Here any combination along the resources are being used efficiently. The production of more and more clothing will involve growing marginal cost: ever increasing amounts of food have to be sacrificed for each additional unit of clothing produced. So governments would analyse and determine what is the best to produce to satisfy the habitants.
All systems have this scheme on solving the economic problem, however, in a Market system economy, in order to ration scarce resources the price mechanism operates to deal with. In this system the government takes no effective economic decisions in resource allocation. Rational consumers and private firms form markets. In each market a balance is achieved between consumers effective demand and the output of firms that can be supplied the balance is achieved at the equilibrium market price. Factor markets are created for labour, land and capital and market prices are established in each. Thus a series of market prices is created, this is called the price mechanism. It is changing market prices that act as signals to consumers and producers. Rising market prices will tend to encourage production by attracting resources into a market, falling prices the reverse. Thus resources are reallocated automatically by the invisible hand of the price mechanism. The price mechanism uses automatic signals of excess profit and factor earnings to allocate the scarce resources in an economy to meet the wishes of consumers, as reflected in price changes in the product market.
The advantages of a market system is that it functions automatically, there is no need of bureaucracies to co-ordinate economic decision, the economy can respond quickly to changing demand and supply conditions. When markets are highly competitive, no one has great power, so prices are kept down. The more efficiently firms can combine their factors of production, the more profit they will make. On the other hand, competition is often limited, a few giant firms may dominate an industry; this lack of competition and high profits may remove the incentive for firms to be efficient. Power and property is unequally distributed, not profitable business are insufficient and luxuries are produced more than necessities.
Further more market system provides insufficient merit goods, and public goods would not be provided because they cannot command a price. Moreover negative externalities are high, like socially undesirable pollution and demerit goods that may be produced.
In a planned or command economy the basic resource allocation are carried out by a centralised administrative process or Central Planning Authority. It is usually associated with socialist economic system where land and capital are collectively owned.
In order to solve the economic problem the State plans the allocation of resources between current consumptions and investment for the future, the output of each industry and firm, the techniques that will be used, the labour and other resources required by each industry and firm and the distribution of output between consumers. His will depend on the government’s aims. It may distribute goods according to peoples needs or to act as an incentive to work harder.
The advantages of the planned economy system are that production is not undertaken for profit , therefore it is argued that there is a greater likelihood of public and merit goods being produced. There is greater equality in the distribution of income and wealth. There is a more stable economic management nor unemployment or inflation. Nonetheless, wrong goods may be produced, large bureaucratic structures which can be inefficient are created and there is less competition among firms, since each firm simply responds to the instructions it receives from planners.
This kind of market provides public and merit goods, which beneficiate the habitants. Production and consumption of demerit goods can be limited or prevented altogether. Externalities are controlled for the satisfaction of neighbours.
A mixed economy system combines, the market ideas with the government intervention. A private enterprise responds to market force but with state control and economic planning. The role of the government performs varies between countries.
In a mixed economy the government provides public and merit goods. It controls the economy (macro-economy) and attempts to achieve certain economic objectives like high and stable level of employment, stable prices, economic growth and equilibrium in the balance of payments, through the use of monetary, fiscal and supply side policies. It redistributes the income through taxation, social security payments and other institution payments. It also places taxes and subsidies on goods and services to influence their prices modifying the system. It also controls the productive efficiency by taking decisions of nationalisation or privatisation, subsidising and controls the monopoly and oligopoly.
In a market system there are imperfections which prevent the efficient allocation of resources through the market mechanism. Hence allocative and productive efficiency may not be properly achieved, with a resultant loss of welfare to society.
When imperfection allocates, there is a productive inefficiency
This imperfections can arise from imperfect competition, in both goods and factor markets, externalities (social costs and benefits) and missing markets, which are the market fails to provide so-called public and merit goods. In order to fill this holes, the government is required. It is important to reduce the effects of externalities and to manage the missing markets.
Governments spend lots of money each year on public goods. Because private sector producers will not supply them because they cannot be sure of making an economic profit. This is due to the characteristics of public goods , which are non-excludible, so goods cannot be confined to those who have paid for them. Non payers can take a free ride or advantages and enjoy the benefits of consumption. Another characteristic is the non-rivalry in consumption, this means that consumption by one person does not reduce the availability of a good to others. The obvious solution is that these goods are provided collectively by the government, and financed through taxation of individual households and businesses. Some examples of public goods include flood control systems, street lighting and national defence.
Merit goods are those goods and services that the government feels that people will under-consumed, and which ought to be subsidised or provided free at the point of use. The public and private sector of the economy provide merit goods and services. Consumption is thought to generate positive externality effects where the social benefit from consumption exceeds private benefit. Some examples of merit goods are health service, education and work training programmes. In order to finance these goods and provide more merit goods than the ones given by the private sector, the government intervention is needed. It often provides them by getting the money from taxation.
A way of promoting merit goods by government is to subsidise the producers. An example are the grants available to employers who create new employment in different areas. Another way is by subsiding the consumers, like lowering the taxes on unleaded and diesel fuel and the suggestion that owners of old cars should be given money to scrap them. In both cases, these lower private costs by the amount of the subsidy, which is designed to reflect the social benefit of the externality. They internalise the externality. Other forms of encouraging positive externalities to have merit goods is by providing free recycling facilities or sponsoring an advertising campaign to promote the use of a good. A different approach is to offer the good free but ration the supply.
There are also demerit goods which are though to be bad for society. The consumption of demerit goods can lead to negative externalities, which causes a fall in social economic welfare, the government intervention is important for the reduction of its consumption. They try to reduce negative externalities by laying down maximum pollution levels or even ban the pollution creating activities. Government can also give local residents the right to claim compensation if pollution levels are more than certain level. It sets taxes on the polluters so that the tax is equal to the value of externality. It also can set a limit on the amount of pollution permitted , hence if a firm emit fewer pollution it can sell its permits to other company that emits higher levels permitted.
Merit goods provide positive externalities but if left wholly to the private sector it is likely that merit goods will be under-consumed. Partly this is because individuals do not understand or appreciate the social benefits that can result from consumption of education or healthcare as examples. Also demerit goods have to be controlled by government, otherwise private sectors would not have care on the social costs of the city. Public goods are left also to government assistance, because private firms don’t care about anything which wouldn’t give private benefits.
