What is Economy | Different types of Economy or Economic Systems

    What is the Economy/Economic system?

    Every society has an economic system. 

    It is a system of resource allocation and resource ownership.

    The economy is a system spread over a particular area that reveals the nature and level of economic activities in that area. Economic activity is an activity that is based on or is related to the use of scare resources for the satisfaction of human wants, like, production, consumption, investment, and exchange.

    All institutions and organizations operating in a defined area that produce goods and services and enable people to earn incomes are collectively called an economy.

    An economy system provides people the means to work and earn a living. 

    The type of economic system that is best for society depends on its ability to 
    (a) satisfy people’s wants and needs, 
    (b) fulfill its economic goals.

    What is the Central Problem of an Economy?

    Every economy faces three central problems. These are three problems concerning resource allocation. These are: 
    1. What to Produce
    2. How to Produce
    3. For whom to Produce

    1. What to produce

    Resources are scarce in relation to human needs. A society cannot have everything its people want, so it must decide what to produce. Allocation of resources and the problem of choice requires that we decide what to produce and whatnot.

    The problem of choice is an economic problem. It arises while choosing where to use a particular resource as resources are limited and have alternative uses. If resources are not scarce problem of choice will not arise.

    What to produce involves two decisions: 

    (a) The economy has to decide what goods and services to be produced. For example, Consumer goods, capital goods, war-time goods, or peacetime goods.
    (b) The next step is to decide about its quantity. Say, how much consumer/capital goods are to be produced.    

    2. How to produce

    How to produce means how to organize production. This problem is concerned with the choice of technique of production. This problem is related to the efficient use of resources. It implies more production at less cost. 

    Broadly there are two techniques of production:

    1. Labour intensive technique- labor is used more than capital.
    2. Capital intensive technique- capital is used more than labor. The goods and services should be produced efficiently. The efficient technique of production is that which uses the least amount of scarce resources to provide the same amount of output or in other words, the production would be undertaken at a minimum cost.

    3. For whom to produce

    After deciding what and how to produce, society must decide who will receive the things produced. A society has to make a choice about who will receive the existing supply. These questions concerning what, how, and for whom to produce are never easy for any society to answer. 

    This problem has two aspects:

    1. The first aspect relates to personal distribution, that is, distribution of production among the different individuals and households.
    2. The second relates to functional distribution, that is, distribution of income generated from production among the factors of production. 

    What are the Factors of Production?

    Factors of production are the resources used to produce goods and services. There are four factors of production:

    1. Labor or human capital is the physical and mental abilities effort people use to produce goods and services. Labour is heterogeneous. Every job requires some human capital.

    2. Land generally refers to all-natural resources. These are the resources that are provided by nature and used to produce goods and services. Minerals, water, air, oil and gas deposits, mountains, etc. fall under this category.

    3. Physical capital is the stock of commodities used to produce goods and services such as machine tools, computers, buildings, equipment, warehouse space, tools, research, and development. Financial capital is used to acquire economic capital.

    4. Entrepreneurship is the effort used to coordinate the factors of natural production resources, labor, physical capital, and human capital to produce and sell products. An entrepreneur comes up with an idea for a product, decides how to produce it, and raises funds to bring it to the market. 

    What are the types of Economy?

    What is Economy | Different types of Economy or Economic Systems

    An economy that does not interact or trade with other economies in the world is called a closed economy. In contrast, an economy that interacts or trade freely with other economies around the world is open economy. Based on economic activities, the economic system can be categorized as:
    1. Traditional Economy
    2. Command Economy
    3. Market Economy
    4. Mixed Economy

    1. Traditional Economy

    A traditional economy is an economy in which the allocation of scarce resources and other economic activities are determined by the custom or practice or traditions.

    Benefits of Traditional Economy

    1. In traditional economy, groups keep producing what and how they have been producing. Everyone knows which role to play. 
    2. In this way, what and how to produce problems are easily solved. 
    3. The problem for whom to produce is determined by the customs and traditions of society. Tradition directs how people lead lives.

    Drawbacks of Traditional Economy

    1. It does not welcome new ideas and ways of producing goods and services. 
    2. The lack of progress in traditional economy causes economic stagnation and a lower standard of living than in other economic systems.

    2. Command Economy

    In a centrally planned or command economy, the decisions and choices regarding resource allocation are made by some central authority or government. These economies can be headed by a king, a dictator, a president, or someone who makes the major economic decisions.

    It is the government or central authority that decides what resources should be used, how much should be paid for inputs, what goods should be made, and what their price should be. Only the central authority decides the overall basket of goods and services that people can consume.

    This approach is based on the theory that only the government is able to make fair and proper provision for all members of society. Social welfare or collective welfare is the main motive behind allocation of resources to the production of different goods and services.

    Characteristics of Command Economy

    1. The government makes major economic decisions. 
    2. Most command economies severely limit private property rights. Individual freedom also is limited.
    3. Individual choices are limited because people have to live within the government’s restrictions. 
    4. Government officials tend to favor themselves when making economic decisions. The result is that some of the country’s money often goes to luxury goods.

