Edexcel A-Level Economics · Revision notes

1.1.6 Free Market, Mixed and Command Economies

Every economy has to answer the same questions: what to produce, how to produce it and for whom. Economic systems differ in who answers them. In a free market economy, prices and individual decisions do. In a command economy, the state does. Every real economy is a mix of the two.

Three economic systems

A free market economy Resources are privately owned, and decisions about production and consumption are made by individuals and firms responding to prices. Firms produce what is profitable; consumers buy what they want and can afford. The state's role is limited to essentials such as enforcing contracts and protecting property rights.

A command (planned) economy Resources are owned or controlled by the state, and a central authority decides what is produced, how and for whom. Prices, output targets and wages are set by planners rather than by markets. The Soviet Union and North Korea are the main historical and current examples.

A mixed economy Both the market and the state allocate resources. Most goods are produced privately and sold through markets, but the state provides some goods and services directly, regulates markets, and redistributes income. Every modern economy, including the UK, is mixed; they differ in the balance between market and state.

Three economists

Adam Smith (1723–1790) In The Wealth of Nations (1776), Smith argued that individuals pursuing their own interest are led, as if by an invisible hand, to promote the interest of society. A baker supplies bread not out of kindness but to earn a living, yet society is fed. Competition keeps prices down and directs resources to where they are most wanted. Smith also recognised a role for the state in defence, justice and public works.

Friedrich Hayek (1899–1992) Hayek argued that the knowledge needed to run an economy is dispersed across millions of people, and no central planner could ever gather it.

Key idea: Prices act as signals that pass this information on: a rising price tells producers that a good is scarcer or more wanted, without anyone needing to know why.

For Hayek, central planning is bound to fail because it cannot replicate this information, and he also warned that it concentrates power in the hands of the state.

Karl Marx (1818–1883) Marx argued that capitalism exploits workers. Workers create value, but the owners of capital keep part of it as profit. He predicted that inequality would grow and that capitalism would eventually be replaced by a system based on common ownership of the means of production. His ideas inspired the command economies of the twentieth century.

Advantages and disadvantages of a free market economy

Advantages

• Efficient allocation. Prices signal what consumers want, and resources move to where they are most valued.
• Incentives. The profit motive encourages firms to cut costs and innovate.
• Choice. Consumers can choose from a wide range of goods.
• Economic freedom. Individuals choose what to buy, what to produce and where to work.

Disadvantages

• Inequality. Market outcomes can leave large differences in income and wealth.
• Market failure. Public goods may not be provided, merit goods are under-consumed, and negative externalities such as pollution are over-produced.
• Monopoly power. Without regulation, firms can grow large enough to exploit consumers.
• Instability. Free markets can experience booms and recessions, with unemployment.

Advantages and disadvantages of a command economy

Advantages

• Equality. The state can distribute income and output more evenly.
• Social priorities. Resources can be directed to goals such as full employment, healthcare and education.
• Control of externalities. In principle the state can take account of wider social costs.

Disadvantages

• The information problem. Planners lack the knowledge to set the right output and prices, leading to shortages and surpluses.
• Weak incentives. Without profit or competition, there is little reason to innovate or cut costs.
• Bureaucracy and inefficiency. Planning is slow and costly.
• Restricted freedom. Consumers and workers have limited choice.

The role of the state in a mixed economy

In a mixed economy the state typically:

• provides public goods, such as defence and street lighting, that markets would not supply;
• provides or funds merit goods, such as education and healthcare;
• corrects externalities through taxes, subsidies and regulation;
• redistributes income through progressive taxes and benefits;
• regulates markets to protect consumers and limit monopoly power;
• manages the macroeconomy to promote growth and stability.

Evaluation: How far the state should go is a matter of judgement. Too little intervention leaves market failures uncorrected; too much risks government failure.

Key terms

Common mistakes

• Treating the UK as a free market economy. It is a mixed economy with a large public sector.
• Presenting Smith as opposed to all state activity. He saw a role for the state in defence, justice and public works.
• Describing the systems without the three questions. The difference between systems is who decides what, how and for whom.
• Giving only theoretical advantages of planning. The information and incentive problems are the central weaknesses in practice.

How this has been examined

In the Edexcel papers indexed on this site, this topic has appeared in two formats:

• 1-mark multiple choice — asked twice across 2 series (2019 to 2023)
• 4-mark "Explain" data response — asked once (2023)

Where this goes next

How prices allocate resources in a market economy is developed in 1.2.7 Price mechanism. The failures of free markets are set out in 1.3.1 Types of market failure, the tools the state uses to correct them in 1.4.1 Government intervention in markets, and the ways intervention itself can go wrong in 1.4.2 Government failure.