Free Market v. Command Economies
Theoretical Economic Systems
Free Market v. Command Economies
Basically, there are only three systems. At one extreme we have the free market economy, where there is a very limited role for the government. At the other end we have the command economy, where the government takes virtually total control. As with market structures (with perfect competition and monopoly), these two extremes are highly unrealistic. Just about every economy in the world is a mix of the two, and is, therefore, called a mixed economy. The question is, what is the degree of mix?
Let's see how these different systems answer the three basic economic questions (see above).
A free market economy
Before we look at how the three questions are answered, we must quickly look at some of the characteristics of a free market economy.
Characteristics of this system
1.
Ownership: Nearly all of the country's factors of production are owned privately. Although it might make sense to argue that firms own some of the resources, it is private individuals, or groups of individuals, who own the resources. They then rent them out to the firms so that they can produce the goods and services. Richard Branson is in charge of Virgin, but first and foremost he is a private individual who owns the majority of the shares. He could get someone else to run the company. This brings into play one of the government's limited roles. Through the legal system, the government must uphold the property rights of these private individuals.
2.
Objectives: Everyone in this system is motivated by pure self-interest. Consumers maximise welfare, firms maximise profits and the private individuals, who own the factors of production, aim to maximise rents (on land), wages (on labour), interest and profit (on capital).
3.
Free enterprise: Basically, firms can sell anything they want. They effectively respond to the consumers, who are allowed to buy anything that is sold by the producers. Workers can take on any job they want (this may seem obvious, but wait and see what happens in the command economy).
4.
The level of competition: Very high. Basically, it is assumed that nearly every market is a perfectly competitive one, with numerous buyers and sellers and no barriers to entry or exit. Firms are competing desperately for customers and the consumers are competing with each other for the goods on offer.
5.
The pricing system: Nearly all markets are perfectly competitive. You may remember that in these circumstances, the price mechanism allocates the economy's resources. The reason why it is called the price' mechanism is because the price acts as a signal and an incentive for producers to act in the required way so as to maximise their gain, which, in turn, optimises the allocation of resources in the whole economy.
What, how and for whom?
We now need to see how these three important questions are answered in a free market economy.
What will be produced?
You might think that the firms decide what is finally produced. Actually, in a free market economy, it is the consumers who have all the power. Consumer sovereignty exists. In a free market, a firm will only produce a good if the consumer is prepared to buy it. Through their purchases (or money 'votes') consumers effectively dictate to the firms what should be produced. If consumers, on mass, stop buying bitter (perhaps they prefer drinking lager in pubs) then the producers (the brewers) would stop making it. So the answer to the question is, "whatever the consumers want."
How will it be produced?
The simple answer is, "the firms." But there is more to this question than that. "How" also means "how well." Due to the highly competitive environment that exists, there will be pressure on firms to produce the goods as efficiently as possible and keep their prices as low as possible. As we said earlier, most industries will be perfectly competitive, so in the long run firms should be both productively efficient and alloctively efficient.
For whom will it be produced?
In other words, who actually ends up consuming the goods that are produced? Well, we said earlier that consumers' money votes determines what is actually produced. But it will also determine what consumers can actually buy. Those with more money will be able to consume more of the goods produced. Who has the most money? The rich, of course, but why are they rich. For some, it is inherited wealth, earning high incomes from the sales of the factors of production that they own (renting land and making profit and interest from capital).
For others, who inherited nothing, their wealth may come from the successful sale of their labour services. David Beckham came from nothing, but he is able to sell his labour services (kicking a football!) for tens of thousands of pounds a week!
Of course, in this system, if you have nothing and you do not have marketable labour skills (for most people this will be a good education), then you will remain poor. The free market system tends to create an unfair distribution of income. The wealthy consume a disproportionately large share of what is produced.
A command economy
As with the free market system, before we look at how the three questions are answered, we must quickly look at some of the characteristics of a command economy. Remember that, in complete contrast to the free market economy, a command economy has a very powerful government sector (or 'planners') and the workers and consumers are subordinate.
Characteristics of this system
1.
Ownership: Nearly all of the country's factors of production are owned publicly by the government (or the state). The only factor over which the government does not have total control is labour, but as you will see, they certainly have indirect control over the workers.
2.
