Decision‑Making in Market, Planned and Mixed Economies
Learning objective
Explain how scarce resources are allocated in market, planned and mixed economies, evaluate the strengths and weaknesses of each system and assess which system allocates resources ‘best’ against the Cambridge IGCSE/A‑Level criteria of efficiency, equity, innovation and stability.
1. Basic economic ideas & the problem of scarcity
- Scarcity & choice: Resources are limited; societies must decide what to produce, how to produce it and for whom it is produced.
- Opportunity cost: The value of the next best alternative that is fore‑gone when a choice is made.
- Economic methodology: Uses models, assumptions (ceteris paribus) and simplified diagrams to explain real‑world behaviour.
1.1 Factors of production
| Factor | What it is | Reward |
|---|
| Land | Natural resources (soil, minerals, water) | Rent |
| Labour | Human effort – physical & mental | Wages |
| Capital | Man‑made tools, machinery, buildings | Interest |
| Enterprise | Risk‑taking, organisation, innovation | Profit |
1.2 Production possibility curve (PPC)
- Shows the maximum output combinations of two goods that can be produced with existing resources and technology.
- Key features: efficiency (points on the curve), inefficiency (inside), unattainable (outside), and the opportunity cost (slope).
- Constant vs. increasing opportunity cost – a bowed‑out curve reflects rising opportunity cost as resources are reallocated.
1.3 Classification of goods
| Type of good | Characteristics | Examples (UK) |
|---|
| Private goods | Excludable & rival | Chocolate, a car |
| Public goods | Non‑excludable & non‑rival | Street lighting, national defence |
| Merit goods | Undervalued by consumers, socially desirable | Vaccinations, education |
| Demerit goods | Over‑consumed, socially undesirable | Cigarettes, high‑alcohol drinks |
2. Micro‑economic foundations
2.1 Demand and supply
- Law of demand: When price falls (ceteris paribus), quantity demanded rises.
- Law of supply: When price rises (ceteris paribus), quantity supplied rises.
- Movement along a curve = change in price; shift of the curve = change in any non‑price determinant (income, tastes, technology, etc.).
2.2 Market equilibrium
Intersection of the demand and supply curves determines the equilibrium price (P*) and quantity (Q*). Any deviation creates a surplus (price above P*) or a shortage (price below P*), which induces price adjustments.
2.3 Consumer and producer surplus
- Consumer surplus: Difference between what consumers are willing to pay and what they actually pay (area above price and below demand curve).
- Producer surplus: Difference between the price received and the minimum price at which firms are willing to supply (area below price and above supply curve).
2.4 Elasticities
Measure responsiveness of quantity to a change in another variable.
- Price elasticity of demand (PED): \(\displaystyle \varepsilon_{d}= \frac{\%\Delta Q_{d}}{\%\Delta P}\).
Determinants: availability of substitutes, proportion of income, necessity vs. luxury, time horizon.
- Price elasticity of supply (PES): \(\displaystyle \varepsilon_{s}= \frac{\%\Delta Q_{s}}{\%\Delta P}\).
Determinants: spare capacity, time to adjust, nature of the good.
- Interpretation: \(|\varepsilon|>1\) = elastic; \(|\varepsilon|<1\) = inelastic; \(|\varepsilon|=1\) = unit‑elastic.
3. Government intervention in micro‑economics
3.1 Why intervene?
- Market failure: externalities, public goods, information asymmetry, merit/demerit goods.
- Equity: reduce income & wealth inequality, provide a safety net.
- Stability: prevent excessive price volatility in essential markets.
3.2 Main policy tools (with UK examples)
| Instrument | Purpose | UK example |
|---|
| Tax (excise, carbon) | Internalise negative externalities | Carbon tax on fossil fuels |
| Subsidy | Encourage positive externalities/merit goods | Renewable Energy Guarantees Scheme |
| Price ceiling | Protect consumers from high prices | Rent control in some cities |
| Price floor | Support producers | Minimum wage |
| Regulation | Correct information problems, ensure safety | Food safety standards |
| Public provision | Supply merit/public goods directly | National Health Service (NHS) |
3.3 Measuring inequality
- Gini coefficient: 0 = perfect equality, 1 = perfect inequality.
- Distinguish stock concepts (distribution of existing wealth) from flow concepts (distribution of income over a period).
4. Decision‑making in different economic systems
4.1 Market (free‑market) economy
- Decision‑makers: Households (consumers) and firms (producers).
- Mechanism: Price signals generated by supply and demand.
- Incentives: Profit maximisation for firms; utility maximisation for households.
- How it works:
- Higher demand → price rises → firms expand output (profit motive).
- Excess supply → price falls → firms cut output (avoid losses).
