Economic system seeks to answer three fundamental questions in economics, namely:
- What goods will be produced?
- How will the goods be produced?
- For whom will the goods be produced?
These three questions give rise to two poles of the economic system: a free market economy and a command economy (socialism). Free markets are economic systems in which individuals own most, if not all, resources and control the use of those resources. Sometimes, we call a free market economy as capitalism or a market economy.
The free market stems from the ideas of Adam Smith, an eighteenth-century economist. He thought that all parties wanted to get better.
Businesses want to get the most maximum profit possible when producing goods or providing services, either by charging high prices or lowering quality.
Likewise, households want low prices and quality products. They also have an interest in getting a high salary.
Businesses and households meet in the market to solve problems. When pursuing their respective interests, both will try to work hard, take risks, and produce the best. Hence, according to their respective bargaining power in the market, the market settlement will provide the best outcomes for businesses and households.
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On the other hand, socialism is a form of command economic system in which the government controls and controls its resources. Karl Marx, an economist of the nineteenth century, initiated the ideas of socialism. He sees self-interest as having a great tendency to hurt others because market forces are often unequal.
He believed that business owners in capitalists societies exploited workers by paying them far less than their value. Businesses have more power to do so than workers. He then uses the term surplus value to describe the difference between the total value of production and the subsistence wage paid to workers.
Distinguishing socialism from free markets
Most countries adopt a mixture of socialism and free markets (mixed economic systems). Some countries, such as China and Vietnam, are more inclined towards socialism. The government in both countries has a more significant role.
Meanwhile, other countries such as the United States and the United Kingdom are more inclined towards the free market. The private sector’s role is significant.
In general, the free market and socialism have differences regarding the following factors:
- Ownership of resources
- Private property
- Role of government
- Efficiency of resource allocation
- Income distribution
- Price determination
Ownership of resources
Under a free-market economy, the private sector owns the resources. Owners have an incentive to maximize the resource’s value, promoting efficiency in the economy.
Under socialism, the public owns the resources and means of production, either through democratically elected governments or public enterprises. In public enterprises, everyone owns their shares. It enables a more equitable distribution of goods and services.
Under a free market, private property is sacred. Proponents believe that its owners are more likely to use it most productively.
On the other hand, according to the socialists, those who own property will ultimately have more political power. They believe that the government should own most of it and ensure it benefits all, not just capital owners.
Under socialism, the government made all economic designs. They plan, organize, and make decisions on the allocation of economic resources. Government plays a vital role in almost all economic activities, including production and distribution and consumption.
A free-market economic system would not have such a plan. The government does not decide what goods and services will be produced or how to produce them. It all depends on the market. The government doesn’t intervene in the market. It only plays a role in enforcing the law, especially about private rights.
Efficiency of resource allocation
Market mechanisms enable efficient resource allocation in a free market economy. Competition, profit motive, and demand forces drive businesses to be more efficient and competitive. They try to cut costs and build innovation. Inefficient companies will be forced out of the market because they cannot compete.
On the other hand, under socialism, the allocation of resources is inefficient. Households and businesses have no incentive to be better off. Business is going according to government plans. They are not profit-oriented and do not compete with each other, so there is no need to be afraid of going out of business. It all makes businesses reluctant to be more efficient and innovative.
Under a free-market economy, unemployment is a common phenomenon. Individuals compete to get jobs, and when they don’t, they are unemployed. Job opportunities increase during a prosperous economy (economic expansion), pushing the unemployment rate down. In contrast, during a sluggish economy (recession), the unemployment rate increases as employment shrinks.
Under socialism, the economy is likely to reach full employment. The government mobilizes everyone to work on economic projects. Of course, individuals cannot refuse it.
Income distribution refers to how all income, goods, and services in the economy are shared. Under socialism, the government determines it. Individuals depend on the state for everything, from food to health care.
If the government is fair, it raises equality among the population. Everyone has the same opportunity. But, if not, it results in corruption among bureaucrats.
Under a free-market economy, the government doesn’t do it. Everything works following the law of supply and demand. Market mechanisms operate independently through supply and demand. It determines all aspects of the economy, from price, product type, income, wealth, and goods distribution.
Individuals work hard to earn income and become rich. They compete with each other, resulting in winners and losers: those who win become rich, and those who lose become poor. Thus, poverty and economic inequality are common phenomena under a free market economy.
In a free market, prices change to match supply and demand. When demand exceeds supply, the price rises. Likewise, if demand is lower than supply, the price falls. The government does not try to control or fix prices for goods and services.
In contrast, under socialism, the government makes decisions and controls prices. Control may vary between socialist countries. Price controls keep the market out of equilibrium. As a result, shortage ( excess demand) and surplus (excess supply) are common phenomena in this economic system.