Objectives: The complete opposite of the pure self-interest of the free market system. No one (in theory) thinks of himself (or herself). Consumers, workers and the government are all assumed to be working for the 'common good'. This system is often associated with communist Soviet Union (as it was before 1989), but the fascist Hitler ran a 'planned' economy, albeit rather dictatorially. I'm not sure that system ended up being for the common good! Also, democratic countries often attempt a less severe form of planned economy via socialism.
3.
Free enterprise: There is none.
4.
The level of competition: Very little. Certainly, in the former Soviet Union, black markets used to develop as a result of shortages in the shops. There would be competition between these racketeers, I suppose. But in theory there was no competition.
5.
The pricing system: There is no competition, so there is no price mechanism. The authorities set the prices. It is because they set prices at low levels to make sure that everyone can afford the goods that excess demand occurs causing long queues for goods outside shops. Another inevitable consequence is the creation of black markets.
6.
The planning system: This is an extra characteristic of the command economy. The other five has tried to follow the five given in the 'free market economy' section. As the government runs the system, they have the job of planning how all the resources should be used. They have to decide what should be produced and in what quantities. They must decide how the goods are to be made. What labour should be used and where? What techniques of production shall we use? How will the completed goods be divided between the workers (or consumers)? The key point is that they directly set the output levels and price levels.
What, how and for whom?
We now need to see how these three important questions are answered in a command economy. Notice that the brief answer to all three questions is, "It's up to the planners."
What will be produced?
The consumer no longer has any control. The planners (or the government) decide what will be produced. The question is, how do the planners know what the consumers want and need better than the consumers themselves?
How will it be produced?
There are no such things as 'firms' in a planned economy. The planners direct the resources into producing 'units'. They are not really firms. They have no autonomy. So, as we said above, the planners decide on the quantities of output and methods of production.
For whom will it be produced?
In the free market, the richer you were, the more you could buy. Of course, very poor people could end up with very little. The planner tries to be fair in distributing the output of the economy. Wages are determined by the planners, as are the prices of the goods produced. So the government is, effectively, determining how much each consumer can consume.
A mixed economy
A mixed economy is one that is a mix of the two extremes above. Below is a list of the characteristics of these economies. It should be noted, though, that a 'mixed economy' could mean anything depending on the degree of mix. For this reason, it is difficult to answer the 'three questions' specifically, and so I won't bother. Instead, after the Characteristics sub-section, I have written a section looking at some examples of economies with different emphasises on the market/planning split.
Characteristics of this system
1.
Ownership. The government owns some of the country's factors of production publicly and some are owned privately.
2.
Objectives. Again, a combination of the two extremes. The market part of the economy will be motivated by self-interest. Firms will profit maximise, consumers will maximise their welfare and the factor owners will maximise rent, interest and profit. The government, again, has the 'common good' goal. We will see what that entails later.
3.
Free enterprise. Only in the free market part of the economy (the private sector).
4.
The level of competition. Again, the private sector can be quite competitive. It depends on the market structure that prevails in the various industries. In the real world few industries are perfectly competitive. Governments do tend to set up bodies, though, whose job is to make sure that industries do not become too uncompetitive (The Competition Commission and the Office of Fair Trading).
5.
The pricing system. The price mechanism operates in the private sector. Its efficiency depends on how competitive the market structures are. The government run activities, like the NHS and education in the UK, tend to be provided free at the point of use, although there are some charges even in these areas (paying for prescriptions and school lunches)
Real world examples
In the real world it is fairly easy to assess how 'mixed' an economy is. Economists simply look at the percentage of a country's Gross Domestic Product (GDP) that is devoted to government spending.
The USA is often thought of as the economy with the most capitalist or 'free market' model. The statistics bear this out - the government spend just over 30% of GDP. This is one of the lowest figures in the world, and yet the government is still a huge player in the economy. Even in the capitalist centre of the world (the land of the free!), there is a need for a defence system and a system of law. There is a health system and a system of welfare payments, but they are only used as a last resort, or by the poor who have no choice. Those who can afford it have health insurance.
The UK currently devotes about 40% of its GDP to government spending. That extra 10% means that the health service is more comprehensive, as is the welfare state, although it can be argued that both are in decline. The first because the demand for health care grows much faster than the average growth rate of the economy, partly due to the need to introduce new technology as it is invented. The second because of the huge increase in claimants (the unemployed, for example) plus the increase in the number of pensioners relative to those in work. And then there's the transport system!
