The allocation of resources in different systems

An economic system is a particular way of allocating scarce resources in order to solve the economic problem. All societies face the so-called 'economic problem', which arises from the fact that, while resources are limited human needs and wants appear to have no limit.

The economic problem was famously clarified by US economist, Paul Samuelson when he said that all societies needed to answer three fundamental questions:

  1. What to produce?
  2. How to produce?
  3. For whom to produce?1

In order to answer these questions and solve the economic problem, economies must use resources to create and distribute the goods and services society requires. Economic resources are those resources which have alternative uses and therefore have an opportunity cost.

Economic resources

Economists identify five key types of economic resource, or factor of production:

  • Land and natural resources - the so-called 'gifts of nature' – shortened to 'land' Land includes all natural resources, and the land in which they can be found. The reward to land is rent.
  • Human resources – simply known as ‘labour’. Human resources can also be called 'human capital' and includes the quantity of workers and their skills and abilities. Wages are the reward to labour.
  • Capital assets and raw materials – ‘capital’. Capital includes all assets made by humans that can be used to make goods and services, and includes machinery, tools, equipment and technology - as well as raw materials waiting to be turned into goods or services. The reward to capital is the 'rate of return on capital', for simplicity called the interest rate.
  • Enterprise – ‘the skill and effort of the entrepreneur’. The main role of the entrepreneur is to combine the other factors to produce goods and services to produce an output which generates more revenue than cost, and hence make a profit.
  • The environment – also called ‘environmental capital’. It is only relatively recently that the environment has been included as a factor of production.

While there are many specific solutions to the economic problem identified by Samuelson, there are two fundamental economic systems: free markets and central planning.

Decision making in free markets

Free market systems allocate prices to goods, services and resources through the unregulated interaction of buyers and sellers in markets. Free market economies solve the economic problem by allowing the market forces of demand and supply to operate freely, with buyers, sellers and factor owners acting in their own self interest. Markets allocate prices through a ‘price mechanism’ – first identified by 18th Century Scottish economist, Adam Smith. Smith saw the price mechanism as an 'invisible hand' that guides resources to where they are best used.

Markets resolve the economic problem posed by Samuelson by answering the following:

What to produce

What to produce in a market economy is decided by consumers who express their tastes, needs and wants through the exercise of their purchasing power. Economists assume that consumers are looking to maximise ‘utility’ when they allocate their income and will reallocate it when they wish to increase their utility. For example, consumer’s may wish to allocate more of their income to the pursuit of fitness, and they may seek to purchase gym membership, and sports goods. This encourages firms to enter the market and resolve the problem of how to satisfy this demand.

In a market economy, the consumer is said to be 'king' - known as the principle of 'consumer sovereignty'.

How to produce

In a free market system, how to produce is decided by firms looking to maximise profit. This will be achieved if the cost of producing goods and services is less than the revenue generated from selling those goods and services. The need to keep costs as low as possible and increase revenue as much as possible determines how goods and services are produced. For example, taking sports goods, how clothes are designed and manufactured is determined by sports clothes producers such as Nike and Adidas who look to maximise their profits. These major producers, and other firms will compete for sales, either by reducing costs or by improving the product, or marketing it more effectively.

For whom to produce

The final piece of Samuelson’s jigsaw is to solve the problem of who gets the benefit of production. To answer this, we return back to the consumer and how they choose to allocate their income between alternative goods and services. In simple terms, we might assume that consumers with the greatest income will exert the greatest purchasing power in the market. However, income alone does not determine consumption - a multi-millionaire might choose a Spartan lifestyle. Hence, those with high incomes do not necessarily get all the goods and services – that is not how markets work.

In most industries, some firms will enter a market to produce goods and services explicitly for individuals and households on low incomes. In fact, if we take the gym/sports gear market as an example, there are at least 50 major sports goods manufacturers3 operating in the global market, with thousands more small and medium sized producers, covering very low budget items up to exclusive one-off designs, with the oldest being the US producer Reebok (1895) and the newest entry being the Indian producer, Performax (2015).

Ultimately, it is the rewards that are earned by labour, by capital owners and land owners, and by entrepreneurs that determine 'who' gets the goods and services that society produces. In a free market economy, these rewards are determined by the relative demand and supply of factors of production in factor markets.

Command systems

'Command' economies provide an alternative solution to the economic problem by allocating resources according to plans of the state, or by an agency appointed by the state. This method is referred to as central planning, where decisions are centralised rather than taken by individual buyers and sellers as they interact in markets.

What to produce

What to produce in a centrally planned system is determined by the preferences of those who hold the power to make decisions. This depends on who ‘rules’ the country – in Ancient Egypt the rule of the pharaoh Kings meant that decisions about what to produce were centralised, with power in the hands of the Kings who delegated some decision making to priests. Different rulers and different command systems may choose to allocate resources differently, depending on their own priorities, cultures and beliefs.

How to produce

In command economies, how to produce is also likely to be determined centrally, with producers being set specific targets. Prices will tend to be set by state committees according to the preferences of central government.

