitate macroeconomic stabilization and the movement of private capital.

However, the transition process has its own pains and problems.

Problems of transition when central planning in an economy is reduced

  • Sharp fall in GDP:  

The first immediate problem that an economy may face will be a sharp fall in its GDP because of the reduction in its output. The fall in output of each East European country during the transition period was because of the fact that the state-owned businesses lost customers as the old network between businesses fell apart. This was because it was all based on state planning—the government told each firm which other firm would receive their output and they would be paid accordingly. They would also be told where it should buy their inputs. During the transition period firms had to actively seek customers, whereas before they didn’t need to do so.

  • Lack of entrepreneurial abilities: 

Entrepreneurs, due to a lack of experience, may not run firms efficiently. They may not choose the right production methods or output levels to maximize profits. Workers may be dogmatic in setting minimum wage levels, and may demand wages from firms that might be deemed as being excessive in relation to firm revenue. As a result, the relations between a firm and the labour that it employs will deteriorate and resource wastage will occur in nearly all industries in the economy.

  • High rate of unemployment:  

Due to the transition, now that there is no central planning, the factories can produce whatever they want. They will start cutting back on investment because they do not want to take too many risks, which will lead to reduced demand in the economy. Furthermore, because of this, the suppliers will also cut off workers, leading to large scale unemployment and this leads to the reduced demand which will have an impact on the decrease in the output of the country.

One of the strengths of a planned economy is that there is virtually no unemployment. However, during the transition many enterprises will be forced out of business because of the lack of funds and demand to support them.

Another reason was that some of the firms were forced to become efficient after the transition, due to the competition from other firms and foreign enterprises. The easiest way of becoming efficient for these firms was by laying-off workers and making the remaining workforce work harder and more productively. All the countries in the transition process found unemployment as one of the heaviest burdens they had to bear.

In a state economy the central planning body determines the output level of each industry and specifies the amount of resources to be allocated; consumer preferences are given little importance. As the market economy develops, demand for certain goods may fall, while for others it may rise rapidly. Certain industries may become inept and shut down, while market-oriented businesses will thrive but still face a shortage of resources. Therefore, the economy will produce inside the PPC as an inefficient allocation of resources prevails.

  • Rise in the informal sectors:  

The countries worst affected by the GDP fall may have a rise in their informal sectors. For example, in 1988, countries like Uzbekistan and Georgia had informal sectors that were greater than their formal sectors. This also affects GDP because the revenue earned in the informal sector is not included in a country’s GDP. 

  • High inflation:

The transformation is also associated with high inflation. A rise in price is almost inevitable if an economy moves towards a free-market system. In a market system resources are allocated by price. The free market price is inevitably higher than the old state price, since consumers have been rationed in the past, so demand will be greater. So, when a market system is introduced, the price will rise until demand equals supply. There is no shortage because some consumers have been priced out of the market. Higher prices can spark a wage-price spiral. Workers will react to higher prices of goods by demanding higher wages. If firms give higher wages, then they must make up for the cost by increasing the price of their goods, which will, in turn, gives rise to further wage demands. The government must then give firms money to pay the workers and to prevent them from going bankrupt. If they don’t, they will have protests, strikes, and civil unrest to deal with; whereas if they print too much money it will simply make it worthless. 

  • Process of privatization:

In a command economy land and capital is owned by the state, whereas in a market economy it is predominantly owned by the public sector. So the move from one type of economy to the other involves the sale of state assets to private individuals—privatization. This can be done through a number of ways, such as by giving property and capital away to individuals and companies currently employing them (e.g., tenants of council housing could be given their accommodation). The problem with this is that it is a very arbitrary and unfair way of sharing out the state-owned businesses and capital. This would divide society into the rich and poor. The state could also sell its assets to the highest bidder and use the proceeds to reduce tax or reduce government debt.  

  • Merit, demerit, and public goods:

In addition, as consumers gain power in the allocation of resources, certain goods which may be deemed good for society (merit goods) will be produced below the socially optimum level whilst those reckoned as harmful (demerit goods) will be produced in greater numbers. Due to the problems of non-excludability and non-rivalry, public goods, although necessary, will no longer be produced in the country.

  • Negative externalities:

There may be a time gap before a new framework of government controls can be developed to offset the disadvantages of a market economy. In this period, firms seeking to keep their costs low may create pollution by disputing their waste in an unsafe manner.

  • Market imperfections:

Imperfect competition is also likely to develop like monopoly (single dominant seller), with consequences for prices output, quality, and consumer sovereignty. These problems are likely to be faced by transitioning economies, yet the impact of these problems can be reduced. The government primarily needs to ensure that its assets are distributed fairly among the people. In order to avoid large income gaps among the population, the government can maintain its net social security safety net system and introduce tax reforms (such as VAT).

  • Corruption and consumer abuse

As the economy starts the transition, the legal system is usually not adequate to prevent corruption. Loop-holes in the legal system would mean that the markets are not properly regulated to protect consumers. Market-driven economies will only develop when citizens are granted extensive property rights, and can protect these rights through the legal process. This was largely absent in the former communist transition economies.

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