Chapter 4

Resource allocation
in different
economic systems
LEARNING INTENTIONS

In this chapter you will learn how to:

• explain decision-making in market, planned and mixed
economic systems
• analyse the advantages and disadvantages of resource
allocation in market, planned and mixed economic systems.

ECONOMICS IN CONTEXT

Vietnam: Asia’s rising star

Over the past 30 years, Vietnam has changed from one of the
world’s poorest economies to a lower middle-income country. This
remarkable achievement originates from the development of its
economic system. Since 1986, under the Doi Moi reforms,
Vietnam has changed from a centrally planned economy to an
economy that has the characteristics of both a state planned and a
market economy.

Figure 4.1: The business district of Ho Chi Minh City, Vietnam

Vietnam’s recent economic growth has been spectacular. In 2019,

growth was expected to reach 6.6%, slightly below the 7.1%
which it achieved in 2018. This growth is largely attributed to the
manufacturing of electronic goods, industrial parts and footwear
for export as well as strong domestic demand.
Vietnam has embraced the global economy. The country has
negotiated free trade deals including the Comprehensive and
Progressive Agreement for a Trans-Pacific Partnership. Also, it has
benefited, controversially, from the on-going trade dispute between
China and the USA.
Vietnam’s businesses remain state-owned. Some economists
believe state ownership is a weakness. Private ownership and
foreign investment are not allowed, in line with the government’s
socialist planning objectives.
Discuss in a pair or a group:
• What are the advantages and disadvantages of Vietnam’s
economic system?
• How might Vietnam’s economic growth increase even
further?
4.1 What are economic systems?
The fundamental problem of scarcity requires choices to be made. The
problem is common to all economies: low-income, middle-income and
high-income. The choices that are made and how they are made is
determined by the economic system of a particular country. A country’s
economic system identifies the means by which households, firms and
the government make decisions relating to the three resource allocation
questions:
• What goods and services are to be produced?
• How are the goods and services to be produced?
• Who should receive the goods and services?

TIP

Re-read Sections 1.1 and 1.4 to remind yourself of the fundamental

economic problem and the three questions related to the allocation of
resources.

Traditionally, economists have recognised three main types of economic

system: the market economy, the planned economy and the mixed
economy. In market economies, resource allocation decisions are
largely driven by the market mechanism, whereby individuals and
firms take these decisions without government intervention.
Over the past 30 years or so, the planned economy has been replaced by
the mixed economy in many countries in Central and Eastern Europe,
the former Soviet Union and southern Asia. The market has an
increasing role to play in mixed economies as the countries face a range
of problems and prospects.

KEY CONCEPT LINK

Scarcity and choice: Scarcity and choice apply in all economic

systems. How choices are made in an economic system depends
on the relative importance of government and the market
mechanism.
4.2 The market economy
In the market economy, resources are allocated by the forces of demand
and supply through the price mechanism (see Figure 4.2 below).
Decisions on how resources are to be allocated are regularly taken by
millions of individuals and thousands of firms. The government has
little or no direct involvement in the process of resource allocation.
Households and firms interact as buyers and sellers. Price and the
unrestricted operation of the price mechanism are central to the way in
which resources are allocated.

How the price mechanism works

Figure 4.2: The price mechanism at work

Figure 4.2 shows how the market may operate with no government
interference. The starting point is that there is excess supply in the
market – too much is being produced compared to demand. Excess
supply results in goods being stockpiled in shops and warehouses. To
encourage individuals to buy and so clear the excess stocks, firms
reduce the price. This may clear the excess supply, but it is likely to
mean that some firms which previously produced the good will now no
longer be willing to do so. With less supply in the market, the price
rises. In time, assuming no change in demand, firms may choose to re-
enter the market. The increase in supply will lead to a fall in price and
the whole process will continue. Therefore, prices and the self-interest
of individuals and businesses act as a guide to the decisions that have to
be made.

ACTIVITY 4.1

Using Figure 4.2, draw a similar diagram to show how the market
responds to a situation where a firm is faced with a sudden, big
increase in demand for one of its products.

Role of the government in a market economy

In principle, the government should have no direct role in the workings
of the market economy and should not interfere in the operation of the
price mechanism. As long as the price mechanism is working
efficiently, the government’s role is to watch what is happening and
only intervene when the price mechanism does not provide the best
allocation of resources. Figure 4.3 shows how the market economy
works.

