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 world has so far witnessed six economic systems; 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 a society.
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. 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 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 be 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 benefit. Its objectives in doing this will depend upon its political or ideological framework. There is no private profit, because all resources are publicly owned.
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 choice.
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 next.
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 may intervene:
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 growth.
7. To moderate the ups and downs in the trade cycle trying to stimulate economic activity during a recession.