Many other European governments spend up to 50% of their GDP (France, for example), but the darling of the political left wing (who believe in a caring, spending state) is Sweden, whose government spend almost 60% of its GDP (it was as high as 70% in the mid 90s)! State benefits and pensions are generous; the health service is of a good quality and is free at the point of use; there is automatic retraining for those who lose their job and free child minding facilities for women wanting to go back to work. There are no student loans either!
You are probably saying to yourself at the moment, "Why aren't all countries like Sweden?" Well, all these lovely government provided things do not come cheap. Sweden also has one of the highest tax burdens in the world. This causes problems for incentives (why work that extra hour if you will lose over 50p of ever £1 that you earn?) and lack of foreign investment in Sweden.
The question that governments have to ask themselves is, "Do I want our economy to be like the USA or more like Sweden?" It is difficult to get the mix right. A government never manages to please all the people all of the time. If I was an unemployed person with little spare cash, I think I'd rather live in Sweden, where I'd get free health care and training for a job. If I were rich I'd rather live in the USA; I could afford good health care and a private pension, etc., from my post-tax income and still have money over to enjoy as I wished.
In this Learn-It, I shall be looking at the advantages and disadvantages of free market systems. As you will see, the advantages of free market economies can be easily turned around to become disadvantages of command economies. Equally, the disadvantages of free market systems often highlight advantages of command economies.
The advantages of a free market economy (and the disadvantages of command economies)
1.
Efficiency. We said earlier that free market economies are very competitive. Most of their industries are assumed to be perfectly competitive and so allocative and productive efficiency will occur. It makes sense that free market economies allocate their resources more efficiently. Decisions about what to produce are made by the people who will actually consume the goods. Planners are less likely to make the correct decisions across the whole economy.
2.
Choice. Firms will produce whatever consumers are prepared to buy. Remember that the consumer is sovereign. Due to the free enterprise factor, there are no restrictions on what the firms can produce. It is of no surprise, therefore, that there will be a much larger choice of goods and services in a free market economy compared with a command economy. The planner will be more concerned with making sure there are enough essential goods to go around rather than allocating resources efficiently between all goods.
3.
Innovation. Firms will always be looking to produce something new to get ahead of their competitors. We said earlier that, even though the government's role is limited, one of its jobs is to protect property rights. This will include intellectual property rights through patents. Hence, there are incentives in the free market system for firms to be innovative and produce better quality products. Obviously there is no incentive for the planner to be innovative. As long as they produce the essentials the planners will be happy.
4.
Higher economic growth rates. One does not have to be an expert economic historian to see that countries whose economic system has been nearer to the free market model have grown much faster than those with a command economy since the second world war. The most successful economy in the world (in terms of size) has been the USA, and they have been one of the freest economies in the world. Given the three factors above, it is not surprising that this is the case. It should be noted that many mixed economies have grown quite well, but certainly the post-war command economies had the worst record.
The disadvantages of a free market economy (and the advantages of a command economy)
1.
Public, merit and demerit goods. Public goods cannot be provided privately because of their two characteristics, non-diminishability and non-excludability. These goods have to be provided publicly. Even in a very free market, one of the government's few roles will be to provide defence, for example. But there may be a problem with merit goods and demerit goods. Merit goods, like health and education, tend to be under provided in a free market. Certainly in the USA the public health system is a 'last resort' system. People are advised to buy health insurance. Of course, the poor might not be able to afford this, and some people might simply decide not to bother if they feel particularly healthy. Demerit goods are bad for you. Government should ban class A drugs, and tax cigarettes and alcohol heavily. A government with a limited role might not take enough action in this area, causing health problems for the economy.
Of course, the advantage of a command economy is that the strong government will make sure that public and merit goods are consumed at the right levels and that demerit goods are banned or taxed heavily.
2.
Unequal distribution of income. For many, this is the big disadvantage of a free market economy. In a free market with very limited government, benefits will be low, the health service poor and schools under funded. If you start life with very little, and do not even get a good education, then there will be very little protection from destitution. A command economy might not have the efficiency and enterprise for the successful to make millions, but at least the strong government will try to make sure that nobody falls through the safety net. It will be a fairer economy, even though it is likely to be less successful overall.
3.
