Comparative Systems

Market Economy vs. Command Economy

The Price System

• Command Economy – Government plans how and what to produce. It is enforced by law.

• Market Economy – Individuals plan and laws protect their transactions.

• A competitive market:– Has many producers and consumers.– Consumers and producers are both price

takers.• Two Exceptions:

• If a product only has a single producers that producers affects the market price when deciding how much to sell.

• If all producers acted together they could affect market price.

Information, Rationing, and Motivation in a Market Economy

• The price increase will signal that apartments are more valuable.

• The price system will automatically ration available supply to consumers impersonally. Those that are willing to pay the most for a good will obtain it.

• The higher price informs producers of the increased scarcity of apartments and the possibility of earning profits motivates producers to build more apartments.

Information, Rationing, and Motivation in a Command Economy• Governments are often unwilling to increase prices even

if the demand increases. Adjustments are costly politically and in terms of planning.

• If prices aren’t flexible then excess demand persists.• Increases in production is undermined because

producers rarely share in the economic profits.• Central planners can order more production but are

penalized if increased demand is not permanent. Therefore they often opt for inaction.

• Motivation for change is often political rather than economic.

Systems and Coordination

• Market Systems– Prices fall in response to excess supply and rises in

response to excess demand so as to equate the quantity demanded and supplied of a good.

– Coordinates the interdependent actions of specialized producers without a legally imposed central plan.

– Fosters the division of labor that is responsible for increasing the “wealth of nations”.

• Command Economy systems – Have great difficulty in coordinating economic

activity.– Lack a market economy’s ability to

automatically and inexpensively collect information about consumer wants and production capabilities.

– Cannot automatically and inexpensively provide incentives and motivation for people to make wealth-promoting decisions.

Five Pieces of a Market Economic System

• Reasonably stable prices and a well-functioning monetary system that facilitates voluntary exchange.

• A system of private property and property rights defined, established, and protected by law.

• Market incentives that are generated by a price system whose rewards and penalties motivate decision makers.

• Flexible prices that fluctuate in response to individual’s voluntary decisions and exchanges (market exchange).

• A legal system that is broadly obeyed and a culture that generates a climate of trust.

Problems with Transition

• Explosion of suppressed inflation.– In Hungary annual inflation rate rose to more than

30%. Ukraine experienced inflation at a rate of 500% in the early 1990s.

• Exposure of hidden unemployment.• Decreases in production. • Difficulty in providing monetary framework for

market transactions.– Russian businesses began to pay bills and taxes with

what they produced. 70% of payments collected by Russian industries were in non-monetary form in 1998 or “payment in kind”/direct barter.

Requirements for the Creation of Private Property

• Creation of private property rights.

• Requires enticing entrepreneurs to start new businesses.

• Transferring of State Owned Enterprises (SOEs) to private ownership.– Laws protecting corporate shareholders.– Establishment of modern bankruptcy laws.

Honesty and Trust

• Countries must develop and enforce a system of contract, criminal, property, and tort law to carry out its economic transformation.

• Corruption, in the form of bribes, illegal transfer of state-owned assets to private hands, and use of the government for private gain, must be controlled.

Conclusion

• Almost all of the transition economies have freed most prices, but they are reluctant to free the prices of necessities, such as food and shelter.

• The transitional economies recognize the need to improve incentives but differ in their willingness to adopt market incentives.