Profit‑maximising firm chooses output \(q\) to maximise
\[
\max_{q}\; \pi = Pq - C(q)
\]
First‑order condition: \(\displaystyle P = MC\) (price equals marginal cost).
Example: When UK apple prices rise in summer because of a short harvest, growers receive a higher price signal and plan larger plantings for the next year.
4.2 Planned (command) economy
- Decision‑makers: Central planners, ministries or state agencies.
- Mechanism: Administrative allocation of inputs, output targets and fixed prices.
- Incentives: Achievement of plan quotas, political or ideological goals.
- How it works:
- Government sets a national plan (e.g., “5 million tonnes of wheat”).
- Resources (labour, capital, raw materials) are assigned to meet the targets.
- Enterprises are evaluated on output, not profit.
Social‑welfare optimisation (theoretical)
\[
\max_{q_1,\dots ,q_n} W = \sum_{i=1}^{n}\alpha_i U_i(q_i)
\]
subject to \(\displaystyle \sum_{i} a_{ij}q_i \le R_j\) for each factor \(j\).
(The syllabus does not require formal algebra; this illustrates the planner’s problem.)
Example: The former Soviet Union’s five‑year plans set output targets for steel, coal and machinery, allocating labour and raw materials through ministries rather than market prices.
4.3 Mixed economy
- Decision‑makers: Households, firms and government agencies.
- Mechanism: Price signals operate alongside policy instruments (taxes, subsidies, price controls, regulation, public provision).
- Incentives: Profit and utility motives coexist with government objectives of efficiency, equity, stability and environmental sustainability.
- How it works:
- Markets allocate most goods via prices.
- Government intervenes where markets fail (e.g., pollution, public goods).
- Policy tools modify the optimisation conditions for firms and consumers.
Profit maximisation with a per‑unit tax \(t\)
\[
\max_{q}\; \pi = (P - t)q - C(q)
\]
First‑order condition: \(\displaystyle P - t = MC\). The tax raises the effective marginal cost, reducing output.
UK mixed‑economy examples:
- National Health Service – public provision of health care.
- Carbon tax – internalises the external cost of carbon emissions.
- Subsidies for wind farms – encourage socially desirable renewable energy.
5. Macroeconomic foundations
5.1 National‑income aggregates
| Aggregate | Definition | Measurement method |
|---|
| GDP (Gross Domestic Product) | Value of all final goods & services produced within a country in a year. | Production, income or expenditure approach. |
| GNI (Gross National Income) | GDP + net primary income from abroad. | GDP + (income earned by residents abroad – income earned by foreigners domestically). |
| NNI (Net National Income) | GNI – depreciation of capital stock. | GNI – capital consumption allowance. |
5.2 Circular‑flow diagram
- Closed economy: Households provide factors of production to firms; firms provide goods and services to households; income flows opposite to goods/services.
- Open economy: Adds the foreign sector – exports (goods out) and imports (goods in) plus capital flows.
5.3 Aggregate demand and aggregate supply (AD/AS)
- AD curve: \(AD = C + I + G + (X-M)\); downward‑sloping because of the wealth, interest‑rate and exchange‑rate effects.
- SRAS: Short‑run aggregate supply – upward sloping; firms respond to higher demand by increasing output, but wages are sticky.
- LRAS: Long‑run aggregate supply – vertical at potential output (full‑employment GDP); reflects full utilisation of resources.
- Equilibrium: Intersection of AD with SRAS (short‑run) and with LRAS (long‑run).
5.4 Economic growth, unemployment and inflation
- Economic growth: Increase in potential output (LRAS) measured by real GDP growth rate.
- Unemployment types:
- Frictional – short‑term job search.
- Structural – mismatch of skills.
- Cyclical – caused by insufficient aggregate demand.
- Inflation: Sustained rise in the general price level; measured by CPI or RPI.
6. Government macro‑policy
6.1 Fiscal policy
- Tools: Government spending (G) and taxation (T).
- Objectives: Stimulate (expansionary) or restrain (contractionary) aggregate demand, achieve full employment and price stability.
- UK example: The 2022 “mini‑budget” increased spending and cut taxes to boost demand (later reversed due to inflationary pressure).
6.2 Monetary policy
- Authority: Central bank (Bank of England).
- Instruments:
- Bank rate (interest rate).
- Open market operations (buying/selling gilts).
- Quantitative easing (asset purchases).
- Objectives: Control inflation, support growth, maintain financial stability.
6.3 Supply‑side policies
- Improve productive capacity and long‑run growth.
- Examples:
- Investment in infrastructure and R&D.
- Education and training programmes.
- Tax incentives for firms (e.g., reduced corporation tax on R&D).
