Intro to Econ: Command Economic System
Economics is a social science concerned with the production, distribution, and consumption of goods and services. It studies how individuals, businesses, governments, and nations make choices on allocating resources to satisfy their wants and needs, trying to determine how these groups should organize and coordinate efforts to achieve maximum output.
Economics can generally be broken down into macroeconomics, which concentrates on the behavior of the aggregate economy, and microeconomics, which focuses on individual consumers and businesses.
One of the earliest recorded economic thinkers was the 8th-century B.C. Greek farmer/poet Hesiod, who wrote that labor, materials, and time needed to be allocated efficiently to overcome scarcity. But the founding of modern Western economics occurred much later, generally credited to the publication of Scottish philosopher Adam Smith’s 1776 book, An Inquiry Into the Nature and Causes of the Wealth of Nations.
The principle (and problem) of economics is that human beings have unlimited wants and occupy a world of limited means. For this reason, the concepts of efficiency and productivity are held paramount by economists. Increased productivity and a more efficient use of resources, they argue, could lead to a higher standard of living.
Despite this view, economics has been pejoratively known as the “dismal science,” a term coined by Scottish historian Thomas Carlyle in 1849. He used it to criticize the liberal views on race and social equality of contemporary economists like John Stuart Mill, though some sources suggest Carlyle was actually describing the gloomy predictions by Thomas Robert Malthus that population growth would always outstrip the food supply.
Command Economic System
A command or planned economy occurs when the government controls all major aspects of the economy and economic production. In a command economy, it is the government that decides what to produce, how to produce goods and how to distribute goods and services within the economy. Command economies were often associated with the political system of Communism. It was Karl Marx, in the Communist manifesto who argued for ‘common ownership of the means of production.’
A command economy works in contrast to a free market economy. In a free market economy, goods and services are produced by private enterprise with distribution occurring according to market forces.
How A Command Economic System Works
- Government ownership of the means of production. In command economies, governments will own some or all of the industries producing goods and services.
- Government pricing and production decisions. In a command economy, production is decided by government agencies, who decide the most socially efficient goods to produce. Government agencies may also set prices or give consumers rations directly.
- Government macro-economic objectives. In a command economy, the government will have over-riding macroeconomic objectives such as employment rates and what to produce.
- Some centrally planned economies may consist of not just state-owned enterprises, but some privately owned firms who are closely directed by state management.
Advantages of a Command Economic System
- Supporters of command economies argue that it enables the government to overcome market failure, inequality and create a society that maximizes social welfare rather than maximises profit.
- Command economies can prevent abuse of monopoly power.
- Command economies can prevent mass unemployment, often a feature of capitalist economies.
- Command economies could produce goods which benefit society and ensure everyone has access to basic necessities.
- Although Command economies are associated with failing inefficient economies of the late Soviet Union and Cuba, in the 1920s and 30s, the Soviet Union made periods of very rapid economic growth. Between 1928–40 – the first three Five-Year Plans, the Soviet Union made rapid economic growth changing from a largely agrarian society to a major industrial nation. (This also occurred during a period of depressed world demand during the Great Depression.)
Disadvantages of a Command Economic System
- Government agencies usually have poor information about what to produce. Centralization means that decisions are taken by people who may have no access to what is actually happening. Command economies, like the Soviet Union, often produced goods that weren’t used.
- Unable to respond to consumer preferences.
- Inefficient firms are protected and kept going; making it hard for resources to move to dynamic and efficient firms.
- Threat to democracy and liberty. A command economy creates a very powerful government which limits individuals rights to pursue economic objectives. This invariably creates a climate where governments can extend their control into other areas of people’s lives.
- Bureaucratic. Command economies tend to be very bureaucratic with decisions held up by planning and committees.
- Price controls invariably lead to shortages and surpluses.
Differences Between a Command Economic System and a Free Market Economic System
- Definition. A free market economy is a market system whereby the pricing of goods and services is primarily determined by the sellers and buyers, and is hence based on demand and supply. On the other hand, a command economy is an economy whereby the market system is fully controlled by the government.
- Government regulation. While a free market economy is regulated by the producers and consumers and there exist minor to none government regulation, a command economy is regulated by the government.
