Resource allocation in different economic systems

Economics AS · Basic economic ideas and resource allocation. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

An economic system is the way a country answers the questions of what, how and for whom to produce. In a market economy, private firms and consumers decide. Prices move with demand and supply, and firms follow profit, so consumer spending guides what is made.

In a planned economy, the state owns most resources and a central agency sets output targets and prices. Planners cannot know what every consumer wants, so shortages and surpluses are common.

A mixed economy uses both methods. The market allocates most goods, while the government provides things the market supplies badly, such as defence, and may tax and spend to reduce inequality. Almost every real economy is mixed.

Rules to remember

Market economy: resources are allocated by the price mechanism; private ownership; the profit motive.
Planned (command) economy: resources are allocated by the state; state ownership; output targets.
Mixed economy: both the market (private sector) and the government (public sector) allocate resources.
Consumer sovereignty: consumers' spending decisions determine what firms produce.
Market problems: public goods not provided, merit goods under-consumed, demerit goods over-consumed, unequal incomes.
Planning problems: shortages and surpluses, little incentive to cut costs or innovate, limited consumer choice.
When price controls are removed, prices rise towards market levels and queues shorten.

Common mistake

Students say a mixed economy is one that produces both goods and services. It means that both the market and the government take part in allocating resources.

Worked example

In one country, bakeries sell bread at any price they choose, while the government provides free primary schooling paid for by taxes. Which economic system is this, and how is each product allocated?

Bread: firms and consumers decide, and price rations it to those willing and able to pay. This is market allocation.
Schooling: the government decides how much to provide, and every child can use it whatever the family income. This is state allocation.
Both methods are used in the same economy.

Answer: It is a mixed economy: bread is allocated by the price mechanism and schooling by the government.

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