Figure 4.3: The market economy

When the price mechanism does not work efficiently, the market ‘fails’.
Examples of market failure are where the government provides goods
such as healthcare which would be underprovided, fire services which
would not be provided at all, and where it seeks to regulate situations to
prevent firms using their power to control the market for excessive gain.
The true market economy is in certain respects an ideal. No actual
economy operates as a pure market economy. In the US, federal and
state governments have important roles to play in providing some
limited public services.
Hong Kong SAR provides an interesting case of a near-perfect example
of a market economy. All businesses are privately owned and Hong
Kong’s bus, rapid transit rail service (MTR) and road tunnels are
operated by private companies. The economy is dominated by local,
US- and European-owned multinational companies. Since 1997, a ‘two
systems, one country’ structure has been in place, retaining many of the
benefits of a market economy.
4.3 The planned economy
Like the market economy, the planned economy in its true form only
exists in theory. (The planned economy may be referred to as the
command economy or the centrally planned economy.)
In a planned economic system, the government has a central role in all
decisions that are made. The choices in terms of what to produce, how
to produce and for whom to produce are all centralised. Decision-
making is taken by planning boards and organisations and, in principle,
production is controlled by the state. Unlike the market economy, the
preferences of consumers and manufacturing organisations in a planned
economy are controlled centrally.
The key features of a planned economy are that central government and
its organisations are responsible for the allocation of resources.
Production targets are set for the main sectors of the economy, such as
agriculture and manufacturing. Invariably, these are linked to planning
for long-term growth through an increase in productive potential. Price
control of most essential items and the determination of wages are also
controlled. Finally, the ownership of most of the productive resources
and property is in the hands of the state. In short, the market does not
have a real role in the allocation of resources.
In a planned economy, government organisations find it necessary, for
political as well as economic reasons, to control the workings of the
market mechanism. A typical example is where basic foods such as
bread and meat are hugely subsidised by the government to keep prices
at a low, fixed level. The rise and fall of prices, so important in the
market economy, does not take place. A consequence of artificially low
prices is often excess demand relative to supply. There are not enough
basic foods for everyone, and queuing becomes a way of life. Private
ownership of productive resources is restricted to small shops,
restaurants and personal services, such as hairdressing.

Figure 4.4: Empty supermarket shelves in Poland in the early 1980s

Governments of planned economies tend to set goals which are different

from those of governments in market economies. The objective is to
achieve a high rate of growth in order to catch up on the progress made
by the advanced market economies. Nowadays, there are very few
planned economies; examples include Cuba and North Korea.

TIP

When writing an answer about a planned economy, try to include a

present-day example. Cuba and North Korea are as close to planned
economies as the theory suggests. Albania and Vietnam could be
mentioned as socialist economies rather than full planned economies.
4.4 The mixed economy
The mixed economy is the typical economic system. In a mixed
economy, both the private sector and public sector have a part to play
in the allocation of resources. Decisions involve an interaction between
firms, labour and the government mainly through the market
mechanism. There is private ownership of most productive resources
although there is some public ownership.
Over the past 30 years or so, privatisation has been the trend.
Privatisation involves the transfer of resources from public ownership to
the private sector. This has been the case in many economies including
the emerging economies of Central and Eastern Europe and Pakistan.
The previously planned economies in Europe have had to move along
this path towards a mixed economic system prior to becoming full
members of the European Union (EU).
The increased emphasis on market forces has resulted in some
problems. The UK, for example, has lost many jobs in manufacturing as
factories have closed and production has moved to lower-cost locations
mainly in China, the rest of Southeast Asia and in Central and Eastern
Europe.
Elsewhere, there have been similar trends. One of the most dramatic has
been in the former Soviet Union where the economy has been
restructured (perestroika). This has been the case in its former satellites
such as Poland, the Czech Republic, Slovakia, Hungary, Lithuania and
Estonia. Opening up the economy in this way has resulted in huge
inward flows of foreign investment, particularly in the manufacturing
and retail sectors. There have been opportunities for private sector
businesses to be developed – cafés, small shops and garages as well as
the local ownership of productive resources are now the norm. In some
cases, such as where former state-owned companies have been sold to
the private sector, the new owners have made vast sums of money in a
very short period of time through adapting the businesses to make the
most of the opportunities of the market mechanism. Even in Albania,
once seen as one of the few remaining planned economies, the
government has recently decided to allow limited privatisation and a
greater emphasis on the market mechanism.
The experience of the Asian Tiger economies varies. Singapore and
Hong Kong, for example, have always focused strongly on the market
to allocate resources. Their governments have created an economic
situation where free enterprise is encouraged. The rewards can be high.
Other economies have placed more emphasis on central planning, such
as Malaysia, the Philippines and Indonesia. The extraordinary continual
growth of China over the past 15 years or so is linked to the controlled
management of the economy but with very clear opportunities for
foreign investors as well as domestic companies to influence the
allocation of resources.
Figure 4.5 provides a broad explanation of where selected economies
fall in terms of the relative strengths of the market and planned systems
of resource allocation. To clearly varying degrees, all countries would
seem to fit within the definition of a mixed economy.

