Economic output will be maximized only when resources are allocated by a mechanism that takes full account of their relative scarcity and costs. At one theoretical extreme lies centralized planning, where allocations are all determined administratively; at the other, an unregulated market system. In reality, all countries use a combination of markets and government intervention. This reflects the experience that no planning organization is capable of calculating relative scarcities for all goods and services, while entirely free markets can have major failings.
Markets may not perform perfectly because of insufficient information or because they do not take adequate account of indirect losses and benefits (the so-called externalities such as pollution or worker training). Nor can free markets handle public goods (such as national defence), where the cost of supply is independent of the number of beneficiaries, or natural monopolies. Finally, markets do not act to correct inequalities in income and wealth. Some market failures are so evident that they cannot be ignored; in addition, governments will always have legitimate non-economic objectives that can be pursued only by intervention.
The challenge for every government, whatever its political complexion, is to intervene in ways that minimize economic costs to achieve desired goals. To overcome weaknesses, almost all the economic reforms attempted by market and centrally planned economies have placed greater reliance on prices to decentralize decisionmaking. Where administrative skills are generally at a premium, the theoretically optimal solution to a public management problem-such as a value added tax to fund government operations without introducing fiscal distortions-may prove impractical, and a second-best solution must be sought. The option of using price incentives in place of administrative solutions always merits serious consideration. Not only do price incentives lighten the administrative burden but they also reduce costly distortions.
The use of market mechanisms does not require or assume private ownership. Both in socialist countries and within the public sector in "mixed" economies, reforms based on market mechanisms have been effective without changes in ownership. The difficulty lies in ensuring that prices reflect costs. In any economy a vast amount of rapidly changing information on the supply and demand for goods and services must be handled promptly and accurately.
Competitive markets permit the necessary flexibility and responsiveness and, because they decentralize the task of handling information, also economize on scarce administrative resources.