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Resource Allocation in Planned and Free Market Economies

Discuss the way in which resources are allocated in planned economies and free market economies. Consider which type of economic system is likely to have the more beneficial outcome. [12]

Category:

Economic Systems

[CIE AS level November 2017]

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Answer

Tip : A good answer will analyse the ways in which resources are allocated in each economic system and examine the failures that are likely to occur in the planned economy and the market econonomy . Do not forget to provide a detailed justification of why the mixed economy is the best form of economic system.


Step ➊ : Define ‘planned economy’ and ‘free market economies’ in the introduction.

The economic system is the term is used to describe the means or allocative mechanism by which its people, businesses and government make choices regarding the allocation of scarce resources. Traditionally, economists have recognised three distinct types of economic system – these are the market economy, the planned economy and the mixed economy. It is often debated which one of these economic systems is more beneficial.


Step ➋ : Discuss how the free market allocates resources through the price mechanism

In a free market economy, decisions on how resources are to be allocated are usually taken by the price mechanism. The price mechanism determines the production, utilization of resources, and pricing. This means that the forces of demand and supply determine what goods and services will be produced, how they will be produced and for whom will they be produced.  Prices act to indicate the likely market value of particular resources. For example, a commodity in short supply but that has a high demand attached to it will have a high price. Alternatively, one that has a high supply and low demand will have a much lower price attached to it. Prices and the self-interest of people and businesses therefore act as a guide to the decisions that have to be taken. For example, if consumers decide they want more of a good, demand will exceed supply and prices will rise. This is a signal to suppliers to expand production to meet the higher demand. Most importantly, the government has a very restricted part to play in a market economy.

The advantages of a market economy include increased efficiency, productivity, and innovation. The profit motive encourages producers to be more efficient. The lack of government intervention leads to competition and increased efficiency. With the existence of competition, a business tends to do whatever is necessary to lower its costs and achieve a higher number of sales and increase its profit.  Innovation is also promoted because it provides a competitive edge.


Step ➌ : Discuss the failure of the free market in resource allocation


➤ 3.1 In a market economy, merit goods will be under-produced and demerit goods will be over-produced.

It is often argued that the free market is unable to allocate resources efficiently due to market failures. For example, there tends to be an overconsumption and overproduction of demerit goods. A demerit good is a good that is worse for the individual consumer than the individual realises. Examples are alcohol, cigarettes and various drugs. There is also an under-consumption and under-production of merit goods.  A merit good is defined as a good that is better for a person than the person who may consume the good realises. Examples are education and healthcare.

➤ 3.2 Public goods cannot be provided by the free market because of their two characteristics, non-diminishability and non-excludability.

The free market fails to provide public goods such as defence or street lightning. This is because public goods are non-excludable and non-rival.  Non-excludable means that it is costly or impossible for one user to exclude others from using a good, and this gives rise to the free-rider problem. Non-rival means that the consumption by one consumer does not restrict consumption by other consumers.

The market economy also does not take externalities into consideration. For example market economies are likely to produce more pollution, which is bad for the environment.


Step ➍ : Discuss how the planned economy allocates resources


In the planned economy, the government has a central role in all decisions that are made and, unlike the market economy, the emphasis is on centralisation. Central planning boards and organisations make decisions in enterprises that are state-owned or under state regulation and control.

Complete state control over resource allocation would involve a considerable loss of individual liberty. Workers would have no choice where to work; consumers would have no choice what to buy.


Step ➎ : Discuss the failure of the command economy in resource allocation

It is argued that planned economies cannot detect consumer preferences resulting in shortages and surpluses  If production is planned, but consumers are free to spend money incomes as they wish, there will be a problem if the wishes of consumers change. Shortages will occur if consumers decide to buy more; surpluses will occur if they decide to buy less.  Market prices play little or no part in informing resource allocation decisions and queuing rations scarce goods. Thus resources will not be allocated in an efficient way.

If there is no system of prices, or if prices are set arbitrarily by the state, planning is likely to involve the inefficient use of resources. For example,  a rational decision cannot be made between an oil-fired and a coal-fired furnace if the prices of oil and coal do not reflect their relative scarcity.


Step ➏ : Discuss why the mixed economy can be considered as the most beneficial form of economic system.


➤ It is clear that the market and planned economies are types of economic systems that occur in theory and not in reality.

In a mixed economy, some resources are owned by the public sector (government) and some are owned by the private sector. The public (or state) sector typically supplies public, quasi-public and merit goods and intervenes in markets to correct perceived market failure.

Decisions on most important economic issues involve some form of planning (by private as well as public enterprises) and interaction between government, businesses and labour through the market mechanism. Private ownership of productive resources operates alongside public ownership in many mixed economies.

Mixed economies may have a distinct public sector, where public goods such as defence are allocated mainly by the government.

In mixed market economies, the government may control the pattern of production and consumption, by the use of legislation (e.g. making it illegal to produce unsafe goods), by taxes and subsidies or by nationalisation. In many sectors, resources are allocated by a combination of markets and planning, such as healthcare and, which have both public and private provision.

The government may impose taxes to dissuade the consumption of demerit goods and provide subsidies to encourage the consumption of merit goods. This is shown in the figure below.

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Initially, consumers are not informed about the harmful effects of demerit goods, the equilibrium price and quantity demanded and supplied in the free market is at P1Q1. When indirect taxes are imposed, the supply curve shifts from S1 to S2. The higher price P3 will dissuade consumers from buying the good and the quantity demanded falls to Q2.

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A subsidy payment will lead to a shift to the right in the supply curve. The figure above shows that introducing a subsidy in the market results in a fall in price from P2 to P3. The lower price would encourage consumers to buy more of merit goods. There will be a rise in quantity demanded and supplied from Q2 to Q3.

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Step ➐ : Conclude.
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To conclude, the mixed economy is the best form of economic systems because both the free market and government participation is required in the allocation of resources by combining the best of both worlds. 

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♕ Mark scheme
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For Analysis: That explains how resources are allocated in centrally –planned economies including the strengths and weaknesses of this system. (Up to 4 marks)

That explains how resources are allocated in free-market economies including the strengths and weaknesses of this system. (Up to 4 marks)

8 marks maximum

For Evaluation: That exercises some judgement in considering which type of economy would have more benefit. This must make use of the analysis that is offered. There must be a conclusion for full marks. 4 marks maximum

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♕ Guidance
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In a centrally planned economy, the price mechanism does not exist. Central and regional planning committees allocate resources. In free-market economies resources are allocated by the market mechanism with a very limited role for the government. The weaknesses of each system often lead to the conclusion that the mixed economy is most beneficial.

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♕ Examiner’s reports
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The answers provided here were often descriptive rather than analytical. Many candidates provided answers that were perceptions of planned economies based upon historic examples rather than economic theory. The better answers did examine failures in resource allocation that were likely to occur in both systems and gave some underpinning economic theory but such answers were relatively rare. Evaluation was often weak and assertive and often made a simple statement in support of mixed economies with insufficient justification for this model of resource allocation.

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