Free market, planned and mixed economies

Overview

How a free market economy answers the questions of what, how a planned economy answers the questions of what and mixed economy.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Describe how a free market economy answers the questions of what, how and for whom to produce.

   Model answer

   What is produced is decided by consumers through their spending: goods that sell profitably are made and those that do not are dropped. How goods are produced is decided by firms seeking the lowest cost, since competition punishes waste. For whom they are produced is decided by income and wealth: those with the most purchasing power obtain the most goods. Prices coordinate all three decisions with no central direction.

2. 2

   Describe how a planned economy answers the questions of what, how and for whom to produce.

   Model answer

   A central authority decides what to produce by setting output targets for each industry, decides how to produce by allocating factors and specifying techniques, and decides for whom by setting wages, prices and rations. Resources are owned collectively rather than privately, and the plan rather than the price mechanism directs them. Consumer preferences influence the outcome only to the extent that planners choose to take them into account.

3. 3

   What is a mixed economy, and why are almost all real economies mixed?

   Model answer

   A mixed economy combines private ownership and market allocation for most goods with state ownership, provision and regulation in areas where markets are judged to perform poorly. Almost all real economies are mixed because the pure alternatives both fail in practice: markets under-provide public goods such as defence and generate large inequalities, while comprehensive planning cannot handle the information required to run a modern economy. The interesting question is not whether an economy is mixed but where the boundary between the two sectors is drawn.

4. 4

   Explain the role of the profit motive in allocating resources in a free market.

   Model answer

   Profit is the difference between revenue and cost, so it is high where consumers value a good more than the resources used to make it are worth elsewhere. High profit attracts new firms into an industry, expanding output, while losses drive firms out of industries where consumers value the output less than the resources cost. The pursuit of private gain therefore moves resources towards the uses consumers want most, which is the sense in which the market coordinates without direction.

5. 5

   Analyse three advantages of allocating resources through a free market.

   Model answer

   First, price signals convey information about relative scarcity and consumer preferences instantly and cheaply, so resources move to their most valued uses without anyone collecting or processing central data. Second, competition and the profit motive create a permanent incentive to cut costs and to innovate, since a firm that fails to do so loses customers to one that does. Third, consumers have wide choice and firms respond quickly to changes in taste, because responding is the route to profit.

6. 6

   Analyse three disadvantages of relying entirely on a free market to allocate resources.

   Model answer

   First, allocation follows purchasing power rather than need, so a market can leave essential goods unaffordable for poorer households while producing luxuries for the rich, and inequality tends to widen over time. Second, markets take no account of external costs and benefits, so goods generating pollution are over-produced and goods generating wider benefits such as vaccination are under-consumed. Third, some goods will not be provided at all: public goods such as street lighting cannot easily be charged for, so private firms have no incentive to supply them.

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