The environment. Free market economies are likely to produce more pollution, which is bad for the environment. Command economies can make sure that the production processes that they chose are as environmentally friendly as possible. They should be able to make sure that the level of output is the socially optimal level of output. Governments can try to force firms into producing the socially optimal level of output through the use of taxes, but governments with a limited role will not be keen to use taxes. Although the tax on petrol is high in the UK, it still doesn't cover the problems caused by the exhaust emissions (in health as well as the environment). Petrol prices have risen, but in real terms, the rise has not been as high as for bus and rail fares. In the USA, petrol is ridiculously cheap. The minimal tax on the good does not begin to cover the environmental damage.
Having said all that, the command economies of the 80s had notoriously poor records on the environment. In theory, they should have been able to monitor pollution levels closely, given that they had control of production, but this simply did not happen.
So, which system is best?
As you can see, both systems have advantages and disadvantages. As extremes, neither of the systems work, but from the experience of the world economy over the last few decades, it appears that the free market has won the argument. Details of what went wrong in the old command economies can be found in the next Learn-It.
It would be misleading, though, to say that the free market is the winner without any provisions. Free markets with very limited governments would fail in other ways: poor health and education services, low state benefits and pensions and, perhaps the worst in a civilised society, an unfair distribution of income. Most of these problems do not exist if you are one of the richer members of society, but if you are poorer you have nothing. And the rich might not like it if the poor revolted (the French Revolution?).
Hence, all economies in the world are now mixed. But what degree of mix is best? We are now moving into the realms of normative economics, that is to say, subjective opinions.
Most sensible people would like to see an economy that is free in most markets, but where the government has a significant role. Remember that for each of the choices below, the preferable one with the better level of government provision will result in higher taxes, which results in less take-home pay for individuals to spend as they please.
Should the NHS be totally free, or should people have to pay for some non-essential elements of the service (like prescriptions, eye tests, minor operations and even making in-patients pay for bed and breakfast)?
Should three years of study at university be totally free (including a grant for living expenses), or should individuals pay for a portion of the costs, given that they themselves will benefit in the future as well as society in general?
Should unemployment benefits be generous, or should they be relatively low, not just to keep taxes down, but to create incentives for the unemployed to look for work?
Should the state pension be generous, or should individuals be forced to make their own provisions? Remember, pensions that grow with the stock market will probably be worth more than any handout that the government can afford, especially with an ageing population. The value of the state pension relative to wage earners gets worse every year; it rises with the inflation rate, which is smaller than that rate at which average earnings rise. This change was made twenty years ago.
As you can see, the extent to which the government should intervene is a normative question and a difficult one at that. To sum up, governments need to get the balance right in the classic equity v. efficiency argument. All civilised societies ought to have a minimum safety net of essential services, but if it is too big and costly, the higher taxes will make the economy less efficient and less attractive to foreign investors. Do the poor get a bigger slice of a smaller cake, or a smaller slice of a bigger cake?
What went wrong?
Some of you might remember the Berlin Wall falling down late in 1989, and along with it the concept of communism throughout Eastern Europe and the Soviet Union. The driving force for this change was people power. They were sick of being dictated to and wanted to have the chance to vote and have a say in the running of their country, like their democratic neighbours in the rest of Europe. But at least part of the dissatisfaction with these communist political systems must have been down to economics.
These economies were struggling. The ideal of the central plan was breaking down. People's standard of living was declining. One of the reasons for the mess was that the state owned enterprises began to ignore instructions from the government. This caused chaos as the output levels were not as planned, and this had knock on effects for other enterprises that relied on this output.
Unsurprisingly, investment from abroad was non-existent. More importantly, there was little investment from within these economies. The capital stock was old, obsolete and falling apart. Inevitably, the quality of the goods produced was low, and yet consumers still had to queue at the shops to buy them.
One of the supposed advantages of the command economy was the fact that the planning authorities could keep pollution low through their control of the production process. Even on this measure these economies were failing. The old factories with their out-of-date and dirty machinery were creating an unacceptable level of air and water pollution.
The transition process
All of the transition economies experienced pain during the transition. Output fell dramatically, inflation rose (hyperinflation in some of the countries) and unemployment levels rose. The next section will look more closely at a couple of countries; one that recovered from this mess quite well and one that did not. For now, we need to look at the reasons why the transition process was so difficult.
One of the key problems was that the old command economies had no labour, capital or goods markets. Everything had been directed by the state. The creation of these markets from scratch was very difficult.
