The mixed economy

The Command Economy

To highlight the role of markets and prices, we now ask how resources might be allocated if markets did not exist. One example is a command economy.

A command economy is a society where the government makes all decisions about production and consumption. A government planning office decides what will be produced, how it will be produced, and for whom it will be produced. Detailed instructions are then issued to households, firms, and workers.

Such planning is a very complicated task, and there is no complete command economy where all allocation decisions are undertaken in this way. However, in many countries, for example in the Soviet bloc, there was a large measure of central direction and planning. The state owned factories and land, and made most important decisions about what people should consume, how goods should be produced, and how much people should work.

To appreciate the immensity of this task, imagine that you had to run by command the city in which you live. Think of the food, clothing, and housing allocation decisions you would have to make. How would you decide who should get what and the process by which these goods and services would be produced? Of course these decisions are being made every day in your own city, but chiefly through the allocative mechanism of markets and prices.

The Invisible Hand or Free Market Economy

Markets in which governments do not intervene are called free markets.

Individuals in free markets pursue their own interests, trying to do as well for themselves as they can without any government assistance or interference. The idea that such a system could solve the what, how, and for whom problems is one of the oldest themes in economics, dating back to Adam Smith, the famous Scottish philosopher-economist whose book The Wealth of Nations (1776) remains a classic. Smith argued that individuals pursuing their self-interest would be led “as by an invisible hand” to do things that are in the interests of society as a whole.

Suppose you wish to become a millionaire. You play around with new ideas and invent a new good, perhaps the television, the motor car or the hand calculator. Although motivated by our own self-interest, you make society better off by creating new jobs and opportunities. You have moved society's production possibility frontier outwards – the same resources now make more or better goods – and become a millionaire in the process. Smith argued that the pursuit of self-interest, without any central direction, could produce a coherent society making sensible allocative decisions.

This remarkable insight has been studied at length by modern economists.

The Mixed Economy

The free market allows individuals to pursue their self-interest without any government restrictions. The command economy allows little scope for individual economic freedom since most decisions are taken centrally by the government. Between these two extremes lies the mixed economy.

In a mixed economy the government and private sector interact in solving economic problems. The government controls a significant share of output through taxation, transfer payments, and the provision of goods and services such as defence and the police force. It also regulates the extent to which individuals may pursue their own self-interest.

In a mixed economy the government may also be a producer of private goods such as steel or motor cars. Examples of this in the UK include the nationalized industries such as railways and coal.

Most countries are mixed economies, though some are close to command economies and others are much nearer the free market economy. Even the Soviet Union allowed consumers some choice over the goods they bought. Private agricultural markets co-existed with centrally organized 'collectives'. Conversely, even countries such as the United States which espouse more enthusiastically the free market approach, still have substantial levels of government activity in the provision of public goods and services, the redistribution of income through taxes and transfer payments, and the regulation of markets.