The basic economic problem is one of infinite wants and limited resources. An economic system is a mechanism for resolving this problem of scarcity and choice. Because economic resources are limited relative to society’s demand for goods and services, some means of allocating resources between alternative ends is required. Different kinds of economies have developed as nations have tried different approaches to solving their basic economic problems. However, the economies of all nations mix elements from two main economic models. These models are capitalism and central planning.

Capitalism calls for the ownership and control of all major businesses by private individuals. Many economies are based on the principles of capitalism. These economies are called private enterprise, free enterprise or free market economies because they allow people to carry out most economic activities free from government control. Even in these countries, however, the government owns some land and capital and exercises some control over the economy.

The Scottish economist Adam Smith first stated the principles of capitalism in the 1700's. Smith believed that governments should not interfere in most business affairs. He said the desire of business people to earn a profit, when regulated by competition, would work almost like an invisible hand to produce what consumers want. Smith's philosophy is known as laissez faire.

Central planning calls for government control of all major economic activities and government ownership of nearly all productive resources. It calls for giving government planners control of the production, pricing, and distribution of goods and services.

A centrally planned economy is a way of organising the economy to produce goods and services. Under this economic system economic decision making is centralised in the hands of the state with collective ownership of the means of production. It is the state which decides what goods and services are to be produced in accordance with its centralised national plan. Resources are allocated between producing units, and final outputs between customers by the use of physical quotas.

The main rationale underlying state ownership of industry is the view that collective ownership of the means of production ‘by the people for the people’ is preferable to a situation whereby ownership of the means of production is in the hands of the capitalist class who are able to exploit their elite position to the detriment to the populace at large. State control of industry enables the economy as a whole to be organised in accordance with some central plan, which by interlocking and synchronising the input-output requirements of industry is able to secure an efficient allocation of productive resources.

However, critics of state-owned economic systems argue that in practice they tend to be ‘captured and corrupted’ by powerful state officials, and that their top-heavy bureaucratic systems result in a highly inefficient organisation of production, and insensitivity to what consumers actually want.

A free-market economy is another method of organising the economy to produce goods and services. Under this economic system, the means of production are privately held by firms and individuals. Economic decision making is highly decentralised with resources being allocated through a large number of goods and services markets. The market synchronises the decisions of buyers and sellers and by establishing an equilibrium price determines how much of a good will be produced and sold.

Free-market advocates argue that a decentralised market based system leads to a more efficient allocation of productive resources in line with the demands of buyers, and that in the pursuit of individual self interest it will produce economic results which are beneficial to society as a whole.

Critics of private enterprise economies, however, argue that market based economies may not fully respond to the demands of buyers where supply is in the hands of powerful supplier, that it cannot ensure the production of certain products for which no market exists, that it can generate pollution and other externalities and that it leads to gross inequalities in the distribution of income.

A mixed economy combines public and private provision of goods and services. The mixed economy is a characteristic feature of most present day countries. The precise mix of private enterprise and state activities, however, does vary substantially.

The market mechanism allocates resources. One way of judging how well the market performs its function of allocating resources is to consider its efficiency. Efficiency is concerned with how well resources are used to produce an end result. There a number of different kinds of efficiency which need to be considered.

Static efficiency occurs at a point in time. Dynamic efficiency is concerned with how well resources are allocated over a period of time. It concerns how resources are allocated over time so as to promote technical progress and economic growth.

Productive efficiency exists when production is achieved at the lowest possible cost. There is productive inefficiency when the cost of production is above the minimum possible given the state of knowledge.

Productive efficiency will only exist if there is technical efficiency. Technical efficiency exists if a given quantity of output is produced with the minimum number of inputs. However, not all technically efficient outputs are productively efficient.

Distributive efficiency is an aspect of market efficiency which denotes the efficiency of a market in distributing its outputs from suppliers to customers. The costs of distribution include transportation, storage and handling expenses, together with the distributors profit margins. In addition, suppliers incur selling costs in creating and sustaining a demand for their products, such as advertising and other product differentiation expenditure. Optimal distributive efficiency is achieved when physical distribution costs are minimised and selling costs are maintained at the minimum level to sustain total market demand.