- Objective. The objective of a free market economy is the maximization of profits. On the other hand, a command economy focuses on social as well as macroeconomic objectives.
- Consumer preferences. In a free market economy, consumers’ preferences are taken into consideration. On the other hand, the consumers’ preferences are not taken into consideration in a command economy as the government decides the item and amount of production.
- Innovation and economic development. While the free market economy encourages innovation and development, the command economy does not encourage innovation and development.
- Business ethics. A free market economy creates unhealthy competition leading to poor business ethics. This in turn leads to unemployment and inequality. On the other hand, the government is able to control the mode in which business is carried out in a command economy hence reducing unhealthy business practices as well as unemployment.
- Resource distribution. There is unequal resource distribution in a free market economy hence a wide gap between the rich and the poor. On the other hand, a command economy enhances equal distribution of resources hence a small gap between the rich and the poor.
- Preservation of natural resources. The drive to earn higher profits in a free market economy can lead to the misuse of natural resources. With a command economy, however, the government is able to control overuse of natural resources.
In a command economy, macroeconomic and political considerations determine resource allocation, whereas, in a market economy, the profits and losses of individuals and firms determine resource allocation. Command economies are concerned with providing basic necessities and opportunities to all members.
While a free market economy is a market system whereby the pricing of goods and services is primarily determined by the sellers and buyers, and is hence based on demand and supply, a command economy is an economy whereby the market system is fully controlled by the government. It is important to note that what may work for one nation may not work for another. Although most nations follow a mix of the two, it is essential to understand the pros and cons of each system before putting it in use.
Transition from a Command Economic System to a Mixed Economic System
Basic requirements for a successful transition:
- Macro economic stability (difficult with period of turmoil)
- Deregulation of Prices
- Liberalization of Trade
- Privatization of state-owned assets
- Establishment of market-supporting institutions such as property laws
- Social Security, e.g. unemployment benefits.
- External Assistance
When prices were deregulated, rampant inflation was often a problem. However, the problem with reducing inflation is that it can exacerbate the problem of falling Real GDP. Falling Real GDP poses meant problems for governments there will be extra pressure put on the governments budget, there will be fewer taxes collected but increased need for spending.
Liberalization of Trade
This is important for exploiting comparative advantage, however, in the short term, the developing economies may struggle to compete.
Many state-owned industries were very inefficient, with poor quality goods, over-staffing, and lack of incentives etc. In the Short-term privatization caused many problems such as:
- An increase in unemployment and a negative multiplier effect
- Many industries were so bad nobody wanted to buy them
- Working practices were not relevant to the free market
- The problem of corruption. Many state managers converted assets into their private property
- There was also a need to privatize the elaborate state admin system
As a % of GDP East Germany got the most and it was the most successful. Russia got the least and struggled the most.
Problems Faced By Russia And Other Countries Transitioning From a Command Economic System to a Mixed Economic System
- GDP fell by 50% between 1989 and 1998 – However, GDP was previously overstated
- Collapse of the value of the rouble led to a fall in confidence and deterred foreign investment
- Crime and Corruption increased.
- The nation’s assets became concentrated in the hands of a few billionaires while many ordinary people saw a fall in the real value of their pensions and wages.
Why Did It Get Worse After the Transition from a Command Economic System?
- Statistics were misleading.
- Austere macroeconomic policies needed to prevent hyperinflation in the wake of price liberalization
- Failure of corporate control. Workers and managers not used to incentives of free market
- Lack of Entrepreneurs
- Lack of Trade with Russia
- Inefficient nature of the economy
- Poor infrastructure
- Corruption meant many taxes not collected
A mixed economy means that part of the economy is left to the free market, and part of it is managed by the government. Mixed economies start from the basis of allowing private enterprise to run most businesses. Then, governments intervene in certain areas of the economy, such as providing public services (health, education, waste management) and the regulation or private business (e.g. legal right to private property, and abuse of monopoly power) In reality, most economies are mixed, with varying degrees of state intervention.
Features of a Mixed Economic System
- Individuals are able to set up business and make a profit. However, usually progressive taxes and means-tested benefits reduce inequality and provide a safety net.
- Prices are determined by market forces or the ‘invisible hand’. But the government may regulate some goods. For example, placing a higher tax on cigarettes to discourage use.