For whom to produce

Again, in command systems, decisions regarding the distribution of goods and services are made by the rulers or smaller committees representing them. For example, resources in Ancient Egypt were owned by the Kings, and managed through a system of bureaucracy run largely by priests. The working population was a complex mix of bureaucrats, farmers, traders and at least three types of slave2. To avoid revolt it may be a priority to ensure that everyone can consume some goods and services. For example, in Cuba, many if not most goods are rationed so that families receive a specific quantity of goods. In North Korea, production and distribution are centralised, with agricultural products sent from local 'co-operatives' to the central government, where it is then stored in regional state controlled facilities4.

Unofficial economies

It should be noted that, in most command economies, unofficial ('black') markets exist for many goods, especially at a local level.

Mixed systems

Mixed economies are those where economic activity is organised through a combination of market forces and incentives, and central planning.

Mixed economies may solve the economic problem in several different ways. It is common to have two distinct sectors – the public and private sector, where some goods and services are allocated through market forces – the ‘private’ sector – with other goods and services allocated through planning – the ‘public sector'. The private sector typically produces private goods, and the public sector is typically responsible for public goods.

The Beveridge curve

In most mixed economies, certain industries themselves are ‘mixed’ – with private producers or suppliers operating within the same industry as state suppliers – or more commonly, operating with state funding. For example, merit goods are commonly produced by private suppliers operating alongside publicly funded suppliers.

In reality, all economies are mixed, though there are wide variations in the amount of mix and the balance between public and private sectors.

Evaluation of mixed economies

Mixed economies can exploit the advantages of free markets and planning while eliminating or restricting the disadvantages. More specifically, mixed economies have the following benefits:

Advantages of markets

  1. Individuals can own private property.
  2. Entrepreneurs can start their own business.
  3. Prices act as signals, automatically providing information to buyers and sellers.
  4. Entrepreneurs can be encouraged to innovate by the profits motive.
  5. Markets can allocate resources to produce private goods.
  6. Efficiency is encouraged as firms attempt to reduce costs.
  7. The quality of goods and services will be driven up as a result of competition.
  8. Where private goods are concerned, the consumer is 'sovereign'.

However, markets have certain disadvantages:

Disadvantages of markets

  1. Markets can fail to produce public goods, and insufficient merit goods.
  2. Markets may fail to control the production and consumption of harmful demerit goods.
  3. Not all individuals or households are guaranteed to receive a minimum level of income.
  4. Inequalities in the distribution of income can become excessive.
  5. Firms can dominate a market and exploit their market power.
  6. Information may become 'asymmetric' allowing those with more information to exploit those with less information.
  7. Market economies can experience volatile swings in economic activity, with excessive growth and deep depressions.

Advantages of state involvement

It seems clear that in order to make markets work, government intervention through central planning may be required to increase economic welfare. Interventions may include the following:

  1. Market failures can be compensated for by using indirect taxes and subsidies, and by producing public goods.
  2. Production can be co-ordinated at times of crisis - such as the production of vaccinations during the COVID-19 pandemic.
  3. The state can limit the import of harmful goods with import controls.
  4. Inequalities can be reduced by having progressive direct taxes.
  5. Minimum wages can reduce poverty.
  6. Competition can be regulated to control monopoly power.
  7. Prices can be regulated by setting maximum and minimum price controls.
  8. Economic activity can be regulated via fiscal, monetary and supply-side policy.

The view of the Keynesians

Keynesians (named after British Economist, John Maynard Keynes) share the view that, while markets generally work effectively at the 'micro' level of the economy, they often fail to allocate resources effectively at the 'macro' level, and can experience destabilising cycles of activity.

Economic problems are, they argue, largely a consequence of the inability of the macro-economy to fully adjust and move towards a stable level of national income where inflation in the goods market and unemployment in the labour market. For Keynesians, such adjustment either does not happen, or does not happen quickly enough, so that in the longer run it is possible that economic activity will settle at a dysfunctional equilibrium level.

The culprit, they argue, is the fluctuating level of demand in the economy - aggregate demand. Aggregate demand can either be excessive - leading to increases in average prices - or insufficient - leading to unemployment. This means that unemployment, or inflation, can become embedded and difficult to shift. In short, markets do not necessarily create full employment or a stable price level. This means that government should actively intervene in the economy to stimulate or restrict aggregate demand through fiscal policy.

The view of the Austrian School

It is also the case that some economists, including those of the Austrian School consider any government intervention to be sub-optimal. For example, Hayek argues persuasively that even minimal government intervention will lead to sub-optimal economic performance because any form of planning cannot co-ordinate resources as effectively as that which happens when individuals interact with others in markets.

In other words, Samuelson's three questions can be better answered by allowing individuals to use the information they have to make their own decisions. Collectively, individuals freely interacting in markets generates much more useful information than is available to governments and central planners. According to Hayek, the key to success is decentralisation not central planning.


Minimum wages

How does a minimum wage work?

Minimum wage
Monopolies

How inefficient are monopolies?

Monopolies
Inequality

How is inequality measured?

Inequality


Sources and endnotes

1. Samuelson, P, 1948, Economics: An introductory analysis, New York, McGraw-Hill Book Co.

2. https://en.wikipedia.org/wiki/Slavery_in_ancient_Egypt

3. https://en.wikipedia.org/wiki/List_of_sporting_goods_manufacturers

4. https://www.britannica.com/place/North-Korea/Economy