Allocative efficiency or economic efficiency is concerned with whether economic resources are allocated in order to produce that combination of goods and services which best accords with the pattern of consumer demand. This is achieved when all market prices and profit levels are consistent with the real resource costs of supplying products. Specifically, consumer welfare is optimised when for each product their price is equal to the lowest real resource cost of supplying that product including a normal profit reward to consumers. The following diagram depicts a normal profit equilibrium under conditions of perfect competition with price being determined by the intersection of the market supply and demand curves and with free market entry and exit serving to ensure that price is equal to minimum supply cost.

By contrast, where some markets are characterised by monopoly elements, then in these markets, output will tend to be restricted so that less resources are devoted to producing these products than the pattern of consumer demand warrants. In these markets, prices and profit levels are not consistent with the real resource costs of supplying the products. Specifically, in monopoly markets the consumer is exploited by having to pay a price for a product which exceeds the real resource cost of supplying it, this excess showing up as abnormal profit for the monopolist.

The profit maximising output of the monopolist is determined by equating marginal cost and marginal revenue. This involves a higher price and a smaller output than would be the case under perfect competition, with barriers to entry serving to ensure that output restriction and excess prices persist over the long run.

Another element of market performance is technological progressiveness. This denotes the extent to which firms develop and introduce new and improved products, production and distribution techniques. Radical inventions and innovations may make it possible to reduce manufacturing and distribution costs, thereby permitting a lowering of the supply price to the consumer.

Technological progress in aggregate terms affects a country’s rate of economic growth.

Product performance is a further aspect of market performance. It denotes the quality and performance of existing products and firms’ records with respect to the development of new products. The introduction of new products and the qualitative improvement of existing products may enhance consumer welfare by providing consumers with better value for money in terms of price-quality trade-offs.

The market allocates resources between alternative uses in line with patterns of consumer demand. , which in turn reflect a given size and distribution of national income. Resources are optimally allocated when the proportions in which factor inputs are combined to produce goods and services reflect their relative costs so as to minimise costs of production, and when the output of goods and services fully reflects the distribution of consumer preferences as between those goods and services.

Pareto optimality describes the maximisation of the economic welfare of the community. There are three conditions which must hold in order for a Pareto optimum to be attained. There must be optimal distribution of goods between consumers, optimal allocation of inputs in productive uses and optimal amounts of output. If all of these conditions are met, then it would be impossible to improve the welfare of one or more individuals without simultaneously reducing the welfare of another or others.

The production possibility boundary is one way of illustrating the economic problem of scarcity. It shows the maximum amount of goods and services that can be produced by the economy at a given point in time with available resources and technology. The boundary is curved rather than straight to show that not all resources are equally efficient in the production of one good as opposed to another.

The indifference curve is a curve showing alternative combinations of two products, each of which give the same utility or satisfaction. If it is assumed that it is not possible to make comparisons about welfare between individuals, then all points on the production possibility boundary give an optimal allocation of resources. However, if value judgements are made, then a community indifference curve can be constructed and a single optimum allocation of resources can be found. This point is known as the Pareto optimum.

All real economies combine elements of capitalism with those of central planning. However, nations differ from one another in the extent to which they rely on the two approaches. The United States and Canada have economic systems that use relatively little government control. For this reason, their economies are often described as capitalist.

Many other nations have economic systems that use more central planning than the United States does but less than the Soviet Union and the Eastern European countries did. In these nations, the government may own and run such important industries as steel mills, coal mines, and railroads. Many other industries are privately owned. Countries of this type include the United Kingdom and Sweden.

The Soviet Union and many nations of Eastern Europe once relied heavily on central planning. The governments of such countries owned nearly all productive resources and controlled all important economic activities. Government officials made all key decisions about how goods were produced, priced, and distributed. The economic system used by these countries was often referred to as Communism. No nation where this system was used prospered.

