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What are the main characteristics of a free market economy and centrally planned economy?

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What are the main characteristics of a free market economy and centrally planned economy?

Every country consists of a social institution which controls, manages, and attempts to solve the basic economic problems of what to produce, for whom to produce, and how to produce.  Such social institutions are known as economic systems, and vary in their approach to solve the economic problem.  The most basic and known economic systems are the Market Economy, the Mixed Economy, the Market Economy, the Planned Economy and the Traditional Economy.  The two economic systems which are of complete contrasts are the Planned Economy, which is revolved around government decision and the Market Economy, which is based on the free-market.  

A country which the government controls the factors of productions and resources, assesses the demand, sets production targets, and creates an input/output analysis in order to determine the required goods that need to be employed in order to achieve the target is following a Planned Economy, and can be said to a socialist country.  In this economy, the government decides what to produce, how to produce, and for whom to produce.

The fact that the government does set targets does mean that economic growth will be achieved when the targets increase and inputs reduce.  However, often times, the target isn’t met and if not, there is minimal ways of repayment.  In addition, with the minimal incentives, the target is often manipulated.

In a planned economy, the government sets fixed price system, which implies that the state determines the price of goods with minimal account of the demand of the good; however, this also suggests that the goods are rarely over or under priced.  In a fixed price system there is minimal incentive because the prices and wages are fixed, which demoralizes the employees, and thus decreases incentives.  Nevertheless, the fixed price system also suggest that a greater majority of the society will be able to afford the good or service, and thus, it will be more beneficial for society, and not only those who can afford the good or service such as education and health care.

A planned economy can often cause problems with the fact that they can misallocate resources, which means that there will be over production of goods.  In addition, allocating enough resources for production on every single good and service is a demanding task and a slight miscalculation could ruin everything.  There is however, in a planned economy, less wastage of resources, primarily labor.  

In a planned economy, the government controls the freedom of entry and exit, because the state decides who works where, and often times, the state attempts to substitute a number of firms with a single firm per market, which will suggest that there is monopoly, and thus, minimal or nil competition.  With less competition, there is no desire to improve ones level of production and resources, and thus, no development of resources and technology to help minimize the use of resources.  This also implies that people will have no rights to become entrepreneurs or capitalists and set-up their own firm because the state will issue all that.  

In addition, as they organize how the economy is run, the government will ensure full employment, therefore there is no unemployment, however, this can also lead to over employment, where there are too many people working on the same profession.  This might be perceived as a positive point but actually it is not good because it decreases efficiency of labor.  

Planned economies usually focus their production on capital, public and merit goods.  Firstly, the government focuses on capital goods rather than consumer goods, which can be seen on the PPF Figure 1.  As a result on the greater concentration on producing capital goods, the curve will after a long time, shift to the right, as can be seen in Figure 2, which indicates economic growth, and the country will be more self-sufficient.  However, this could   also imply that the country is closed to trade and thus technology isn’t very modern, and the most efficient way to shift the curve of the PPF to the right is ruled out.  With the public goods, which are goods that are non-diminishing, the state will produce a majority of public goods in both countries which are run under a planned economy and free-market, because these goods consist of street lamps etc. and if the government does not supply these goods through taxation, no one will as they are non-profitable, but only beneficial for society.  Lastly, the government produces a great amount of merit goods, which are goods which are deemed socially desirable by the political process with positive externalities and social benefits outweighing social costs, through advertisement and then providing the goods at cheap or free prices using subsidies e.g. contraception.  Merit goods are usually underprovided in a free-market economy.    image00.pngimage01.png

In contrast to the Planned Economy, there is the ‘Free Market’, or ‘Market Economy’, in which there is consumer sovereignty, and the consumer has choices, self-interest, and the ability to own property, and the right to build an industry.  The main objective in a free-market economy, unlike the planned economy, is to make a profit.  However, there is rarely any country that is purely a free-market economy.  image02.png

A ‘free-market economy’ consists of a free price system where prices are set by the interchange of supply and demand and the free-market.  During this interchange of supply and demand, the consumer and seller bid for prices, which allow a transaction to occur and thus an equilibrium price will be met, which can be seen in figure 3.  In figure 3, the increasing demand, which is seen by the shift in curve from the consumers signals the producers to supply more computer games as their main objective is the earn more profit.  As we can see, the advantage of such a system is that prices will be set according to the demand of good, will aid in utilizing the allocation of resources because the price will determine how society will utilize its resources, and distribute income.

As a result of the price mechanism, the supplier and seller could have more incentive for the business.  In a free price mechanism, the goods which command higher prices, which will force the suppliers to increase supply, will provide an incentive for the supplier and seller of the business because they are able to obtain greater profits.      

Unlike in a command economy, the increasing incentive in a free-market will create a great amount of competition between firms.  In a free-market, the high incentive will stimulate the entry of firms, depending on the type of market i.e. oligopoly, monopolistic competition, perfect competition, or monopoly, which will create a lot of competition between firms, and thus more efficient production of goods and services to satisfy the consumers demand.  This also suggests that the firms must be efficient and provide good services and in most cases decrease prices.  In addition, the competition instigates research and development, which can improve the productivity and efficiency of goods and services and minimize the use of resources.  

The goods provided in a free-market, are usually consumer goods and any other good that there is a market for.  Providing a good that has no market defeats the purpose of a free-market, and the firm will obtain minimal profits.  The people have the decision to produce any good or service and with the main objective of earning money, they will produce what will satisfy the demand in the market.  As a result, one will only demand for what one is able to afford and thus ones income plays a major role.  Unlike the planned economy, the goods produced and their value will only be of use for those who can afford it, which is why it is important for governments to produce public and merit goods.  The producers will use, with their technological advancements, minimal resources, and thus minimize cost of production to produce the best product, which will maximize profits.  

