Economic systems

There are two basic solutions to the economic problem as described by Paul
Samuelson, namely those based on free markets and those based on central
panning.

Free market economies

Markets enable mutually beneficial exchange between producers and consumers,
and systems that rely on markets to solve the economic problem are called market
economies. In a free market economy, resources are allocated through the
interaction of free and self-directed market forces. This means that what to produce
is determined consumers, how to produce is determined by producers, and who gets
the products depends upon the purchasing power of consumers. Market economies
work by allowing the direct interaction of consumers and producers who are pursuing
their own self-interest. The pursuit of self-interest is at the heart of free market
economics.

command economies
The second solution to the economic problem is the allocation of scarce resources
by government, or an agency appointed by the government. This method is referred
to as central planning, and economies that exclusively use central planning are
called command economies. In other words governments direct or command
resources to be used in particular ways. For example, governments can force
citizens to pay taxes and decide how many roads or hospitals are built.

Command economies have certain advantages over free market economies,

especially in terms of the coordination of scarce resources at times of crisis, such as
a war or following a natural disaster. Free markets also fail at times to allocate
resources efficiently, so remedies often involve the allocation of resources by
government to compensate for these failures.

Command economies have certain advantages over free market economies,

especially in terms of the coordination of scarce resources at times of crisis, such as
a war or natural disaster. Free markets also fail at times to allocate resources
efficiently, so remedies often involve the allocation of resources by government to
compensate for these failures.

Communism
The benefits of command economies over free market capitalism became the central
economic idea of German philosopher and economist, Karl Marx, who advocated
state ownership of the means of production - namely, land and capital. He also
predicted the eventual collapse of capitalism. The real value of an economic activity,
Marx argued, could always be traced back to labour rather than capital, and hence
capitalism’s pursuit of higher profits though the accumulation of capital was always at
the expense of labour, who would increasingly have to produce more and more
output to satisfy the needs of capitalists.

According to Marx, when the ‘reality’ of this sets in, labour would realise it was being
exploited and would rise up and overthrow ther capitalist ‘masters’. While the ideas
of Marx seem out of touch with the reality of history, Marx’s economic theories are
widely studied and still influential.

Mixed economies
There is a third type of economy involving a combination of market forces and
central planning, called mixed economies.

Mixed economies may have a distinct private sector, where resources are allocated
primarily by market forces, such as the grocery sector of the UK economy. Mixed
economies may also have a distinct public sector, where resources are allocated
mainly by government, such as defence, police, and fire services. In many sectors,
resources are allocated by a combination of markets and panning, such
as healthcare and, which have both public and private provision.

Positive and normative

economics
As a social science, economics attempts to use the principles and methods of
science to explain economic behaviour. This involves making positive
statements about the economic world.

Positive statements are those that can be verified, and are factual, such as:

‘.. House prices have fallen by 15% over the last year...’

In contrast, normative statements are based on opinion and value

judgement. Statements suggesting that something ‘ought to’ happen, or that
something is ‘unfair’, are normative because they are matters of opinion.

For example, ‘..the recent fall in house prices is unfair to the rich..’.

This statement cannot be tested because it not based on anything testable. If there
is an agreed definition of fairness, and it can be measured, then it might be possible
to test the effect of the change in house prices on the degree of fairness experienced
by a certain identifiable group of people defined as rich. Therefore, this statement is
normative, impossible to verify, and based on opinion rather than fact.
The ceteris paribus rule
Economics is a social science, and, unlike the physical sciences, cannot engage in
controlled experimentation to demonstrate how variables are connected.

In the real world, economic variables such as price and income, are constantly
changing, and this creates a problem in demonstrating the relationship between
variables. For example, a fall in price is likely to lead to a rise in consumer demand if
we assume nothing else changes.

Of course, for independent reasons, income could also fall while demand does not
rise. The fall in price could have been counteracted by a fall in income. The ceteris
paribus rule, that all other things remain the same, is used whenever attempting to
demonstrate the link between economic variables. Without this assumption, positive
economics is impossible.

