Let's see how these different systems answer the three basic economic questions (see above). Before we look at how the three questions are answered, we must quickly look at some of the characteristics of a free market economy. We now need to see how these three important questions are answered in a free market economy.
For others, who inherited nothing, their wealth may come from the successful sale of their labour services. Of course, in this system, if you have nothing and you do not have marketable labour skills (for most people this will be a good education), then you will remain poor. As with the free market system, before we look at how the three questions are answered, we must quickly look at some of the characteristics of a command economy. Ownership: Nearly all of the country's factors of production are owned publicly by the government (or the state). Definition of Positive Externality: This occurs when the consumption or production of a good causes a benefit to a third party.
If you walk to work, it will reduce congestion and pollution, benefiting everyone else in the city. For example, in a free market without government intervention, there would be under-consumption of education and public transport. Positive externalities in the housing market  – examples of positive externalities in the housing market, such as  improved local communities, improved public health and better environmental standards.
About the AuthorTejvan studied PPE at LMH, Oxford University and works as an economics teacher and writer. The efficient production possibilities for a single producer or group of producers can be shown graphically. To find the efficient possible combinations of X and Y that the available resources can produce, we must remember to use them in the order of comparative cost advantage. If we want any X produced, the comparative advantages (costs) would require that Red produce the X, since Red is the lowest cost producer.
Here, the red numbers represent Red switching from making Y to making X (the first five Xs must be made by Red in order to be efficient).
If we graph these efficient possibilities, we get a diagram called the production possibilities curve, which shows all of the combinations of flats and lubes that are possible and efficient.
First, the slopes of the three segments making up the PPC indicate the costs of having the producers make X. Third, all of the combinations below the PPC (which are also described as being inside or to the left of the PPC) are possible, but not efficient. Fourth, points to the right of the PPC, (which could also be described as being outside or above the PPC) represent combinations of X and Y that are not possible using the resources or producers available.
In addition, if new resources are employed, or if other things change, combinations which are now impossible might be made possible in the future. In addition to having more resources, the possibilities might be expanded by having better technology, education (training), weather, or infrastructure (such as communications or transportation of parts and the like). The curves shown above are smoother than the Red, Purple, and Blue curve, reflecting the shape we would expect if there were many more resources or producers (actually, the smooth curves are made up of many tiny segments put together instead of only three).


At one extreme we have the free market economy, where there is a very limited role for the government.
Although it might make sense to argue that firms own some of the resources, it is private individuals, or groups of individuals, who own the resources.
Consumers maximise welfare, firms maximise profits and the private individuals, who own the factors of production, aim to maximise rents (on land), wages (on labour), interest and profit (on capital). They effectively respond to the consumers, who are allowed to buy anything that is sold by the producers.
Basically, it is assumed that nearly every market is a perfectly competitive one, with numerous buyers and sellers and no barriers to entry or exit. You may remember that in these circumstances, the price mechanism allocates the economy's resources.
David Beckham came from nothing, but he is able to sell his labour services (kicking a football!) for tens of thousands of pounds a week! Remember that, in complete contrast to the free market economy, a command economy has a very powerful government sector (or 'planners') and the workers and consumers are subordinate. The only factor over which the government does not have total control is labour, but as you will see, they certainly have indirect control over the workers.
Certainly, in the former Soviet Union, black markets used to develop as a result of shortages in the shops.
The producer or resource that can produce X at the lowest cost (in terms of Y given up or not produced) should be used to produce the first few units of X. That is why Red's segment is flattest (Red's costs of making X are least), Purple's is steeper than Red's, (because of Purple's higher cost of making X).
If we are producing a combination of X and Y that is on the PPC, and is thus efficient, more of one good can be produced only by producing less of the other good. If such changes make greater production possible, a new production possibilities curve must be drawn, as is shown below. These might reflect the production possibilities of X and Y for a large factory, a large city with lots of producers, or a whole country.
At the other end we have the command economy, where the government takes virtually total control.
Workers can take on any job they want (this may seem obvious, but wait and see what happens in the command economy). Firms are competing desperately for customers and the consumers are competing with each other for the goods on offer.
The reason why it is called the price' mechanism is because the price acts as a signal and an incentive for producers to act in the required way so as to maximise their gain, which, in turn, optimises the allocation of resources in the whole economy. As we said earlier, most industries will be perfectly competitive, so in the long run firms should be both productively efficient and alloctively efficient. It is because they set prices at low levels to make sure that everyone can afford the goods that excess demand occurs causing long queues for goods outside shops. As the government runs the system, they have the job of planning how all the resources should be used. The question is, how do the planners know what the consumers want and need better than the consumers themselves?


E.g you are able to educate other people and therefore they benefit as a result of your education.
It is based on this idea: for any amount of one good that is produced, there is one efficient (maximum) amount of another good that could also be produced, given the resources and technology we have to use. The purple numbers represent Purple then switching from Y to X, at a cost of three Y per X. For example, if we are producing 5X and 50Y and wish to produce more X, we can do so only by reducing the production of Y. An inefficient combination might be produced if resources (producers) are used in a way that does not consider or exploit their comparative advantages, such as if Blue (rather than Red) is used to make the first X.
As with market structures (with perfect competition and monopoly), these two extremes are highly unrealistic. Richard Branson is in charge of Virgin, but first and foremost he is a private individual who owns the majority of the shares. This system is often associated with communist Soviet Union (as it was before 1989), but the fascist Hitler ran a 'planned' economy, albeit rather dictatorially. For example, if we wish to produce a particular amount of good X, there is a maximum amount of good Y that could also be produced. If a combination is inefficient, it is possible to produce more of one of the goods without producing less of the other good. Just about every economy in the world is a mix of the two, and is, therefore, called a mixed economy.
Through their purchases (or money 'votes') consumers effectively dictate to the firms what should be produced.
So, as we said above, the planners decide on the quantities of output and methods of production. Most PPCs will be flatter at the top than at the bottom, indicating that the cost of making X (the good on the horizontal axis) increases as more of it is being made. The fact that producing an additional X requires us to produce fewer Ys indicates that the original combination (of 5X and 50Y) was efficient. If consumers, on mass, stop buying bitter (perhaps they prefer drinking lager in pubs) then the producers (the brewers) would stop making it. Also, democratic countries often attempt a less severe form of planned economy via socialism. This also means that the cost of making Y (the good on the vertical axis) is decreasing as less of it is made.
Through the legal system, the government must uphold the property rights of these private individuals. For some, it is inherited wealth, earning high incomes from the sales of the factors of production that they own (renting land and making profit and interest from capital).




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