Theoretical Economic Systems

Theoretical Economic Systems

Basically, there are only three systems. At one extreme we have the free market economy, where there is a very limited role for the government. At the other end we have the command economy, where the government takes virtually total control. As with market structures (with perfect competition and monopoly), these two extremes are highly unrealistic. Just about every economy in the world is a mix of the two, and is, therefore, called a mixed economy. The question is, what is the degree of mix?

Let's see how these different systems answer the three basic economic questions (see above).

Before we look at how the three questions are answered, we must quickly look at some of the characteristics of a free market economy.

Characteristics of this system

  1. Ownership: Nearly all of the country's factors of production are owned privately. Although it might make sense to argue that firms own some of the resources, it is private individuals, or groups of individuals, who own the resources. They then rent them out to the firms so that they can produce the goods and services. Richard Branson is in charge of Virgin, but first and foremost he is a private individual who owns the majority of the shares. He could get someone else to run the company. This brings into play one of the government's limited roles. Through the legal system, the government must uphold the property rights of these private individuals.
  2. Objectives: Everyone in this system is motivated by pure self-interest. Consumers maximise welfare, firms maximise profits and the private individuals, who own the factors of production, aim to maximise rents (on land), wages (on labour), interest and profit (on capital).
  3. Free enterprise: Basically, firms can sell anything they want. They effectively respond to the consumers, who are allowed to buy anything that is sold by the producers. Workers can take on any job they want (this may seem obvious, but wait and see what happens in the command economy).
  4. The level of competition: Very high. Basically, it is assumed that nearly every market is a perfectly competitive one, with numerous buyers and sellers and no barriers to entry or exit. Firms are competing desperately for customers and the consumers are competing with each other for the goods on offer.
  5. The pricing system: Nearly all markets are perfectly competitive. You may remember that in these circumstances, the price mechanism allocates the economy's resources. The reason why it is called the price' mechanism is because the price acts as a signal and an incentive for producers to act in the required way so as to maximise their gain, which, in turn, optimises the allocation of resources in the whole economy.

What, how and for whom?

We now need to see how these three important questions are answered in a free market economy.

What will be produced?

You might think that the firms decide what is finally produced. Actually, in a free market economy, it is the consumers who have all the power. Consumer sovereignty exists. In a free market, a firm will only produce a good if the consumer is prepared to buy it. Through their purchases (or money 'votes') consumers effectively dictate to the firms what should be produced. If consumers, on mass, stop buying bitter (perhaps they prefer drinking lager in pubs) then the producers (the brewers) would stop making it. So the answer to the question is, "whatever the consumers want."

Basket of goods

How will it be produced?

The simple answer is, "the firms." But there is more to this question than that. "How" also means "how well." Due to the highly competitive environment that exists, there will be pressure on firms to produce the goods as efficiently as possible and keep their prices as low as possible. As we said earlier, most industries will be perfectly competitive, so in the long run firms should be both productively efficient and alloctively efficient.

For whom will it be produced?

In other words, who actually ends up consuming the goods that are produced? Well, we said earlier that consumers' money votes determines what is actually produced. But it will also determine what consumers can actually buy. Those with more money will be able to consume more of the goods produced. Who has the most money? The rich, of course, but why are they rich. For some, it is inherited wealth, earning high incomes from the sales of the factors of production that they own (renting land and making profit and interest from capital).

David Beckham

For others, who inherited nothing, their wealth may come from the successful sale of their labour services. David Beckham came from nothing, but he is able to sell his labour services (kicking a football!) for tens of thousands of pounds a week!

Of course, in this system, if you have nothing and you do not have marketable labour skills (for most people this will be a good education), then you will remain poor. The free market system tends to create an unfair distribution of income. The wealthy consume a disproportionately large share of what is produced.

As with the free market system, before we look at how the three questions are answered, we must quickly look at some of the characteristics of a command economy. Remember that, in complete contrast to the free market economy, a command economy has a very powerful government sector (or 'planners') and the workers and consumers are subordinate.

Characteristics of this system

  1. Ownership: Nearly all of the country's factors of production are owned publicly by the government (or the state). The only factor over which the government does not have total control is labour, but as you will see, they certainly have indirect control over the workers.
  2. Objectives: The complete opposite of the pure self-interest of the free market system. No one (in theory) thinks of himself (or herself). Consumers, workers and the government are all assumed to be working for the 'common good'. This system is often associated with communist Soviet Union (as it was before 1989), but the fascist Hitler ran a 'planned' economy, albeit rather dictatorially. I'm not sure that system ended up being for the common good! Also, democratic countries often attempt a less severe form of planned economy via socialism.
  3. Free enterprise: There is none.
  4. The level of competition: Very little. Certainly, in the former Soviet Union, black markets used to develop as a result of shortages in the shops. There would be competition between these racketeers, I suppose. But in theory there was no competition.
  5. The pricing system: There is no competition, so there is no price mechanism. The authorities set the prices. It is because they set prices at low levels to make sure that everyone can afford the goods that excess demand occurs causing long queues for goods outside shops. Another inevitable consequence is the creation of black markets.
  6. The planning system: This is an extra characteristic of the command economy. The other five has tried to follow the five given in the 'free market economy' section. As the government runs the system, they have the job of planning how all the resources should be used. They have to decide what should be produced and in what quantities. They must decide how the goods are to be made. What labour should be used and where? What techniques of production shall we use? How will the completed goods be divided between the workers (or consumers)? The key point is that they directly set the output levels and price levels.

What, how and for whom?

We now need to see how these three important questions are answered in a command economy. Notice that the brief answer to all three questions is, "It's up to the planners."

What will be produced?

The consumer no longer has any control. The planners (or the government) decide what will be produced. The question is, how do the planners know what the consumers want and need better than the consumers themselves?

Houses of Parliament

How will it be produced?

There are no such things as 'firms' in a planned economy. The planners direct the resources into producing 'units'. They are not really firms. They have no autonomy. So, as we said above, the planners decide on the quantities of output and methods of production.

For whom will it be produced?

In the free market, the richer you were, the more you could buy. Of course, very poor people could end up with very little. The planner tries to be fair in distributing the output of the economy. Wages are determined by the planners, as are the prices of the goods produced. So the government is, effectively, determining how much each consumer can consume.

S-cool exclusive FREE TUTORIAL offer!