It is evident that there are clear distinctions between the two types of economy, where one is more revolved around the decision of the government and the other based on the free-market and consumer sovereignty.  Both markets have their own benefits and disadvantages and having a country which combines both factors and uses the benefits of each market to its advantage should be successful, however, in doing this, the country will have to go through being in a ‘Transition Economy’.

Evaluate the possible consequences that may be encountered when an economy makes a transition from central planning towards a free market.

In many current situations, countries are changing from a planned economy, to a free-market economy, which suggest that the country is under a ‘Transition Economy’.  In doing so, the economy will be deregulated or privatized, and like any choice, there will be consequences and also benefits.

In most cases, when in a transition economy, the GDP of a country will drop dramatically because in a planned economy, everyone’s salary or income is fixed and fairly equal which suggests that the GDP can be high.  However, in a transition economy, the wealthy benefit greatly and their income increases, but the majority of society, who are not as wealthy, will not benefit and their income will decrease and thus, the GDP per capita will drop and the wealth gap increases.  An example would be when Russian economies GDP shrank by 40% from 1990 to1999, which was the time of their transition from a planned to a free-market economy.

In the process of deregulation, industries will be sold to private companies and this will allow the companies to have freedom to choose what to produce, how to produce, for whom to produce, the prices, and wages.  Therefore, there is a change of government institutions and role of the state and also more public involvement, consumer sovereignty and democracy.

In a transition economy, selling industries to private companies will allow freedom of choice and the way they run their business, which means that they have property rights.  As a result, there will most likely be more firms, and thus more competition, which, in the long-term, will allow development, and technological advancements to help minimize resources and maximize the quality of goods.  So in deregulating, we are reallocating our resources and utilizing our resources. In addition, the fact that the firms are owned by private companies suggests differing wages determined by various criteria, which will create more incentive as the employee’s will be earning more profits.  However, like in all market-economies, there will be unemployment, which can be seen when China’s 3.6% unemployment in 2001 during the transition economy time, but more efficiency of the current labor force.  The increasing unemployment suggest a decreasing demand for labor, which can cause incomes to decrease and with this the difference in income and wealth, unequal income distribution can occur.      

With the deregulation of industries, there will be a transition from a fixed price system to a free price system, which implies that prices will be met by supply and demand and there will be an equilibrium price.  However, as the market force is taking over – and in a planned economy, everything is fairly equal and beneficial to all of society, firms will be aiming to maximize profits which will cause them to increase prices and possibly cut supply and therefore, not all of society will be able to afford such goods or services.  As a result of the free price system, the rapid increase of price will create high inflation, which was the case for the Baltic during the transition when inflation rose to 900%.  This high inflation could cause a lot of inequality and more poverty as people are unable to afford the goods and services and also a fall in output.

Corruption can be a major problem in a transition economy as in a planned economy; there is already corruption because the state has the authority to do whatever they feel.  In this case though, there is corruption because governments and institutions collapse leaving a judicial vacuum.  In addition to corruption, a similar problem of the black market can arise.  In Georgia, during the time of its transition, black market became a big problem because they didn’t have resources like oil supplies or natural gases to drive their economic growth, which lead to a quarter of the output in Georgia to be accounted by the black economy and two-thirds of its trade.  The presence of a black economy means that production and exchange are not declared and thus taxes are not paid, which means the government doesn’t collect the tax revenue to invest in infrastructure and other public goods to benefit society and the economic growth.        

As the country is making a transition from a planned economy to a free-market economy, there will be decreasing production of capital goods, and greater production of consumer goods to satisfy the demands of the consumers, which will not benefit the stimulation of economic growth.  In addition, there will be less production of capital and public goods, but more de-merit goods and consumer goods because those products allow companies to maximize profits.  With this transition, I believe that the government should continue to control the production of public goods such as education, health care, infrastructure, energy, and communications because it is very unlikely any private industry will control those businesses as they provide low profit, but the government providing these subsidies, they will be accessible for all of society and not only those who can afford it.

It can clearly be seen that in the transition, there will less government involvement, and as a result, less government subsidies, which implies that there will be a lot of goods and services that only target those who can afford it.  The decreasing government involvement also means that there is a deficiency of legal institutions to handle the setting and collecting of taxes and affirming ownership, which allows companies to take over defunct government run enterprises.  In addition, the lack of financial institutions such as banks and capital markets can cause businesses to close down due to lack of loans, which also prevents new companies from collecting initial loans.  

As there will be more privatization, the country will be more open to trade, which can help shift the PPF to the right, which suggests economic growth.  However, during the time when the country was under a planned economy, the trade was either non-existent or very limited with a few countries and moving to a free-market implies that all countries can invest in the country, which can cause a problem due to the lack of experience, which was the case in Russia that lead to bad decision making.  The increase in trade does however mean that there will be more investments, as there is potential for a lot more returns, and thus, there will be more demand but in often takes a long time to welcome foreign ownership as they are concerned of the stability of the economy.

In conclusion, it can be seen that during a transition economy, there are both the benefits and the consequences which might occur during a period of time.  However, after a while, the country will begin to grow rapidly like China, which grew at around 8% from 1982 to 2002.  I believe that a country which moves which is based on a centrally planned economy should change to a free-market economy but keep some of the government control such as the subsidies and the country should, in the long-term, achieve maximum economic growth.

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