Production possibility
frontiers
An opportunity cost will usually arise whenever an economic agent chooses between
alternative ways of allocating scarce resources. The opportunity cost of such a
decision is the value of the next best alternative use of scarce resources.
Opportunity cost can be illustrated by using production possibility frontiers (PPFs)
which provide a simple, yet powerful tool to illustrate the effects of making an
economic choice.

A PPF shows all the possible combinations of two goods, or two options available at
one point in time.

Production possibilities

Mythica, which is a hypothetical economy, produces only two goods - textbooks and
computers. When it uses all of its resources, it can produce five million computers
and fifty five million textbooks. In fact, it can produce all the following combinations of
computers and books.

OMPUTERS (m) TEXTBOOKS (m)

0 70
1 69
2 68
3 65
4 60
5 55
 6 48
7 39
8 24
9 0

These combinations can also be shown graphically, the result being a production
possibility frontier. The production possibility frontier (PPF) for computers and
textbooks is shown here.

Interpreting PPFs

Firstly, we can describe the opportunity cost to Mythica of producing a given

output of computers or textbooks. For example, If Mythica produces 3m computers;
the opportunity cost is 5m textbooks. This is the difference between the maximum
output of textbooks that can be produced if no computers are produced (which is
70m) and the number of textbooks that can be produced if 3m computers are
produced (which is 65m). Similarly, the opportunity cost of producing 7m computers
is 31m textbooks - which is 70 - 39.

PPFs can also illustrate the opportunity cost of a change in the quantity produced of
one good. For example, suppose Mythica currently produces 3 million computers
and 65m textbooks. We can calculate the opportunity cost to Mythica if it decides to
increase production from 3 million computers to 7 million, shown on the PPF as a
movement from point A to point B. and textbooks is shown here
Pareto efficiency

Any point on a PPF, such as points 'A' and 'B', is said to be efficient and indicates
that an economy’s scarce resources are being fully employed. This is also
called Pareto efficiency, after Italian economist Vilfredo Pareto. Any point inside the
PPF, such as point 'X' is said to be inefficient because output could be greater from
the economy’s existing resources.

Any point outside the PPF, such as point 'Z', is impossible with the economy’s
current scarce resources, but it may be an objective for the future. Pareto efficiency
can be looked at in another way - when the only way to make someone better off is
to make someone else worse off. In other words, Pareto efficiency means an
economy is operating at its full potential, and no more output can be produced from
its existing resources.
Productive and allocative efficiency

A point on a PPF is, by definition, productively efficient in that all of the economies
resources are being fully employed, and their is no waste or unemployment.
However, from the consumer’s (or society’s) point of view a particular combination of
goods may not be allocatively efficient. For it to be allocatively efficient it must satisfy
consumer demand and consumer preferences. As will be seen later, allocative
efficiency is more formally expressed as a level of output where the marginal benefit
to the consumer or the last unit consumed equals the marginal cost of supply of that
unit. Clearly, not all combinations will satisfy this condition.

In the example shown, a society may produce only meat or vegetables, but its
population prefers a varied diet. Hence, point A is likely to be much more allocatively
efficient than point B and C, because these do not meet society’s preferences.

Increasing opportunity cost

Opportunity cost can be thought of in terms of how decisions to increase the

production of an extra, marginal, unit of one good leads to a decrease in the
production of another good.

According to economic theory, successive increases in the production of one good

will lead to an increasing sacrifice in terms of a reduction in the other good. For
example, as an economy tries to increase the production of good X , such as
cameras, it must sacrifice more of the other good, Y, such as mobile phones.

crifice more of the other good, Y, such as mobile phones.

This explains why the PPF is concave to the origin, meaning its is bowed outwards.
For example, if an economy initially produces at A, with 8m phones and 10m
cameras (to 20m), and then increases output of cameras by 10m, it must sacrifice
1m phones, and it moves to point B.

If it now wishes to increase output of cameras by a further 10m (to 30m) it must
sacrifice 2m phones, rather than 1m, and it moves to point C; hence, opportunity
cost increases the more a good is produced.

The gradient of the PPF gets steeper as more cameras are produced, indicating a
greater sacrifice in terms of mobile phones foregone.