Also, the governments had never had to use fiscal policy and monetary policy in the way that developed economies understand. They had to set taxes in order to pay for defence, a legal system and a welfare state for those who were to inevitably suffer during the transition process, but the newly formed private enterprises were struggling in their early days, and so often could not afford the taxes, so they just didn't pay. If the government raised taxes to allow for this, even more businesses left the formal economy and joined the informal economy (or black economy).
So the tax base was very small. How else could the government raise money? In western economies, the government can sell bonds and bills to the public through the stock market. In the transition economies, the stock markets were under developed, so there was only one other way to raise money - print new notes. Of course, this caused the money supply to grow enormously, which is the main reason for the hyperinflation experienced by some of the countries.
Why did output fall so dramatically? One has to remember that the workers were used to working in a state owned enterprise when all production decisions came from above. The sudden switch to private enterprise was a shock. These new entrepreneurs were cautious in their decisions. They did not want to make lots of goods that might not be purchased by consumers. They were not keen on investing in new machinery. So not only was the quality and quantity of their output low, but this had a knock on effect. Businesses that supplied machinery, or the materials required, for the production of the good would suffer too. It was a negative multiplier effect. Low output led to low employment, which led to less consumer spending power and so an even lower output. Prospects did not look good.
Do you remember the most important characteristics of a free market economy? Without the establishment of property rights through an appropriate legal system, the whole economy can break down.
All the transition economies set up a system, but they were often unclear or contradictory. In some countries, businessmen took advantage of the unclear property laws by signing land and factories over to themselves during the privatisation process. The laws were also muddled for foreign investors. It was essential to attract foreign money if the economies were to grow again.
Was the transition a success?
Generally, ten years on, the Central and Eastern European economies (like Poland, the Czech Republic and Slovenia) have recovered from the disastrous early years, whereas the states from the former Soviet Union (now called the Commonwealth of Independent States, or CIS) have stayed in the depths of depression.
Russia's official real GDP, for example, is still only about half the size it was before the transition began. This does mask the fact that many of the struggling economies have huge black economies. In Russia it is almost as big as the formal economy! In recognition of the fact that the high tax revenues were forcing businesses underground, the Russian parliament voted for a large cut in income tax rates in the summer of 2000. Although the tax rates are low (around 10%) the government are hoping that more businesses and individuals will be willing to pay, and so total tax revenue may even rise.
The example of a success story is Poland. To be fair, they did start the transition process a bit earlier than the other economies, but nevertheless, one has to say that Poland is now a recognisable mixed economy. The important fundamentals are there: a good legal framework, a wide tax base and even the currency is relatively stable. Obviously, they had their problems. Growth in real GDP was briefly below -10% in 1990. The unemployment rate (as a percent of the labour force) was just over 15% in the early 90s, and the inflation rate was over 500% in 1990. Now they are growing at the same rate, or slightly faster, than most western economies, the unemployment rate is down to 10%, which is not a dissimilar rate to most of Western Europe and their inflation rate has finally fallen below 10% (a relatively large figure for an EU country, but a real achievement for a transition economy).
At the other end of the spectrum, the Ukraine got it all wrong. The real growth rate has been negative for every year in the 90s, the worst year being 1994 when growth was less than -20%. The inflation rate was almost 5000% in 1993 (the government was simply printing money to get by). Things are better than they were but the growth rate still averages at -2% and inflation is still in the 10-20% range. We said earlier that a robust legal framework is a vital building block for these transition economies. This was missing in the Ukraine. The businesses were 'taken' by politicians and ex-factory bosses. Even criminals were involved.
Businesses struggled to make any money, so they just didn't pay taxes or wages. The poor worker suffered, as did pensioners who relied on the state (who had little money) for their income. As with Russia, the informal economy is large to make up for the formal economy only being a third of the size it was before the changes. But much of this is criminal based. Unsurprisingly, investment form abroad is virtually non-existent. Without this, it is difficult to see where the investment in new machinery that is desperately required will come from. The future looks very grim.
So was the transition process a success? Some of the countries have proved that it can be if the right structural steps are taken right at the beginning. Probably the two most important fundamentals that must be in place are:
1.A robust legal system, and in particular, clear rules governing the issue of property rights. One cannot allow the criminal elements to get their hands on vital industries.
2.A reformed and free capital market, to attract foreign investment. Without this help the transition will struggle to be a success.
Another article from the 7 Days suggests that improving transport in the region will help business and economic growth
