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7. Explain how the three basic economic questions would be answered in a free market economy and in acentrally-planned economy.

The three basic economic questions are, "What to produce", "How to produce" and "For whom to produce". In a free market economy, there is no ruling body over the people (government), so the people would essentially make decisions related to the three economic questions. The producers would determine "what to produce" according to current demand for goods and services, and what would make the most profit for the suppliers. This means that demerit goods would be produced in far larger quantities than merit and public goods. It would also mean that goods and services would be supplied according to the needs and wants of the richer people in society, and pollution would be unaccounted for (in terms of externalities) as well so that suppliers make maximum profit. However people would own resources such as land and capital, allowing them to produce what they deem fit for society. There would also be more research and development (competition) in firms to produce the best products so that consumers would buy them. What is produced will usually be the things that people want, because suppliers have the incentive to satisfy consumer demand in order to reap the benefits. "How to produce" would be determined by the method that is most profitable, this means that capital machinery would be used instead of labor, as it incurs a lesser cost to producers. This means that jobs will be lost and unemployment will rise. However this may mean that consumers will tend to get cheaper goods and services. "For whom to produce" as mentioned previously, will be the target audience from which the producers can make the most money (the rich people), which can result in the less well off people not getting the goods and services they can afford.

In a centrally planned economy, the government owns all resources and decides what, how and for whom to produce. For "what to produce", the government would determine what its people need the most, such as bread, tools etc. Yet this may not necessarily be what the people want, this is a main problem with centrally planned economies. The government will produce what it feels is best for the people, yet the people may not actually want this. Nevertheless there will be more public goods and merit goods than demerit goods, which is beneficial, and pollution and other negative externalities will also be accounted for. For "how to produce", the government uses its state owned resources to produce, using both labor and capital. This is beneficial because in a centrally planned economy, the government aims for 100% employment, so people will always have a job. For example however, in Stalin's Russia, the government would tell its state factories to produce 2 tons worth of nails (for construction), and to meet this production level the factory would produce 20 inch nails weighing 2kg each, which obviously cannot be used. This is a major problem with centrally planned economies. The 'producers' have no incentive, so they will meet the government demands in the easiest way possible. "For whom to produce" is determined by government analysts, and since a centrally planned economy promotes equality, what is produced is generally directed toward the majority of the population.

The following graph shows how supply and demand works in a centrally planned economy, until the government approves, no changes in supply can be made (inelastic supply curve) therefore restricting the 'invisible hand' economics that prevails in a free market. An inelastic supply curve means that if prices change, supply will not change as much. Prices in planned economy are set by government, but unless there is a war or a large event taking place, supply is hardly changed. This means that goods do not have close substitutes, and that consumers have less choice in terms of what they want.