1.1.6: Different types of economy

• In a free market economy, individuals own the factors of production and can make their own choices. Resources are allocated through price mechanism
• Adam Smith believed there is an invisible hand in the market which allocates resources to everyone's advantage, and competition causes lower prices
• Despite believing in the free market, Adam Smith still believed governments needed to provide goods/services that free markets wouldn't
• Friedrich Hayek believed state control of the economy leads to loss of freedom, and that the poor in free countries were better off than those in command economies as they had free will
• Friedrich Hayek also believed that although individuals don't know supply and demand decisions fully, they have enough information to know what they need in their own situation e.g how much food they need
• Advantages of Free Market

  Automatic system due to invisible hand

  Freedom of choice

  High motivation as people know working hard can lead to reward

  Due to competition, firms will produce goods at low cost

  General higher growth
• Disadvantages of free market

  High inequality

  Lack of merit goods and little control of demerit goods

  Resources could be wasted on things like advertising

  Possible monopolies if competition disappears

  Negative Externalities leading to resource misallocation
• In a command economy all factors of production are owned by the state, and everyone is assumed to be selfless, working for a common good
• In a command economy all resource allocation is done by the government. Workers all receive the same wage and products are standardised
• Karl Marx believed capitalism's profit came from exploiting labour as workers were underpaid. He believed that a free market leads to very rich owners and poor workers, which would lead to revolution and cause communism.
• Advantages of command economy:

  Minimum standard of living provided

  Less resources wasted

  Standardised products, which are produced cost effectively

  Government is generally motivated by the wellbeing of the country
• Disadvantages of command economy

  Impossible for state to make so many correct choices, leading to misallocation of resources

  Decision making will be slow and prone to corruption

  Less motivation as everyone receives the same wage

  Consumers lose freedom
• A mixed economy is where both the free market mechanism and government planning allocate a lot of resources. Usually around 40-60% of the economy is controlled by governments
• Government role in mixed economies

  Create a framework of rules

  Modifies the price system

  Redistributes income

  Stabilises the economy through fiscal and monetary policy