The fundamental basis of economics is attempting to allocate the Earth's finite resources to best satisfy the infinite desires and wants of consumers - society at large. It is generally accepted that there is a bipolar economic spectrum, and it is up to any economy where on this spectrum they wish to fall.
At one end of this scale there is the concept of socialism - largely based on the 19th Century views of Karl Marx. Socialism/Marxism decrees that all resources and welfare are owned and distributed by the state to the basis of who needs them receives them. Socialist economies can also be known as command economies.
The other end of the scale is the economics of British economist Adam Smith (1723 - 1790), that of the free market economy, where the allocation of resources is determined by the 'invisible hand' of the price mechanism. Free market economics is now commonly termed as capitalism, although its true theory is rarely appreciated by those who talk of it.
Both free market and command economies have, in principle, distinct advantages over each other, but both equally have disadvantages. In the world today there are precious few examples of a true command economy - the closest being hardline communist regimes such as North Korea. Due to several problems inherent within the capitalist system, a true free market is, to all purposes, implausible. In order to maximise the advantages in a given economy, a compromise between the two must be reached - hence a mixed economy, taking parts of both extremes in order to achieve an effective middle ground.
Free Market Economics
A true free market economy is one in which there is no government intervention whatsoever – there are no taxes or state-funded amenities. Everything within the economy is owned by private individuals and prices for any and all products and services are determined by the price mechanism. All decisions are made by these private buyers and sellers, and the free market assumes that they will act in their own self-interest. This implies that producers aim to maximise their profits, and consumers aim to maximise their utility. With greater welfare being the ultimate goal, free market economies provide an incentive to cut costs through better efficiency and labour productivity, and thus encourages innovation in order to maximise profits.
The price mechanism is one of the most fundamental parts of a free market economy, whereby the monetary value of any good is determined by the supply and demand of that good – if the supply does not meet the demand, the price increases, and in the same way too much supply of a good with limited demand would cause a drop in price. Theoretically, a rise in price should cause a drop in demand, and thus bring the price back down to a level where supply and demand are in equilibrium. Thus, through the price mechanism – the freedom of consumers to purchase what they want – a free market economy means that the finite resources are allocated by market forces alone, without influence from an external source (in effect a government). Therefore, so long as there are no failures and imperfections, a free market economy maximises community surplus and provides the most efficient means of exploiting the resources available.
However, free market economies have significant disadvantages, primarily in that public goods are non-existent. Street-lighting is an obvious example - it would not exist in a free market economy as whoever paid for the light would not have exclusive use of it - other members of society would be able to 'consume' the good for free. This is known as the free-rider problem, and it is because of this that several fundamentally necessary goods would not be supplied in a true free market.
An NHS-equivalent (ie, free healthcare) or free state education would not exist, as these would have to be funded by government, itself funded by taxation. In liberal societies such as the UK, this is generally accepted as being socially undesirable - poorer families would not be able to afford education, and thus lack the qualifications to secure a well-paid job, and thus would not be able to afford healthcare. Furthermore, the UN Charter on Human Rights ensures the right of all children to receive free education.
On top of this, public goods that are taken for granted such as defence, policing and emergency services would not exist, as the free-rider problem discourages producers from entering a market where they do not gain all the benefits.
Other issues with the free market are that the rich get richer while the poor get (comparatively) poorer. People on high incomes are able to buy more goods and services than the less well off, and thus gain greater welfare. Finally, externalities such as pollution are not regulated in the free market, and thus firms would be free to destroy the environment without having to pay for their actions - 'internalising the externality'.
Command or 'planned' economies were common in the mid-20th Century, with the communist nations adopting this Marxist-style economic policy. Its basic structure is at a complete tangent to that of the free markets, which allow the 'invisible hand' of the price mechanism to dictate the monetary value of goods, as the value of goods and services are dictated by a 'central planning 'agency'. In order for this to work, the state has to have absolute power, and therefore ownership of all resources – there is no private ownership whatsoever in a command economy. Instead of profit being the motive for production, a command economy relies on social welfare as an incentive – the work done by employees is for the good of the state as a whole, as all people are provided for equally.
Command economies have a distinct social advantage over free market economies because, with the state having control of the flow of money, income can be distributed in a more equal manner so that a class system does not develop – all people are effectively equal. On top of this, the government of a command economy can determine which goods are produced within its boundaries, and thus it can prevent the production of socially undesirable goods. However, this invariably leads to a large black market developing within the economy. This socialist system existed in the USSR before its collapse, and exists today in North Korea and Cuba, whereby the government sets output targets across an area for each individual component, and allocates the necessary resources required in order to meet these targets.
However, the socialist system has drawbacks in that the central planning agency requires a colossal amount of information in order to function appropriately and set production targets. With an agency requiring such a level of knowledge, there is an almost inevitable bureaucratic overload, which leads to inefficiency – a situation where the resources available are not being put to best use. State-controlled industries are often filled with layers of employees who are not really needed ('red tape'), and cease to be employed in a free market, but retain their jobs in order to maintain high levels of employment in the state.
A further issue with command economies is that, with the state controlling all resources, individuals and firms have no incentive to work as there is no profit motive to encourage innovation. The consequence of this is that goods are often poor quality and there is usually a limited choice. Further problems arise from poor decisions by central planners - China's economy is only now making up for lost time after Mao, who continued pursuing flawed policies based on his irrational beliefs in order to save face.
Therefore, it can be seen that free market economies encourage innovation, efficiency and entrepreneurship, but can result in a situation where the poor are stuck in a rut, while the rich continue to get richer. Basic necessities such as healthcare and education are not provided, neither are amenities like sanitation or street-lighting. And finally, due to price mechanism, economic instabilities cannot be controlled through changing interest rates, as the government does not intervene in free market economies. Externalities such as pollution cannot be stopped, as fines or duties could not be collected by private companies. Simultaneously, it is clear that command economies have too many drawbacks to function effectively too; so while it does result in a fairer society, a lack of incentive to work often results in gross inefficiency and the inability to maintain standards.
As a result, the only feasible solution is a mix between the two – in other words, a 'mixed' economy. In a standard economy, the government operates a taxation policy in order to fund essential services such as education and healthcare, as well as public goods such as defence, policing and utilities. At the same time, private companies operate to produce goods for all other sectors of the economy, which hence work on the price mechanism. Varying degrees of mixing are employed by different nations worldwide - in America healthcare is privatised, suggesting a more free market approach, while in many European countries taxation remains high funding an extremely proficient welfare state, as well as numerous public-owned companies.
In this way, a mixed economy, if controlled well, can reap the social benefits of a command economy, as well as the efficiency and innovations inspired by the strive to increase profits – the hallmark of the capitalist free market.