There are two basic solutions to the economic problem as described by Paul Samuelson, namely those based on free markets and those based on central panning.
Free market economies
Markets enable mutually beneficial exchange between producers and consumers, and systems that rely on markets to solve the economic problem are called market economies. In a free market economy, resources are allocated through the interaction of free and self-directed market forces. This means that what to produce is determined consumers, how to produce is determined by producers, and who gets the products depends upon the purchasing power of consumers. Market economies work by allowing the direct interaction of consumers and producers who are pursuing their own self-interest. The pursuit of self-interest is at the heart of free market economics.
The second solution to the economic problem is the allocation of scarce resources by government, or an agency appointed by the government. This method is referred to as central planning, and economies that exclusively use central planning are called command economies. In other words governments direct or command resources to be used in particular ways. For example, governments can force citizens to pay taxes and decide how many roads or hospitals are built.
Command economies have certain advantages over free market economies, especially in terms of the coordination of scarce resources at times of crisis, such as a war or following a natural disaster. Free markets also fail at times to allocate resources efficiently, so remedies often involve the allocation of resources by government to compensate for these failures.
Command economies have certain advantages over free market economies, especially in terms of the coordination of scarce resources at times of crisis, such as a war or natural disaster. Free markets also fail at times to allocate resources efficiently, so remedies often involve the allocation of resources by government to compensate for these failures.
The benefits of command economies over free market capitalism became the central economic idea of German philosopher and economist, Karl Marx, who advocated state ownership of the means of production – namely, land and capital. He also predicted the eventual collapse of capitalism. The real value of an economic activity, Marx argued, could always be traced back to labour rather than capital, and hence capitalism’s pursuit of higher profits though the accumulation of capital was always at the expense of labour, who would increasingly have to produce more and more output to satisfy the needs of capitalists.
According to Marx, when the ‘reality’ of this sets in, labour would realise it was being exploited and would rise up and overthrow ther capitalist ‘masters’. While the ideas of Marx seem out of touch with the reality of history, Marx’s economic theories are widely studied and still influential.
There is a third type of economy involving a combination of market forces and central planning, called mixed economies.
Mixed economies may have a distinct private sector, where resources are allocated primarily by market forces, such as the grocery sector of the UK economy. Mixed economies may also have a distinct public sector, where resources are allocated mainly by government, such as defence, police, and fire services. In many sectors, resources are allocated by a combination of markets and panning, such as healthcare and, which have both public and private provision.
In contrast to the unregulated free market approach, and that of centrally planned command economies, the majority of economists favour come form of government intervention to make capitalism work better, rather than to prevent it working at all.
These include Keynesian economists, whose name is derived from British economist, John Maynard Keynes, and modern Libertarian Paternalists, including Richard Thaler, who are influenced by behavioural economics.
Keynes laid down the basic ground rules for state intervention in markets, and was, perhaps, the most influential economist of the 20th Century.
Thaler has been instrumental in the emergence of behavioural economics, and the use of experimentation to show how behaviour can be nudged towards more effective actions and outcomes.
These groups are pragmatic in that while accepting that capitalism is the most effective system on which to base a modern economy, it requires considerable intervention at significant times.
In reality, all economies are mixed, though there are wide variations in the amount of mix and the balance between public and private sectors. For example, in Cuba the government allocates the vast majority of resources, while in Europe most economies have an even mix between markets and planning.
Economic systems can be evaluated in terms of how efficient they are in achieving economic objectives.