Command and market economies | Basic economics concepts | AP Macroeconomics | Khan Academy

In this video, we're going to talk about different ways of structuring an economy. In particular, who owns what and how does an economy decide what to produce and who gets the output of that production.

So, on one side, you have what's known as a command economy. Good examples of command economies are the communist states, especially during the 20th century. The USSR, the Soviet Union, being the best example of that. In a command economy, the government controls what's often known as the factors of production, and sometimes in an extreme case, there might not even be private ownership.

So, let's say that this right over here is the government. I'll do this with some type of a building with pillars in it. So, this is the government, and in a command economy, the government will often own the factories and the farms—so the factors of production. Let me draw a little factory here; a little smokestack. The government will tell this factory, "You, this year, have to produce exactly 10,000 cars, no more and no less." The factory says, "Okay, you're our boss; you're the government. We will produce exactly 10,000 cars."

Similarly, the government might tell some—let's say that this right over here is a farm. This is my best drawing of a field, really fast. It needs to say, "Hey, you need to produce, I don't know, 10 million apples." I don't even know if that's a reasonable amount of apples to produce, but you need to produce 10 million apples. The farmers, who essentially work for the government because the government would own that farm, they would produce those apples.

Also, in a command economy, there's the question of who gets these cars and who gets these apples. Well, in an extreme command economy, they will be directly allocated by the government. The government will say, "All right, you get a car, you get a car, you get a car," and it might not be based—and in fact, it will not likely be based on any type of who's willing to pay for the car or who could pay the most for the car. Similarly for the apples. So they're all going to be allocated.

There would have to be a lot of planning done on the part of the government to say, "Okay, how much should we produce of one thing versus another thing, and how do we decide who gets the different things?"

Now, on the other side of the spectrum, you have what's known as a market economy. Most economies in the world, especially the United States, are much closer to being a market economy than being a command economy. Rather than having the government owning the factors of production and deciding who produces what and how much, and who gets those things, in a market economy, it's all based on the factory right over here, independent of the government for the most part—unless you're in certain fields that might have strong influence from the government, let's say you're a military contractor.

But if you're not in one of those fields, if you're fairly independent of the government, what they would say is, "Well, what does the market need?" They might say, "Hey, look, the market needs 5,000 cars that look like this, but then it also needs another 2,000 trucks that look like that." How are they basing it? Well, they might have looked at the past year, "Well, how well is this car selling? How well is the truck selling?"

They might look at competitors. In fact, in a market economy, you'll often have more competition than command economies. You might have one really ginormous factory that's owned by the government or a few, but here you might have competing factories where they're always, "Hey, they made a pretty good car; we're going to make one that's just as good, and it comes in yellow."

So, once again, you have this notion of competition for people to produce things out in the market, and they're also making their best judgment of what does the market actually need. Similarly, you could have your farmers here, and you say, "Hey, you know what? I've been growing a lot of apples, but that doesn't seem to be in demand anymore, so I'm going to grow more, I don't know, peaches, because it looks like the sale of peaches are in fashion this year."

And similarly, who gets these is not dictated by the government; it's determined by the market. So, let's say this is me, let's say this is you, let's say this is someone else. I might not be interested in getting a truck, but I really need to get a new car for my family, so I can drive them around and take vacations and things. Let's say you want to get a car too, but the market will dictate who gets it.

For example, the factory might set a price for this car; they might say it is $10,000 per car. Maybe I'm willing to pay it; maybe I'm not. Maybe I'm like, "Well, I really like that blue car, but I'm not willing to pay $10,000, and this yellow car is available for $9,000, so I am going to get that."

The prices themselves won't necessarily be fixed. If they're not selling enough of these cars at $10,000, they might lower the price to compete with the yellow car at $9,000. Similarly, if there's a ton of people who are willing to pay the price for this truck, they might raise the price on the truck or produce more of it. The severe competition—if one firm doesn't do this well on a regular basis, they might go out of business.

So, there's a strong motivation to be able to meet the needs of the market, and then the prices adjust accordingly. You might say, "Well, what are the positives and negatives that people generally associate with command economies or market economies?"

Well, the motivation that's often given for a command economy is some notion of fairness or some notion of equality—that when you have a market economy, as a byproduct of this mechanism where different people are competing, some people are innovating more or less, some people might be working harder or less, some people might just get luckier or unluckier, you naturally will have some level of inequality. Some of the original ideas behind command economies, like communism, were, "Hey, we don't like this inequality. We want to see more fairness, and so we want to see everyone get exactly the same car; we want to see everyone get exactly the same number of apples."

We don't want to see all of these competing firms; we want one really big efficient factory to just churn out these cars. Now, it turns out in reality that's a little bit utopian. Even at the peak of some of these communist economies, there were people who had better access to certain things. People who might have carried favor with the leadership had more power, had better apartments, better cars, had more access to resources than people who didn't.

In a market economy, yes, there will be some inequality, but the best thing going for it, and the reason why most economies in the world—even ones that are nominally communist, like the Chinese economy—have transitioned to a market economy, is because a market economy is also associated with things like innovation and strong incentives for people to innovate or work or do things.

Think about the situation in a command economy. Let's say that you're a manager at this factory here. The government has told you to produce exactly 10,000 cars and exactly the type of model. Maybe you have an idea for how to make this car more efficient, but no one's really going to reward you for that. If you're not going to be able to get paid more, so that you can buy more things, you might not be as interested in doing it.

While in this situation, you have extreme competition, where as soon as this factory or this company is outselling this one, everyone here is going to think, "Wow, we need to innovate. We need to really work harder so that we can take more market share from the other company." Similarly, at the individual level, different people might say, "Hey, I can only afford the yellow car now, but I really wish I had the blue car, so maybe I'm going to work a little bit harder, or I'm going to try to innovate, or I'm going to try to start a business."

Most of the world has transitioned to something much closer to a market economy because overall, even though you have this inequality, it has made more productivity, more innovation, more goods and services available to more people.

Now, the reality is that most economies, as I mentioned, are close to a market economy, but they aren't a perfect market economy. You still have the government very involved in certain industries. In many economies, the government might be in control of healthcare. The government in almost every country has significant influence in things like the military. The government in, say, the United States, which is considered a fairly capitalist and a fairly strong market economy, still does offer social safety nets when the inequality gets too extreme.

If someone isn't able to feed themselves, they might get food stamps. If someone isn't able to get healthcare because of poverty, they might get Medicaid. So, there's actually a spectrum between a command economy and a market economy, with most economies actually falling in this in-between state, which is sometimes referred to as a mixed economy.

For example, as already mentioned, the United States, which is considered a very capitalist country with a market economy, still does have some public ownership. The government still does control certain aspects of the economy—it still represents a fairly large chunk of the economy. So, a pure command economy: the government would control everything. A pure market economy: you would have very little that's controlled by the government. But the reality in most of the world is that things fall in this mixed economy spectrum.