- Most businesses are privately owned. However, the government may own or be involved in regulating natural monopolies, e.g. tap water, electricity, gas.
- Businesses are free to decide what to produce and price to pay, but there are government regulations on the environment, labor markets and abuse of monopoly power.
- An economy largely driven by private investment and enterprise, but government can intervene to reduce fluctuations in the economic cycle. For example, reduce inflation or boost economic growth (fiscal policy)
Advantages of Mixed Economies
- Incentives to be efficient. Most business and industry can be managed by private firms. Private firms tend to be more efficient than government-controlled firms because they have a profit incentive to cut costs and be innovative.
- Limits government interference. Mixed economies can reduce the amount of government regulation and intervention prevalent in a command economy.
- Reduces market failure. Mixed economies can enable some government regulation in areas where there is market failure. This can include:
- Regulation on the abuse of monopoly power, e.g. prevent mergers, prevent excessively high prices.
- Taxation and regulation of goods with negative externalities, e.g. pollution,
- Subsidy or state support for goods and services which tend to be under-consumed in a free market. This can include public goods, like police and national defence, and merit goods like education and healthcare.
- A degree of equality. A mixed economy can create greater equality and provide a ‘safety net’ to prevent people from living in absolute poverty. At the same time, a mixed economy can enable people to enjoy the financial rewards of hard work and entrepreneurship.
- Macroeconomic stability. Governments can pursue policies to provide macroeconomic stability, e.g. expansionary fiscal policy in times of a recession.
- Even libertarians who dislike government intervention believe there needs to be legal support for private property and government provision of law and order.
Disadvantages of Mixed Economies
- How much should the government intervene? Can be difficult to know how much governments should intervene, e.g. discretionary fiscal policy may create alternative problems such as government borrowing.
- Too much inequality? Mixed economies are criticized by socialists for allowing too many market forces, leading to inequality and an inefficient allocation of resources.
- Government failure. Mixed economies are criticized by free-market economists for allowing too much government intervention. Libertarians argue that governments make very poor managers of the economy, invariably being influenced by political and short-term factors.
Examples of Mixed Economies
Share of government spending as a % of GDP:
- France 55.6
- Finland 53.3
- Belgium 52.2
- Norway 51.8
- Denmark 49.6
- Sweden 49.3
- Italy 48.7
- Austria 48.2
- Faroe Islands 47.7
- Croatia 47.1
- Euro Area 47.1
- Greece 46.3
- Hungary 46.1
- European Union 45.8
- Germany 45.4
- Slovenia 43.7
- Slovakia 42.8
- Portugal 42.7
- Luxembourg 42.6
- Serbia 42.3
- Poland 42
- Czech Republic 41.9
- Iceland 41.9
- Netherlands 41.9
- Spain 41.9
- Bosnia And Herzegovina 40.8
- Cyprus 39.5
- Israel 39.5
- United Kingdom 39.3
- Estonia 39
- Japan 38.9
- Latvia 38.9
- United States
- Malta 37.7
- Bulgaria 36.3
- Romania 36
- Lithuania 34.9
- Switzerland 32.7
- South Korea 30.27
All the above economies are mixed. The government manages a section of the economy, and private firms and individuals operate the rest.
There are different degrees of state intervention. European economies such as Sweden and France have a generous level of social security spending; in western Europe, education and healthcare are free at the point of use. However, in the US, government spending as a share of GDP is lower, but health care has to be paid for.
As economies develop, the government often take a higher share of total spending. Developed countries, such as in Western Europe, often choose to provide state welfare support, and greater government regulation of business and the environment. Developing economies, such as Cameroon and Uganda have government sector which spends less than 20% of GDP.
In reality, a mixed economy depends upon management. Even the most ardent free-market economists will agree we need a degree of government intervention – if only to protect private property. For example, Adam Smith in ‘Wealth of Nations’ argued governments needed to prevent the exploitation of monopoly power.
Very few economists would argue that the government should try and intervene in all areas of the economy. Private business and financial incentives play an important role in a well-functioning economy – even if the desire is to promote greater redistribution. China is an example of a country that has transitioned from a command economy to a mixed economy though the government remains Communist.
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