- Deregulation to reduce business costs.
7. International trade
7.1 Comparative advantage
- A country should specialise in producing the good for which it has the lowest opportunity cost and trade for other goods.
- Gains from trade: higher consumption possibilities, movement to a point outside the domestic PPC.
7.2 Protectionist instruments
| Instrument | Effect on trade | UK example |
|---|
| Tariff | Raises price of imports → reduces quantity imported. | Import duty on steel. |
| Quota | Limits the volume of a specific import. | Ban on certain agricultural imports. |
| Subsidy to domestic producers | Lowers domestic price, encourages export. | Export subsidies for UK aerospace firms. |
| Anti‑dumping duties | Counteracts foreign firms selling below cost. | Duties on cheap Chinese solar panels. |
8. Comparative summary of the three economic systems
| Aspect |
Market economy |
Planned economy |
Mixed economy |
| Decision‑makers |
| Primary decision‑maker |
Households & firms |
Central planners |
Households, firms & government |
| Allocation mechanism |
Price signals (supply‑and‑demand) |
Administrative directives & quotas |
Prices + policy instruments (taxes, subsidies, regulations) |
| Role of profit |
Core driver of production |
Irrelevant – output targets dominate |
Important but moderated by social objectives |
| Typical strengths |
Allocative efficiency, rapid innovation, consumer sovereignty |
Ability to mobilise resources quickly, pursue full‑employment or strategic goals |
Balance of efficiency & equity; correction of market failures |
| Typical weaknesses |
Market failures, income inequality, business cycles |
Information problems, lack of price signals, weak incentives for efficiency |
Potential government failure, policy distortion, fiscal burden |
| Information problems |
Prices aggregate dispersed information |
Planners lack real‑time data; difficulty ranking alternatives |
Distortions when policy interferes with price signals |
9. Evaluation – which system allocates resources ‘best’?
Cambridge assesses allocation against four criteria:
- Economic efficiency (allocative & productive).
- Market economies achieve allocative efficiency when P = MC and markets are competitive.
- Planned economies often misallocate resources because they lack price signals.
- Mixed economies can retain market efficiency while correcting specific failures.
- Equity (distribution).
- Planned and mixed economies can deliberately redistribute income (tax‑benefit systems, public services).
- Pure market systems usually generate greater inequality.
- Innovation and dynamism.
- Profit motive in market economies drives R&D and rapid adoption of technology.
- Central planning often suffers from weak incentives and bureaucratic delay.
- Mixed economies use a combination of market incentives and targeted R&D subsidies.
- Stability and coordination.
- Planned economies can mobilise resources quickly for large‑scale projects (e.g., wartime production).
- Market economies are prone to business‑cycle fluctuations; macro‑policy is needed.
- Mixed economies aim to combine market flexibility with government tools for macro‑stability.
In practice, most advanced economies adopt a **mixed approach**, seeking to capture market efficiency while using fiscal, monetary and regulatory policies to improve equity, foster innovation and maintain macro‑economic stability.
10. Suggested diagrams for classroom use
- Supply‑and‑demand diagram showing a price rise, surplus/shortage and movement to a new equilibrium.
- Consumer and producer surplus diagram before and after a demand shift.
- PPC showing constant vs. increasing opportunity cost and the effect of trade (movement outside the domestic curve).
- Flowchart of central‑planning decision‑making: national objectives → resource allocation matrix → production targets → output monitoring.
- Venn diagram illustrating the roles of price, government and private agents in market, planned and mixed economies.
- AD/AS diagram showing recessionary gap, inflationary gap and the impact of fiscal/monetary policy.
- Circular‑flow diagram (closed and open economy).
- Diagram of a tariff on imports (price increase, quantity decrease).
11. Quick revision checklist
- Define scarcity, opportunity cost and ceteris paribus.
- List the four factors of production and their rewards.
- Draw and label a PPC; explain constant vs. increasing opportunity cost.
- Identify private, public, merit and demerit goods with examples.
- State the laws of demand and supply; differentiate movement along a curve from a shift.
- Calculate consumer and producer surplus from a simple diagram.
- Recall the formulas for PED and PES and the main determinants.
- Explain why governments intervene and match each instrument to its purpose.
- Summarise the decision‑making process in market, planned and mixed economies.
- Define GDP, GNI and NNI; know the three approaches to measuring GDP.
- Sketch the AD/AS model and label equilibrium, recessionary and inflationary gaps.
- Distinguish between fiscal, monetary and supply‑side policies and give a UK example of each.
- State the principle of comparative advantage and illustrate gains from trade on a PPC.
- Be able to evaluate the three systems against efficiency, equity, innovation and stability.