Which System is Best?

Which System is Best?

In this Learn-It, I shall be looking at the advantages and disadvantages of free market systems. As you will see, the advantages of free market economies can be easily turned around to become disadvantages of command economies. Equally, the disadvantages of free market systems often highlight advantages of command economies.

  1. Efficiency. We said earlier that free market economies are very competitive. Most of their industries are assumed to be perfectly competitive and so allocative and productive efficiency will occur. It makes sense that free market economies allocate their resources more efficiently. Decisions about what to produce are made by the people who will actually consume the goods. Planners are less likely to make the correct decisions across the whole economy.
  2. Choice. Firms will produce whatever consumers are prepared to buy. Remember that the consumer is sovereign. Due to the free enterprise factor, there are no restrictions on what the firms can produce. It is of no surprise, therefore, that there will be a much larger choice of goods and services in a free market economy compared with a command economy. The planner will be more concerned with making sure there are enough essential goods to go around rather than allocating resources efficiently between all goods.
  3. Innovation. Firms will always be looking to produce something new to get ahead of their competitors. We said earlier that, even though the government's role is limited, one of its jobs is to protect property rights. This will include intellectual property rights through patents. Hence, there are incentives in the free market system for firms to be innovative and produce better quality products. Obviously there is no incentive for the planner to be innovative. As long as they produce the essentials the planners will be happy.
  4. Higher economic growth rates. One does not have to be an expert economic historian to see that countries whose economic system has been nearer to the free market model have grown much faster than those with a command economy since the second world war. The most successful economy in the world (in terms of size) has been the USA, and they have been one of the freest economies in the world. Given the three factors above, it is not surprising that this is the case. It should be noted that many mixed economies have grown quite well, but certainly the post-war command economies had the worst record.
  1. Public, merit and demerit goods.
    Public goods cannot be provided privately because of their two characteristics, non-diminishability and non-excludability. These goods have to be provided publicly. Even in a very free market, one of the government's few roles will be to provide defence, for example. But there may be a problem with merit goods and demerit goods. Merit goods, like health and education, tend to be under provided in a free market. Certainly in the USA the public health system is a 'last resort' system. People are advised to buy health insurance. Of course, the poor might not be able to afford this, and some people might simply decide not to bother if they feel particularly healthy. Demerit goods are bad for you. Government should ban class A drugs, and tax cigarettes and alcohol heavily. A government with a limited role might not take enough action in this area, causing health problems for the economy.
    Of course, the advantage of a command economy is that the strong government will make sure that public and merit goods are consumed at the right levels and that demerit goods are banned or taxed heavily.
  2. Unequal distribution of income.
    For many, this is the big disadvantage of a free market economy. In a free market with very limited government, benefits will be low, the health service poor and schools under funded. If you start life with very little, and do not even get a good education, then there will be very little protection from destitution. A command economy might not have the efficiency and enterprise for the successful to make millions, but at least the strong government will try to make sure that nobody falls through the safety net. It will be a fairer economy, even though it is likely to be less successful overall.
  3. The environment.
    Free market economies are likely to produce more pollution, which is bad for the environment. Command economies can make sure that the production processes that they chose are as environmentally friendly as possible. They should be able to make sure that the level of output is the socially optimal level of output. Governments can try to force firms into producing the socially optimal level of output through the use of taxes, but governments with a limited role will not be keen to use taxes. Although the tax on petrol is high in the UK, it still doesn't cover the problems caused by the exhaust emissions (in health as well as the environment). Petrol prices have risen, but in real terms, the rise has not been as high as for bus and rail fares. In the USA, petrol is ridiculously cheap. The minimal tax on the good does not begin to cover the environmental damage.
    Having said all that, the command economies of the 80s had notoriously poor records on the environment. In theory, they should have been able to monitor pollution levels closely, given that they had control of production, but this simply did not happen.

As you can see, both systems have advantages and disadvantages. As extremes, neither of the systems work, but from the experience of the world economy over the last few decades, it appears that the free market has won the argument. Details of what went wrong in the old command economies can be found in the next Learn-It.

It would be misleading, though, to say that the free market is the winner without any provisions. Free markets with very limited governments would fail in other ways: poor health and education services, low state benefits and pensions and, perhaps the worst in a civilised society, an unfair distribution of income. Most of these problems do not exist if you are one of the richer members of society, but if you are poorer you have nothing. And the rich might not like it if the poor revolted (the French Revolution?).

Hence, all economies in the world are now mixed. But what degree of mix is best? We are now moving into the realms of normative economics, that is to say, subjective opinions.

Most sensible people would like to see an economy that is free in most markets, but where the government has a significant role. Remember that for each of the choices below, the preferable one with the better level of government provision will result in higher taxes, which results in less take-home pay for individuals to spend as they please.

Should the NHS be totally free, or should people have to pay for some non-essential elements of the service (like prescriptions, eye tests, minor operations and even making in-patients pay for bed and breakfast)?

Education

Should three years of study at university be totally free (including a grant for living expenses), or should individuals pay for a portion of the costs, given that they themselves will benefit in the future as well as society in general?

Should unemployment benefits be generous, or should they be relatively low, not just to keep taxes down, but to create incentives for the unemployed to look for work?

Should the state pension be generous, or should individuals be forced to make their own provisions? Remember, pensions that grow with the stock market will probably be worth more than any handout that the government can afford, especially with an ageing population. The value of the state pension relative to wage earners gets worse every year; it rises with the inflation rate, which is smaller than that rate at which average earnings rise. This change was made twenty years ago.

As you can see, the extent to which the government should intervene is a normative question and a difficult one at that. To sum up, governments need to get the balance right in the classic equity v. efficiency argument. All civilised societies ought to have a minimum safety net of essential services, but if it is too big and costly, the higher taxes will make the economy less efficient and less attractive to foreign investors. Do the poor get a bigger slice of a smaller cake, or a smaller slice of a bigger cake?

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