The market economic system and the price mechanism

Last time

Before we start: last time, in Price elasticity of supply, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Who decides?

Who decides how many mangoes are grown in Pakistan each year, or how many phones are sold in Karachi? In a market, nobody gives the order. Millions of buyers and sellers, reacting to prices, decide it together. That is the market economic system.

Three economic systems

An economic system is the way a country answers the three questions: what, how and for whom to produce. In a market economic system, private firms and consumers answer them, through prices. In a planned economy, the government answers them. A mixed economy combines the two: a private sector and a public sector. Almost every real economy, including Pakistan's, is mixed.

The market economic system

Resources are owned privately, by households and firms, not by the state. Firms are driven by the profit motive. They make what people will pay for, because that is where the profit is. And decisions are guided by the price mechanism: the movement of prices as demand and supply change.

The price mechanism

Follow the chain. Demand for a product rises, so its price rises. Higher prices mean higher profits, so firms supply more, and more resources move into making it. No one planned it: prices did the work.

Three jobs prices do

A rising price is a signal. It tells firms that consumers want more of this product. It is also an incentive. Higher prices promise higher profit, so firms are encouraged to produce more. And it rations. When a good is scarce, a higher price limits how much each person buys, so the good goes to those willing and able to pay.

When demand falls

Now the opposite. When demand for a product falls, its price falls and firms make less profit, or a loss. Firms cut output or close. Workers, land and machines are released, and move to products whose demand is rising. This is how a market economy reallocates resources, without anyone in charge.

Advantages of the market system

Consumer sovereignty: consumers decide what is produced, by what they choose to buy. Efficiency: firms competing for profit try to keep costs low and quality high. Choice and innovation: firms invent new products to win customers. And the system responds quickly when tastes change.

Disadvantages of the market system

Public goods, such as street lighting and defence, are not provided at all, because firms cannot charge for them. Merit goods, such as education, are under-consumed. Demerit goods, such as cigarettes, are over-consumed. External costs such as pollution are ignored. And income is shared unequally, so the poor may not afford basic goods. Firms may also grow into monopolies that charge high prices. Each of these is a kind of market failure.

The planned economy

In a planned economy, the state owns most resources, and the government decides what, how and for whom to produce. It can provide public and merit goods for everyone, and it can keep incomes more equal. But without prices as signals, planners often make too much of some goods and too little of others, and there is little choice or incentive to innovate.

Comparing the systems

Here are the two systems side by side. A mixed economy takes something from each column.

A discuss question

Cambridge often asks you to discuss whether a market economy allocates resources in the best possible way. That needs both sides. Why it might: prices respond to demand, resources move to what consumers want, and the profit motive encourages efficiency. Why it might not: public goods, merit and demerit goods, externalities, monopoly and inequality. Then end with a judgement.

Mistakes that lose marks

Mistake one: writing free market or controlled market. The terms are market, planned and mixed economic systems. Mistake two: listing advantages and disadvantages without explaining each one. Mistake three: in a discuss question, giving one side only, or no conclusion. The fix: name the system correctly, explain each point, and judge at the end.

The full-marks tip

The full-marks tip: explain how the price mechanism works as a chain: demand, price, profit, supply. In a discuss question, give both sides and finish with a judgement.

On one card

So, on one card: the market economic system. Keep it for revision.