    Examples of command economy

    1. North Korea  
    2. Cuba 

    Benefits of Command Economy

    1. The prime strength of a command economy is that it can change direction drastically, i.e, shifting of resources. The former Soviet Union shifted from a rural agricultural society to an industrial nation.
    2. Based on the former Soviet Union- a command economy- can provide many health and public services to everyone at a little or no cost. 

    Drawbacks of Command Economy

    1. It ignores the basic wants and needs of consumers as happened in Soviet Union and North Korea.
    2. This system gives people the incentive to fill their quotas instead of producing a good product. Soviet workers then filled their quotas by producing the world’s heaviest electrical motors.
    3. Command economy requires a large decision-making bureaucracy, which slows decision making and raises the cost of production. 
    4. The planning bureaucracy does not have the flexibility to deal with minor daily bases problems. As a result, command economies face crises and ultimately collapse as did the former Soviet Union.
    5. Rewards for individual initiatives are rare in a command economy. Everyone is expected to perform a job according to the decisions made by central planners.

    3. Market Economy

    A market economy is a free economy in which all economic activities are organized through the market, i.e, through market demand and supply. The economy operates automatically through the price mechanism. 

    The price mechanism is a system of exchange in which market forces of supply and demand interact freely to determine the price of the product. Producers are guided by profit motive and consumers by more satisfaction. 

    In a market economy, people make decisions in their own best interest. It is a mechanism that allows buyers and sellers to come together to exchange goods and services. This approach is based on the fact that it generates more wealth in total than the command approach. 

    People can spend their money on the products they want most which target the question of what to produce. Producers can use the production they think is best production while deciding how to produce. Finally, the income that consumers earn and spend in the market determines for whom to produce.

    Characteristics of a market economy

    1. It is a form of a capitalist economy- an economic system where private citizens own the factors of production. 
    2. Its two main features are private property and private profit motive.
    3. It is a free economy and self- interest is the prime motive.
    4. Producers are free to produce goods and services which are high in demand so that they can maximize their profits.
    5. People are free to buy goods and services in accordance to their choice and preference in order to maximize their satisfaction.
    6. Government does not interfere regarding what and how much to produce and consume.

    Examples of Market economy

    1. United States
    2. Japan
    3. South Korea 
    4. Singapore 
    5. Australia
    6. Great Britain

    Benefits of Market Economy

    1. Market economy provides high degree of individual freedom. Consumers are free to spend their money on goods or services they choose. Producers are free to decide what to produce.
    2. It has relatively small degree of government interference. The government normally tries to stay out of the way of buyers and sellers.
    3. Decision making is decentralized. 
    4. Market economy provides a variety of goods and services. 
    5. In a market economy, the choice one group makes does not affect the choices of other groups, hence provide high degree of consumer satisfaction.

    Drawbacks of Market Economy

    1. A market economy may not provide enough of some basic goods and services for everyone. 
    2. Producers concentrate on providing products they can sell for a profit. 
    3. The market economy has a high degree of uncertainty. 

    4. Mixed Economy

    Mixed economies exhibit the characteristics of all the three economies. In this economy, economic activities are generally left to the free play of the market forces, but the government also exercises its control to regulate the overall course of production, consumption, and investment. The government intervenes in order to ensure social justice along with a higher level of growth. 

    In mixed economies, the government influences economic activity in a variety of ways as well as for a variety of purposes, such as :

    1. Regulating macroeconomic forces through tax and interest policies, that can affect the price of the goods and services and income.
    2. Government can provide goods and services free or at low cost to the people as well as restrict the supply of goods and services.

    Economic wealth is divided between the private sector and the public sector. This approach attempts to combine the efficiency of the market system with the centrally planned system’s approach to the fair and proper distribution

    Socialism is a mixed economic and political system in which the government owns and controls some of the basic productive resources. In socialistic countries, the government also provides some of the basic needs of its people, such as education and health care.

    An extreme form of socialism is communism. It is a political and economic system where all property is owned by government. Generally, communist governments become so involved in economic decisions that they are often called command economies.

    Characteristics of Mixed Economy

    1. If government as well as markets, decide what, how, and for whom to produce, then society has a mixed economy. 
    2. The more socialistic a nation is, the more it will make economic decisions for the motive of the betterment of the people. 
    3. Some governments interfere only in certain key sectors or industries and leave the rest to markets. 
    4.  A mixed economy can turn into a command economy when government intervenes too much.

    Examples of Mixed Economy

    1. China - mixture of traditional, command, and market economies. 
    2. In Norway- the mixed economy is based on capitalism and markets with some elements of socialism. 

    Benefits of Mixed Economy

    1. It provides assistance for some people who might otherwise be left out. In democratic nation, voters have power to affect the what, how and for whom decisions even if the government owns no productive resources.
    2.  Under socialism, the for whom question is addressed more directly. 

    Drawbacks of Mixed Economy

    1. While mixed economies tend to provide more services, the costs for these benefits can mean higher costs for citizens overall. 
    2. In some socialist countries, the availability of services may be limited or the quality may deteriorate over time.
    3. Historically, both socialism and communism have proved to be less efficient than capitalism. 
    4. As socialism has proved to be so inefficient, many socialistic countries today allow more capitalist development. 


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