Governments need to decide how much to intervene in an economy to influence the allocation of resources. The extent of this intervention depends essentially on the way in which they view the efficiency of markets in allocating resources. To help us understand the reasons for, and nature of, this intervention, we identify three different types of economy.
Types of economy
If we think about the economies of USA, Great Britain, France, Russia, China, North Korea and Cuba, are they all the same?
There are two theoretical types of economy, free market and command. Neither of these exists completely in the real world, and all economies are a mixture of both. However, the proportions of free market and command within mixed economies vary considerably.
Free market economies
In a true free market economy there is no government intervention at all. All decisions are left to the market mechanism. Decisions are made by individuals and firms on the basis of supply and demand. Firms use the factors of production to produce what is wanted and the goods and services which give them the most profit. Customers with the most money buy them. It is the 'survival of the fittest' as there would be no government services available for the poor. If you cannot pay, you do not get, and that includes medical services!
Which economy gets nearest to being a pure free market economy? USA and Canada are closer than China.
Centrally planned economies
In centrally planned economies (sometimes known as command economies) the government makes all decisions. There is a central planning organisation, which attempts to co-ordinate all activities. There is little consumer choice. Demand, however, still exists but is not automatically responded to. It should, in theory, put the environment first, regardless of cost.
No fully centrally planned economy has existed. The old USSR and China got close, but there was always a free market element left. Most of the economies which were previously centrally planned, e.g. the USSR, the East European economies and China, are now market economies.
Mixed economies consist of a private sector, in which resources are owned and controlled by private individuals, and a public sector in which resources are owned and controlled by the state. In practice, both the market mechanism and the state have a role to play, and so we describe most economies as mixed. In an ideal world both sectors would produce what they are best at. Some things cannot be provided by the market mechanism alone or, in sufficient quantities through the market, and here government provision may be necessary (see Section 2.4).
So, all economies are mixed, but the mix between public and private control varies.
We therefore have to develop theories that allow for three types of economy.
- Market economies
- Mixed economies
- Centrally planned economies
This can be illustrated on a diagram or spectrum where the type of economy is placed on a scale of government control.
This spectrum shows us where different economies lie in terms of the mix between government intervention and the free market. The further to the left on the spectrum, the more the economy relies on the free market to allocate resources. The further to the right on the spectrum, the larger the role the government plays in the allocation of resources and the closer the economy is to a centrally planned economy.
However, this is a very single dimensional view of a mixed economy and it is important to be aware that governments also differ in the type of intervention as well as the quantity of intervention. For example, governments tend to intervene to ensure that certain goods and services of value to society are produced (e.g. health care). Some governments may intervene by providing these directly, while others may rely on the private sector to provide them, but with rules and regulations on how the good or service is provided. Thus governments may have similar positions on the spectrum, but the nature of the intervention may be very different.
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