How in principle do a) market economies and b) planned economies solve the economic problem? Discuss the practical limitations of both systems by reference to the experience of european economies since 1980.

“Any society faces what economists regard as the basic economic problem – it’s citizens would like to have more goods and services than can be made with the available resources. So that choices have to be made about what is to be produced, including how it is to be done and who is to receive the goods and services when they are available. {Lythe C. The European mosaic (2000) P.221}

This Quotation sums up the economic problem of scarcity relative to human wants for goods and services. This means decisions must be made on how to allocate resources and distribute finished goods and services. The two extremes ways societies can organise their economies into are a) market economies and b) planned economies. This essay will look at how these economies in principle try to solve the economic problem and then discuss some of the practical limitations of both systems.

Planned Economy

On the other side of the spectrum is planned economies. Planned economies are normally part of socialist governments ideologies so the decision of who the finished goods should be distributed to is seen as the most important. These government s are striving for fairness in distribution.

“To each according to his needs” {Lythe C. The European Mosaic (2000) P.253}

At a first glance a centrally planned government seems to have the perfect solution to the economic problem. As information, such as prices demand, market opportunities etc., is vital to solving the economic problem. Through determining the needs of society and setting and solving a set of equations a state can figure out exactly what to produce, how much to produce and when to produce it. From this orders are given out and enforced and production is thoroughly planned from start to finish. {Johnston B. (1985)}

All capital and resources except human labour is owned by the state. The state also makes all the decisions of production and distribution as if it were one big firm. Each producer is given physical targets of how much to produce, how much equipment, labour and materials should be used. Producers are given strict instructions of prices and distribution of their goods; whether to shops or other producers for more production. Performance is strictly monitored to ensure that targets are being met and goods are being allocated correctly. {Turnbull W.N. (1999)}

Practical limitations

Market economy

One of ...

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Practical limitations

Market economy

One of the fundamental problems of a market economy is the fairness in distribution of finished goods and services. If some one cannot afford the market price then they cannot buy the goods they want. This could lead to unemployed people starving. Inheritance of talents and wealth perpetuate this unfairness. This means if you are born poor you will stay poor and if you are born rich then you will stay rich.

“in particular there is a social impact… This analysis reveals a growing divide between rich and poor” {David M.E. The social effects of free market policy. (1990) P.30}

A monopoly is another practical limitation of a market economy. A monopoly occurs when one firm, called a monopolist, produces the entire output for an industry. A monopolist will normally charge a high price and therefore limit output. This will lead to the company making greater profits. See figure three.

Figure three shows how the monopoly equilibrium is not due to an agreement between the producer and the consumers. The monopolist can use it’s power in the market to impose it’s prices on consumers. This leads to society as a whole being worse off as the taking some of the lost consumer’s surplus but not all of it. An example of this is when British Telecom offered limited edition prints. Only 500 were to be reproduced and the price was set at £25. This suggests that British Telecom felt that limiting the Quantity supplied to 500 was necessary to make £25 a viable price. {Lipsey R.G. and Chrystal K.M. (1999)}

Market economies do not take third parties into consideration. When two people come together to trade: a price is bargained for neither party is concerned who or what has been affected by production. The producer wants to have the lowest costs of production to make the greatest profit and the consumer wants the lowest price so he can maximise his consumer surplus. However this may lead to adverse effects on third parties such as the environment. If a producer uses chemicals in production of his good he will want to dispose of the waste in the cheapest way possible to keep his costs down. This may mean dumping it in a river. The environmental effects of this may be catastrophic. Under a free market this would not be a consideration.

An example of this is the use of chlouroflourocarbons (cfc’s) in aerosol sprays. They were cheap and efficient to produce. The problem was they made a massive hole in the ozone layer. {Wainwright H. (1994)}

Planned economy

In practice a centrally planned economy has many limitations. One such limitation is dificulty in co-ordinating all the economic decisions regarding investment, trade and consumption. Due to a rise in the aspirations of consumers the complexity of production increases. The complexity of interrelationships between companies is also massively complex. The planning involved includes making firm decisions that last at least one year in advance. This is difficult as the world is not static and is always changing. {Lythe C.(2000)}. For example in Russia in 1989 most of a bumper crop rotted because of shortages in storage and transportation. Also for many years there was an ample supply of black and white television sets but a severe shortage of toilet paper and soap{Lipsey R.G. and Chrystal K.M. (1999)}

Quality control is another main problem. It is quite simple to monitor production targets of quantities. However it is much more difficult to monitor the quality of products. This was a major problem for the Soviet Union as factory managers were concerned with meeting the targets placed on them by any means availavle. In the 1990’s the problem was so great that eastern products could not compete with the superior goods of market societies.{Lipsey R.G. and Chrystal K.M. (1999)}.

To solve the problem of fairness in distribution food prices were kept artificially low, sometimes below the cost of production.

“In 1981, the State subsidies for the production and sale of meat and dairy products to the population at stable retail prices amounted to almost 19,000 million roubles… To cite an example, the retail price of first grade beef is 2 roubles per kilo while the State spends 3.21 roubles on purchasing processing and sale. Therefore, the Soviet consumer buys meat practically at half price.”{ Reading the introduction of the soviet economy. (1992)}

This led to an excess demand for food leading to rationing, queuing and importation. Consumers were willing to pay more than the set price for food so this led to a rise in black markets.

Another very important problem with a centrally planned economy is there is no incentive to innovate and it can lead to misplaced incentives. In a market economy wages or the lack of them if you are sacked provide incentives to work hard. In a planned economy workers usually have complete job security. Although this is highly attractive it does not provide sufficient incentive to work hard and efficiently. The temptation to shirk is too great.

“in the words of Timothy Garton Ash, who wrote eye witness chronicles of the development of eastern europe from 1980-1990, The social contract between the workers and the government in eastern countries was ‘we pretend to work and you pretend to pay us’ ” {Lipsey R.G. and Chrystal K.M. Principles of Economics (1999) P.3}

Conclusions

As this essay has shown market economies and planned economies try to solve the economic problem in completely different ways. Market economies rely on private ownership, self interest and the interaction of producers and consumers. On the other hand planned economies rely on public ownership and a government making all the decisions regarding inputs, outputs, inventories, and distribution. Both Ideologies have serious drawbacks. The drawbacks of the planned economy were seen by “the dismal record of the soviet economy” with “chronic shortages.. severe inefficiency…and… black markets, bribery and corruption.”

{ Johnston B. Information and the economic problem.(1985)}.Market economies fail in the sense that the distribution of resources is unfair. Monopolies can mess up the whole system by controlling a market. Also a market economy does not take third parties in to account. In practice most countries find that a mixed economy is the best option: market orientated with government intervention.