Economic Systems (Encyclopedia of Business and Finance)
The fundamental economic problem in any society is to provide a set of rules for allocating resources and/or consumption among individuals who can't satisfy their wants, given limited resources. The rules that each economic system provides function within a framework of formal institutions (e.g., laws) and informal institutions (e.g., customs).
In every nation, no matter what the form of government, what the type of economic system, who controls the government, or how rich or poor the country is, three basic economic questions must be answered. They are:
What and how much will be produced? Literally, billions of different outputs could be produced with society's scarce resources. Some mechanism must exist that differentiates between products to be produced and others that remain as either unexploited inventions or as individuals' unfulfilled desires.
How will it be produced? There are many ways to produce a desired item. It may be possible to use more labor and less capital, or vice versa. It may be possible to use more unskilled labor to substitute for fewer units of skilled labor. Choices must be made about the particular input mix, the way the inputs should be organized, how they are brought together, and where the production is to take place.
For whom will it be produced? Once a commodity is produced, some mechanism must exist that distributes finished products to the ultimate consumers of the product. The mechanism of distribution for these commodities differs by economic system.
MARKET VS. COMMAND SYSTEMS
One way to define economic systems is to classify them according to whether they are market systems or command systems. In a market system, individuals own the factors of production and individually decide how to use them. The cumulative decisions of these individuals are reflected in constantly changing prices, which result from the supply and demand for different commodities and, in turn, impact that supply and demand. The prices of those commodities are signals to everyone within the system indicating relative scarcity and abundance. Indeed, it is the signaling aspect of the price system that provides the information to buyers and sellers about what should be bought and what should be produced.
In a market system the interaction of supply and demand for each good determines what and how much to produce. For example, if the highest price that consumers are willing to pay is less than the lowest cost at which a good can be produced, output will be zero. That doesn't mean that the market system has failed. It merely implies that the demand is not high enough in relation to supply to create a market; however, it might be someday.
In a market economy the efficient use of scarce inputs determines how output will be produced. Specifically, in a market system, the least-cost production method will have to be used. If any other method was used, firms would be sacrificing potential profit. Any firm that fails to employ the least-cost technique will find that other firms can undercut its price. That is, other firms can choose the least-cost or any lower-cost production method and be able to offer the product at a lower price, while still making a profit. This lower price will induce consumers to shift purchases from the higher-priced firm to the lower-priced firm, and inefficient firms will be forced out of business.
In a market system, individuals make the choice about what is purchased; however, ability to pay, as well as the consumer's willingness to purchase the good or service, determine that choice. Who gets what is determined by the distribution of money income. In a market system, a consumer's ability to pay for consumer products is based on the consumer's money income. Money income in turn depends on the quantities, qualities, and types of the various human and non-human resources that the individual owns and supplies to the marketplace. It also depends on the prices, or payments, for those resources. When you are selling your human resources as labor services, your money income is based on the wages you can earn in the labor market. If you own non-human resourcesapital and land, for examplehe level of interest and rents that you are paid for your resources will influence the size of your money income, and thus your ability to buy consumer products.
Critics commonly argue that in a market system the rich, who begin with a disproportionately large share of resources, tend to become richer while the poor, who begin with a disproportionately small share of resources, tend to become poorer. They further argue that a government, which is designed to protect private-property rights, will tend to be exploited by those in power, which tends to be the economically wealthy. These critics argue that a market economy leads to selfish behavior rather than socially desirable outcomes.
In contrast, a command system is one in which decision making is centralized. In a command system, the government controls the factors of production and makes all decisions about their use and about the consumption of output. The central planning unit takes the inputs of the economy and directs them into outputs in a socially desirable manner. This requires a careful balancing between output goals and available resources.
In a command system the central planners determine what and how much will be produced by first forecasting an optimal level of consumption for a future period and then specifically allocating resources projected to be sufficient to support that level of production. The "optimal" level of production in a command economy is determined by the central planners and is consistent with government objectives rather than being a function of consumer desires.
As a part of the resource allocation process, the central planners also determine how production will take place. This process could focus on low-cost production or high quality production or full-employment of relatively inefficient resources or any number of other governmental objectives.
Finally, the command system will determine for whom the product is produced. Again, the focus is on socially-desirable objectives. The product can be allocated based on class, on a queuing process, on a reward system for outstanding or loyal performance, or on any other socially-desirable basis for the economy.
