The (Free) Market System (Cambridge (CIE) O Level Economics)

Different Economic Systems

• In order to solve the basic economic problem of scarcity, economic systems emerge or are created by different economic agents within the economy

  • These agents include consumers, producers, the government, and special interest groups (e.g. environmental pressure groups or trade unions)

  • Any economic system aims to allocate the scarce factors of production

• The three main economic systems are a (free) market system, mixed economy, and planned economy
  

What determines the economic system of a country?

• Economic decisions need to be made to answer three important questions

1. What to produce?
   As resources are limited in supply, decisions carry an opportunity cost. Which goods/services should be produced? e.g. better rail services or more public hospitals?

2. How to produce it?
   Would it be better for the economy to have labour-intensive production so that more people are employed, or should goods/services be produced using machinery?

3. For whom are the goods and services to be produced?
   Should goods/services only be made available to those who can afford them, or should they be freely available to all?
   

How These Questions Are Answered Determines the Economic System

How a Market System Works

• A market system works to allocate scarce resources efficiently, purely through the forces of demand and supply (the price mechanism)

  • There is no government intervention in a pure market system (no taxes or government spending)

  • In reality, there is no economy which is a pure market system 

• In a market system, prices for goods and services are determined by the interaction of demand and supply 

  • A market is any place that brings buyers and sellers together

  • Markets can be physical (e.g. McDonald's) or virtual (e.g. eBay) 

• The price mechanism is the interaction of demand and supply in a free market

  • This interaction determines prices, which are the means by which scarce resources are allocated between competing wants/needs

• The price mechanism fulfils several functions in an economy:

  • Prices allocate (ration) scarce resources

    • When resources become scarcer the price will rise further. Only those who can afford to pay for them will receive them

    • If there is a surplus, then prices fall and more consumers can afford them

  • Prices provide information to producers and consumers where resources are required (in markets where prices increase) and where they are not (in markets where prices fall)

  • When prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market to this market in order to maximise their profits

    • Falling prices incentivise reallocation of resources to new markets 

Market Equilibrium and Disequilibrium

• Equilibrium in a market occurs when demand = supply

• At this point, the price is called the market clearing price

  • This is the price at which sellers are clearing their stock at an acceptable rate

• Any price above or below P creates disequilibrium in this market

  • Disequilibrium occurs whenever there is excess demand or supply in a market