Centrally Planned Economies versus Market Economies
To answer the three questions described in the previous post—what, how and who Opens in new window—societies organize their economies in two main ways.
- Centrally planned economy is an economy Opens in new window in which the government decides how economic resources will be allocated.
- Market economy is an economy in which the decisions of households and firms interacting in markets allocate economic resources.
A society can have either a centrally planned economy in which the governmet decides how economic resources will be allocated; or a market economy in which the decisions of households and firms interacting in markets allocate economic resources.The most important centrally planned economy in the world used to be the Soviet Union.
The government decided what goods to produce, how to produce them and who would receive them.
Government employees managed factories and stores.
As a result, the standard of living of the average person in a centrally planned economy tends to be quite low. All centrally planned economies have also been political dictatorships.
Dissatisfaction with low living standards and political repression finally led to the collapse of the Soviet Union in 1991. Today, only a few small countries, such as Cuba and North Korea, still have largely centrally planned economies.
All the high-income democracies, such as Australia, the USA, Canada, Japan and many European countries, are in large part market economies.
Market economies rely primarily on privately owned firms to produce goods and services and to decide how to produce them. Markets Opens in new window, rather than the government Opens in new window, determine who receives the goods and services produced.
In that sense, it is ultimately consumers who decide what goods and services will be produced. This concept is referred to as consumer sovereignty.
By definition, consumer sovereignty is the concept that in a market economy it is ultimately consumers who decide what goods and services will be produced.
This is so because firms must produce goods and services that meet the wants of consumers or the firms will go out of business.Because firms in a market economy compete to offer the highest quality products at the lowest price, they are under pressure to use the lowest-cost methods of production.
In a market economy the income of an individual is determined by the payments received for what they have to sell.
If an individual is a civil engineer and firms are willing to pay a salary of $90,000 per year for engineers with training and skills, that is the amount of income they will have to purchase goods and services and pay taxes. If the engineer also owns a house that is rented out, their income will be even higher.
One of the attractive features of markets is that they reward hard work.
Generally, the more extensive the training a person has received and the longer the hours the person works, the higher the person’s income will be.
Of course, luck (both good and bad), inheritance and other factors also play a role here.
We can conclude that market economies answer the question “Who receives the goods and services produced?” with the answer “Those who are most willing and able to buy them.”