Eastern European countries became command economies in the late 1940s and early 1950s following communist take-overs of their governments. However, the 1990s have seen these economies transforming themselves into market orientated economies. The Eastern European countries sharply reduced their reliance on central planning after a series of revolutions in the late 1980's and early 1990's. Also in the late 1980's, the Soviet Union began to decrease government control of its economy. In 1991, the Soviet Union was dissolved, and afterward many of the former Soviet republics continued to reduce their reliance on central planning.

China and other countries that are often thought of as Communist have also loosened control over economic activities. In the mid-1980's, for instance, the government of China began to relax its control over business activity and prices. The process of transformation for most Eastern European countries began in 1990, although Poland and the former Soviet Union began restructuring in the late 1980s. The initial result was a sharp fall in GDP. It is almost inevitable that a transition from a command structure to a market structure will initially reduce output because of the differences in the way in which resources are allocated. In a private enterprise economies, producers are faced with uncertainties, and may decide to reduce their production in order to minimise their potential loses.

Poland moved from being a command economy in the 1980s to being a mixed economy in the 1990s. During the first two years of transformation from a centrally planned economy towards a free market system the GDP fell in 1990 and 1991 respectively by 11.6% and 7.0%. However, these figures should be treated with some caution. In the enormous upheaval that transition represents, accurate statistics for production in the formal sector of the economy are difficult to collect. The fall in output may be over estimated because large informal black economies have emerged in Eastern Europe.

After the economy settled down, Poland experienced economic growth. With a 3.8% GDP increase in 1993, 5.2% in 1994 and 7% in 1995 Poland has one of the fastest growing economies in Europe. In 1995 Poland's GDP was estimated at USD 118 billion, one of the highest among Eastern European countries.

Large falls in output following transition cannot but have led to increases in unemployment. One of the strengths of the command economies was that they were managed to ensure almost zero unemployment. The move to a market system led to a large increase in unemployment. Many firms have gone out of business because they have been exposed to the free market. Enterprises have also been forced to become more efficient, especially in sectors where there is competition from imports of Western firms. Efficiency is easily gained by shedding labour and making the remaining workforce work harder and more productively.

Economic transition in Eastern Europe has also been associated with very high inflation. An increase in prices is almost inevitable if an economy moves towards a free market system. In a command economy, resources are rationed in a number of different ways, but not through price. In a market system, resources are allocated by price. The free market price is inevitable above the old state price if consumers have been rationed in the past. When a market system is introduced, prices will rise until supply equals demand. There is no shortage because some consumers have been priced out of the market.

Higher prices can spark a wage price spiral. Workers in Eastern Europe have reacted to higher prices by demanding higher wages. If firms give higher wages then firms have to pass on those higher costs in the form of higher prices to the consumer which in turn gives rise to further wage demands. The transition period has been marked by large increases in prices. If these economies are to complete their transition successfully they must regain control of inflation and ensure stable prices. The danger is that reducing inflation will have a deflationary effect on the economy, further reducing growth rates in GDP.

In a free market economy, most land and capital is owned by the private sector. The movement from one type of economy to the other must involve the sale of state assets to private individuals of companies.

The move from a command economy to a mixed economy has inevitably led to a fundamental shift in the distribution of resources. In free markets, resources are allocated to those with spending power. Those with most spending power are likely to be those whose wealth, whether physical or human, is greatest. As a new wealth owning class emerges in Eastern Europe, the distribution of wealth will become less equal. It will also become less equal as wage inequalities widen. Market forces reward those people with high levels of human capital. The extent to which distribution of income becomes less equal depends very much upon the social security safety nets which are left in place after transition has been accomplished.

