A) The distinction between free market, mixed and command economies: reference to Adam Smith, Friedrich Hayek and Karl Marx:
Adam Smith was a key economist during the 1700s and was best known for his book, the wealth of nations. One of the main features of an economy that he believed in was a free market. Adam Smith argued that resources would be most efficiently allocated and therefore best for society when people acted in their own self-interest. This means that businesses aimed to maximise profit and consumers aimed to utility maximise. This concept is called the invisible hand which describes the market forces that allow it to operate at an equilibrium thus maximising the benefit/surplus to both the consumer and producer. For example, by not intervening in the market it meant that if there were enough people demanding a good/service then the free market would produce it. This is due to the fact that the high demand for the good/service will increase its price thus incentivising businesses to produce the good. Therefore the consumer benefits as their wants/needs are taken care of and the business benefits by making a profit. Although Smith believed in the free market he understood the dangers of a lack of competition in the market place, but did not discuss this in detail as it was not a significant problem in 1700s.
This is in contrast to Karl Marx who believed in command economies and was a big critique of capitalism. In command economies, all resources are allocated by the state. Marx believed that economic systems progress through different stages and capitalism was just one stage in the development process which will eventually turn into communism. One of Marx’s main arguments was that free market economies led to the exploitation of workers. This is due to the fact that businesses main aim is to profit maximise. Therefore, to do this they will lower their average costs as much as possible. This is likely to lead to workers being paid a wage that is as low as possible and that is not a fair reflection of their output. Furthermore, as firms want to cut costs to profit maximise, they will be incentivised to replace labour with machinery. This will lead to more mechanisation of the production process causing large numbers of people to lose their jobs. In addition to this, he argued that competition in a free market economy is likely to lead to firms going out of business as they reach a stage where they can no longer compete with the competition. This will then cause monopolies to be created as more firms go out of business. As a result of this, unfavourable consumer market conditions will be created such as high prices and low quality. This is due to the fact that firms no longer have an incentive to lower prices as customers have limited choice of where to buy the certain good/service due to lack of competition. Overall, Mar believed that a combination of all these factors would eventually lead to revolution as inequality increased. Eventually private property would eventually be replaced by common ownership of resources and finally resulting in communism.
Like Adam Smith, Fredrich Hayek also believed in free market economies and that resource allocation would be much more efficient when left to market forces rather than the state. However, he also recognised the issue with free market economies in the provision of public goods. This was the only case in which Hayek believed that government intervention was necessary as public goods were unlikely to be provided by the free market. Furthermore, he accepted that it was unlikely that consumers would make decisions based on perfect information. However, he did believe that they still have the most accurate knowledge of their particular tastes and therefore are best suited to decide what they demand in addition to business being best suited to decide what to supply. As a result of this, Hayek believed that the market best reflected the level of information available to society. Therefore resource allocation will be as efficient as possible, whereas state allocation of resources is inefficient due to insufficient information. Consumers and producers will both observe price movements within the market and make the decision of how much of a good to supply/demand based on this information.
B) The advantages and disadvantages of a free market economy and a command economy:
Free market advantages:
- Choice – In a free market economy if there is enough demand for a certain good/service then firms will see this and then produce it. This is due to the profit motive that firms have. Overall, this leads to an increase in the choice of goods/services that are available to consumers.
- Competition – Free market economies allow firms to compete against each other. This entails many benefits, the main two being lower prices and greater quality. Overall this leads to a greater consumer surplus thus benefiting society.
- Efficiencies – The main reason for lower prices within a free market economy is due to the efficiency gains which high levels of competition can result in. Rather than operating at the profit maximisation point, when there are high levels of competition firms will operate at the allocative efficient point resulting in a lower price and increased choice for consumers.
- Market equilibrium – The free market economy allows markets to operate at their equilibrium. This maximises both consumer and producer surplus. As a result of this, there are no excess demand/supply as the price mechanism is allowed to function freely.
- Responsive to changes in demand
Free market disadvantages:
- Profit maximisation – The main objective of firms is to profit maximise. Therefore, without state allocation of resources consumers may have to pay high prices and suffer from lower quality goods. This is especially the case in markets where there is a lack of competition.
- Externalities and missing markets – Firms act in their own interests to profit maximise. This means that they will produce up to the point where marginal private cost = marginal private benefit rather than up to the point where marginal social cost = marginal social benefit which is in societies interest. This can lead to problems such as the over consumption/over production of demerit goods and the under consumption/under production of merit goods. This will lead to a welfare loss for society. In addition to this, the free market will not provide public goods due to the fact that they are not profitable thus leading to missing markets.
- Monopolies – The big risk of free market economies is a lack of competition in certain markets. This will lead to higher prices and lower qualities as firms don’t need to be efficient in order to make a profit. This often leads to the exploitation of consumers.
Command economy advantages:
- More equal society – The state allocates acts in society’s best interest, maximising social welfare rather than businesses which aim to maximise profit. As a result of this, the state is likely to implement a range of different measures in order to ensure equality within the economy. This may be done through means such as progressive tax system. Furthermore, there is likely to be low unemployment due to the fact that the state decides where people work and what they get paid.
- Provision of public goods – The state will provide goods up to the point where marginal social cost = marginal social benefit thus maximising social welfare. Furthermore, public goods will also be provided despite it not being profitable as the state acts in society’s interest.
- Prevention of monopolies – As the state allocates all resources it mitigates the risk of monopolies being created. As a result of this, market outcomes will benefit the consumer rather than the producer thus increasing consumer surplus. This is due to the fact that the state will not exploit consumers as their aim is not profit maximising.
Command economy disadvantages:
- Inefficient allocation of resources – The main disadvantage of a command economy is due to the fact that they lack a profit motive. As a result of this, they have no incentive to operate as efficiently as possible. This will often lead to higher costs than there needs to be. This may push up prices for consumers despite the state trying to act in the consumers best interests.