Economic Systems, Equity and the Role of Government

Three ways to answer the three questions

A free market economy lets prices decide. A planned economy lets the state decide. Every real economy is a mixed economy; the interesting question is never "market or plan" but where on the spectrum, and why there.

What prices actually do

The price mechanism performs three jobs at once:

• Signalling — a rising price tells everyone the good has become scarcer relative to demand.
• Incentive — that same rising price makes it worth producing more.
• Rationing — it decides who gets the limited quantity, namely those willing and able to pay.

The third job is where equity becomes a problem: ability to pay depends on the distribution of income, which the market did not choose on any moral principle. Markets can be efficient and unfair at the same time — these are separate tests.

Measuring inequality

The Lorenz curve plots the cumulative share of income against the cumulative share of population. The Gini coefficient is the area between the Lorenz curve and the line of equality, divided by the whole triangle below the line of equality: $0$ means perfect equality, $1$ means one household takes everything.

Why governments intervene

Two distinct reasons, and examiners want them kept apart. Efficiency reasons: externalities, public goods, imperfect information, monopoly power. Equity reasons: the market outcome may leave people below what society regards as acceptable. Intervention aimed at equity often costs some efficiency, and the size of that trade-off is an empirical question, not a matter of principle.

Positive and normative

A positive statement can in principle be tested against evidence — it may still be false. A normative statement contains a value judgement and cannot be settled by data alone. Economists also reason ceteris paribus, holding other things constant, which is a modelling device rather than a claim about the world.