There are a number of advantages of a free market economy. In a rich free enterprise economy, consumers will be faced with greater choice. Firms will compete with each other on price if a good is homogenous, or on a wider range of factors such as quality if the good is non-homogenous. Those with high incomes will, by nature of the system, have a great deal of choice. Those on low incomes will have little. In a planned economy, consumers may find it impossible to spend all of their income because there are not enough goods available in the shops, but in a free enterprise there will be no shortages because consumers compete with one another. There will be plenty of goods in the shops, but they may be out of the price range of the poorest in society.

One advantage claimed of the free market economy is that there are strong incentives built into the system to innovate and produce high quality goods. Companies which fail to do so are likely to be driven out of business by more efficient firms. However, this assumes that there is consumer sovereignty in the market. In practice, markets tend to be oligopolistic in structure, dominated by a few large producers which manipulate the market through advertising and other forms of marketing in order to exploit the consumer.

John Kenneth Galbraith, the Canadian economist, advanced the proposition of revised sequence. Galbraith argued that large monopolistic and oligopolistic manufacturers are able to directly effect consumer choices. He said in his book, ‘The New Industrial State’ that that large firms plan their activities so as to minimise market uncertainty, and seek through advertising to create demand for new products before manufacturing them, to the extent that they are able to shape consumer choices, and effectively create the demand for products over time. This would imply that large monopolistic and oligopolistic firms are able to make the price system producer driven. This view contrasts the conventional economic view that consumers express innate wants leading to resources being allocated to satisfy these wants. Many people would assume that this reduction in consumer sovereignty would lead to a decline in allocative efficiency. However, free market economist argue that even if consumer knowledge is imperfect, as a result of advertising, the alternatives, which involve the state deciding what is desirable and undesirable leads to a far less efficient allocation of resources.

In a free market economy, there may be considerable economic growth. However, some free market economies have grown at significantly faster rates than others. Many mixed economies too have grown at comparable if not higher rates. Therefore, it is possible to conclude that free market economies are not the key to high economic growth.

In a pure free market economy, resources are allocated to those with spending power. Individuals with no source of income can pay the ultimate penalty for their economic failure and die. This fear of economic failure is a major incentive for people in a free market economy to take jobs, however poorly paid. The availability of desirable products also encourages people to try and work as hard as they can to increase their income, which they are able to do by investing in their ‘human capital.’ In a free market system, individuals are rewarded for increasing their marginal product with increases in their income, which allow them to buy more products. The lack of incentive in a command economy is one of its main failing points. However, one problem with the free market system is that there are many groups in society who are likely to have little or no income through no fault of their own, such as the handicapped, orphaned or abandoned children and the old.

Before transition, the Eastern European countries were achieving growth rates very similar to those of Western European countries. Unemployment and inflation were low by Western standards. Nevertheless, change was necessary. The command systems of Eastern Europe were based on repressive political structures. Command economies can only be run at the expense of political freedom. They rely on ordering people to take certain actions. To regain personal freedom, individuals had to regain economic freedom. This necessitated a move towards a more market-orientated economy.

The figures also conceal much of the truth about life in Eastern Europe before transition. Inflation was certainly very low. Prices were kept stable by state enterprises on the orders of the central planning authorities. However, there were huge inflationary pressures building up because of a large excess demand in the economy. This excess demand manifested itself not in rising prices but in lengthening queues. Growth of production was satisfactory, but much of what was being produced was going into the defence sector, was being used inefficiently in the production process and was therefore being wasted. Resources were being allocated to provide goods that consumers did not want. Not only was production inefficient, but the goods and services that were being produced were of poor quality in comparison with Western goods. The system provided few incentives for this to be remedied. Furthermore, although there was very low unemployment, a growing proportion of workers were getting jobs in the black economy. They could afford to work hard at their second job because they did so little in their first. In the official sector of the economy, labour was very under productive, mainly because there was little incentive for workers to work hard.

There have been many losers from the change in the economies of Eastern Europe but with time, these countries want to transform themselves into Western market economies, with comparable standards of living. They realised that their command economies would never allow them to do this, but today, East Europeans expect to achieve their aim and catch up with the West.