Figure 4.5: Mixed economic systems

ACTIVITY 4.2

In a pair or a group, select one of the former planned economies

that joined the European Union (EU) in 2004: Czech Republic,
Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia.
Each pair or group should focus on a different country so that you
cover as many countries as possible between you.
For each country:
1 Try to find out what percentage of the economy is in the
control of the government and what percentage of resource
allocation is by the private sector.
2 Obtain information on the importance of the country’s
manufacturing sector such as types of good, firms and what is
exported to the rest of the EU.
3 Obtain data on the country’s annual economic growth rate
since 2004.
Display your findings on a poster for the classroom wall. If there is
time, each pair or group could present its findings to the class.

TIP

A common misconception is that the classification of economies is

exact. Most economies are some form of mixed system which
depends on the relative importance of the roles of the market
mechanism and government.

KEY CONCEPT LINK

Scarcity and choice: The fundamental economic problem exists

in all three types of economy.

REFLECTION

Activity 4.2 required you to collect some data on a former planned

economy that is now a member of the EU. How did you decide on
which country to select? How did you set about collecting the
data? What were some of the data interpretation problems you
experienced?

THINK LIKE AN ECONOMIST

New Zealand’s near market economy

Figure 4.6: New Zealand is a leading exporter of kiwifruit

New Zealand is one of the top-ranked market economies in the

world. In 2019, it was placed third in the Heritage Foundation’s
Index of Economic Freedom. Only Hong Kong and Singapore
have a higher score.
New Zealand has followed a market-orientated economy for many
years. It has fully accepted the principle that prices must be
determined by supply and demand and that economic activity,
including trade, should be as free from regulation as possible.
Since 1980, New Zealand’s governments have pursued policies of
deregulation and privatisation to liberalise the economy.
The country has a range of free trade agreements, particularly with
Australia and other Southeast Asian countries. It is a member of
the Comprehensive and Progressive Agreement for a Trans-Pacific
Partnership.
New Zealand is the sixth richest country in the world in terms of
gross domestic product (GDP) per head (a measure of national
income) and has experienced steady economic growth since 2000,
except for 2010–2012 when its economy was slightly affected by
the global downturn.
1 Explore the Index of Economic Freedom to see how New
Zealand compares with your country or one that you are
familiar with.
2 How relevant are the comparisons you might make?
EXAM-STYLE QUESTIONS: MULTIPLE CHOICE

1 Which of these terms describes a country where government

planning, regulations and directives are responsible for the
allocation of resources?
A capitalist economy
B mixed economy
C market economy
D planned economy
2 A criticism of a planned economy is that it puts more
emphasis on producing capital goods than producing
consumer goods. This is because:
A the system of decision-making is too centralised.
B there are shortages of many consumer goods.
C the government’s focus is on growth and not current
consumption.
D consumers cannot afford to buy any more consumer
goods.
3 A planned economy has recently become a mixed economy.
This process has involved a change in the composition of
what it produces. What is the most likely consequence of this
change?
A an increase in food prices
B an increase in imports
C an increase in structural unemployment
D an increase in the growth rate of the economy
4 A mixed economy can best be described as one in which:
A production is determined by the central government and
the market mechanism.
B agricultural and manufactured goods are produced.
C production is determined by entrepreneurs.
D consumer goods and capital goods are produced.
5 Which of these is the most likely outcome when a mixed
economy privatises its rail services?
A Peak train fares will increase.
B Off-peak train fares will decrease.
C Fewer rail services will be provided.
D Train fares will now be determined by supply and
demand.
6 After a planned economy changed to a more market economy,
there was a reduction in the proportion of household income
that was being saved. How might this be explained?
A Households were more concerned about the economy’s
future economic prospects.
B More ‘big ticket’ goods had become available.
C New charges were introduced for secondary education.
D Household incomes fell.
SELF-EVALUATION CHECKLIST

After studying this chapter, complete a table like this:

You should be able to: Needs Almost Ready
more there to move
work on
Understand the roles of
government and the market in the
three types of economic system:
market, planned, mixed
Analyse the advantages and
disadvantages of resource
allocation in each of the economic
systems