This popular topic in economics is comprehensively condensed into this short article by Clancy Peiris, the economics lecturer at
Wisdom. This article is recommended for students of CIMA foundation level, GCE Advanced Level and London Edexel AS level.
Scarcity of resources means that choices must be made about how the resources will be
allocated leading to the five basic questions of resource allocation.
What goods and services will be produced?
How will these goods and services will be produced?
To whom the goods and services will be distributed?
When these goods and services to be produced?
How much goods and services to be produced?
The economic system decides how scarce resources would be allotted among competing
industries. The world has so far witnessed six such economic systems; namely, tribalism,
slavery, feudalism, capitalism, socialism and the mixed economy.
Whatever the economic system the basic economic issues confronted are the same. The way in
which the resource allocation choices are made, the way the value is measured and the forms of
ownership of economic wealth vary according to the type of the economic system that exists in
Free Market Economy
In a free-market economy the choices and decisions about resource allocation are left to market
forces of demand and supply and the workings of the price mechanism. What producers will
make, what consumers will buy are, in theory, kept in balance by the price that producers will
want for their output and the price that consumers are willing to pay. Individuals own most
wealth with the minimum being collectively owned.
A 'pure' capitalist free market economy is a complete contrast to the planned economy. In a
free market economy price acts as a 'signal' to both producers and consumers.
It indicates what and how much firms should produce to maximize their profits, and how much
consumers should buy to satisfy their wants. If the price is too low, consumers will demand
more than is produced so the price will rise, and vice versa. The price mechanism should ensure
efficiency in the allocation and use of resources, in a market economy.
Consumer sovereignty refers to the freedom of individuals (strictly, the freedom of households
to decide for themselves what they want to buy). The 'consumer is king', and rules the market.
However, when we say 'the consumer is king' we do not mean that consumers can order firms
(suppliers) what to do. What we do mean is that in a free market economy or a mixed
economy, the freedom of consumers to decide what to buy influences output decisions by
suppliers through the price mechanism - i.e. the interaction of demand and supply.
There can be disadvantages to a free market capitalist system in which the State plays no
role in directing the allocation of resources.
1. Since all resources are only available at their prevailing market prices, some members of the
community might be badly deprived, unable to afford even the basic necessitates of life.
2. Some desirable products may not be produced for lack of profitability - for example,
equipments for the handicapped.
3. Some undesirable products may be produced - for example, dangerous addictive drugs.
4. Competition may be eliminated by monopolies, oligopolies and restrictive practices,
reflecting the disproportionate economic power of certain firms and groups in society.
5. Competition may lead to a waste of resources for example, on advertising.
6. Where inequalities of wealth exist, resources may be allocated to producing luxury goods
to the exclusion of necessities for the poor.
7. Some vital services (for example police, fire services and armed forces) would be unsuitable
and some other will not be provided (for example street-lighting, roads, bus-halts etc) by
private enterprise if left alone and therefore require government action to provide them.
These 'goods', whose benefits must be shared by society as whole, are called ‘public goods’.
8. Some of the desirable goods or services, such as health care and education, might be
provided in inadequate quantities in a completely free market economy, and provision of
these 'merit goods' by the state will be necessary to create them in adequate quantities.
9. Prices of some goods for example agricultural goods) might be volatile (subject to big rise
and falls) unless measures for price stabilization are taken by the government.
Centrally Planned Economy
In a centrally planned, also known as command economy, the decisions and choices about
resources allocation are made by the State. Money values are attached to resources and to
goods and services, but it is the government that decides what resources should be used, how
much should be paid for them, what goods should be made and what their price should be.
Although the individual might be allowed to own some personal possessions, most kinds of
wealth would be available for ownership by the state.
In centrally planned or command economy, the government fixes the quantity of each good to
be produced and the price at which it is sold.
It sets quotas for each individual production unit. It decides how many resources should e
employed in producing the goods. The State even decided how each worker is to specialize.
Such a government believes that it knows how to organize, distribute and co-ordinate a
country's resources to its best advantage. Its objectives in doing this will depend upon its
political or ideological framework. There is no private profit, because all resources are publicly
The economies of various Socialist-Communist countries such as China and the former Soviet
Union have been command economies, although in such economies there has often also been a
small free market sector. Another example of a centrally planned command economy was that
of the UK during World War II. To mobilize economic resources for war, the government
took charge of production decisions and consumer goods were rationed.
In a planned economy, economic efficiency depends on the accuracy of the government's plan in
forecasting society's wants and allocating resources to meet them. In such an economy, people
have only limited freedom, if any, in their economic decisions, but in return they may have
'greater security and greater social equality’. Basic necessities are intended to be made available
to everyone at an affordable price, fixed by the government, they all can afford, but in practice
most planned economies suffer from shortages of consumer goods and services which limit that
In a mixed economy the decisions and choices are made partly by free market forces of supply
and demand, and partly by government decisions. Economic wealth is divided between the
private sector and the public sector.
In practice, all modern national economies are mixed economies, although with differing
proportions of free market and centrally planning decision-making from one country to the
Many of the disadvantages of the free market economy listed above indicate that there are
reasons why the government may intervene in the workings of the economy. In mixed
economy, market mechanisms exist, but the state also plays an important role. A government
1. To restrain the unfair use of economic power by monopolies or other bodies which might
be able to impose their wishes on the rest of society.
2. To correct inequalities of the free market system redistributing wealth between individuals
and between regions.
3. To provide goods and services that private enterprise would be reluctant or unable to
provide in sufficient quantities and at an acceptable price, for example:
Goods that is socially desirable but unprofitable for private producers - for example,
special equipment for handicapped people.
Services those are unsuitable for private enterprise because such ownership would be
against the public interest - such as the armed forces or the legal system.
Services that are 'natural' monopolies, being very large and complex - for example, the
provision of domestic electricity or the railway system.
4. To remove socially undesirable consequences of private production - for example, pollution
and regional imbalances in unemployment.
5. To direct changes in the structure of the nation's industries, by retraining programmes, and
to new industries, or investment in research and development, and so on.
6. To manage inflation rates, employment levels, balance of payments and the economic
7. To moderate the ups and downs in the trade cycle trying to stimulate economic activity
during a recession, and to dampen demand when it is so high that steep price inflation