Critics commonly argue that because planned economies cannot effectively process as much relevant information as a market does, command economic systems cannot coordinate economic activity or satisfy consumer demand as well as market forces do. For example, consider an economic planning board of twenty people, that must decide how many coats, apartment buildings, cars, trains, museums, jets, grocery stores, and so forth should be built in the next five years. Where should these planners begin? How would they forecast the future need for each of these? Critics argue that, at best, planners would make a guess about what goods and services would be needed. If they guess wrong, resources would be misallocated and too much or too little production would take place. These critics argue that private individuals, guided by rising and falling prices and by the desire to earn profits, are better at satisfying consumer demand.
Under a capitalist economic system, individuals own all resources, both human and non-human. Governments intervene only minimally in the operation of markets, primarily to protect the private-property rights of individuals. Free markets in which suppliers and demanders can enter and exit the market at their own discretion are fundamental to the capitalist economic system. The concept of laissez-faire, that is, leaving the coordination of individuals' wants to be controlled by the market, is also a tenet of capitalism.
What and how much will be produced? How will it be produced? For whom will it be produced? In a capitalist system, individuals own resources, either through inheritance or through industry. The individual receives compensation for the use of resources by others. This, combined with inherited wealth of the person, determines an individual's spending power. The accumulated spending power and the willingness of individuals to allocate resources to consumption determine demand. The availability and costs of resources, together with the potential for profits of firms, determine supply. In a market system the demand of consumers combined with the supply of producers determine what and how much will be produced.
Because of the economic competitiveness of the market system, the lowest-cost production method will be used. If anything other than the lowest-cost production method was being used, a competing firm would have an incentive to enter production to earn a greater profit and could afford to sell at a lower price, thus driving the original firm out of production. Consumers could then purchase more of the product at a lower price, allowing their limited resources to purchase more.
Production will be allocated to those with available resources and a willingness to purchase the output of production. These purchases then become information for suppliers in determining what and how much to produce in the future.
Thus, pure capitalism is an economic system based upon private property and the market in whichn principlendividuals decide how, what, and for whom to produce. Under capital ism, individuals are encouraged to follow their own self-interests, while the market forces of sup ply and demand are relied upon to coordinate economic activity. Distribution to each individual is according to his or her ability, effort, and inherited property. Typically the economies of Canada, the United States, and Western Europe are considered to be capitalist.
Under a socialist economic system, individuals own their own human capital and the government owns most other, non-human resourcesthat is, most of the major factors of production are owned by the state. Land, factories, and major machinery are publicly owned.
What and how much will be produced? How will it be produced? For whom will it be produced? A socialist system is a form of command economy in which prices and production are set by the state. Movement of resources, including the movement of labor, is strictly controlled. Resources can only move at the direction of the centralized planning authority. Economic decisions about what and how much, how, and for whom are all made by the state through its central planning agencies.
In theory, socialism is an economic system based upon the individual's good will toward others, rather than a function of his or her own self-interest. Socialism attempts to influence individuals to take other people's needs into account and to adjust their own needs in accordance with what's available. In socialist economies, individuals are urged to consider the well-being of others; if individuals don't behave in a socially desirable manner, the government will intervene. In practice, socialism has become an economic system based on government ownership of the means of production, with economic activity governed by central planning. The economies of Sweden and France are examples of a socialist economic system.
Under a communist economic system, all resources, both human and non-human, are owned by the state. The government takes on a central planning role directing both production and consumption in a socially desirable manner.
What and how much will be produced? How will it be produced? For whom will it be produced? Central planners forecast a socially beneficial future and determine the production needed to obtain that outcome. The central planners make all decisions, guided by what they believe to be good for the country. The central planners also allocate the production to consumers based on their assessment of the individual's need. Basic human needs and wants would be met according to the Marxist principle, "From each according to his ability to produce, to each according to his need."
The economies of China, the former Soviet Union, and the former East Germany are examples of communist economies.
MIXED ECONOMIC SYSTEMS
In practice, most economies blend some elements of both market and command economies in answering the three fundamental economic questions: What and how much will be produced? How will it be produced? For whom will it be produced? Furthermore, within any economy, the degree of the mix will vary.
The economy of the United States is generally considered to be a free market or capitalist economic system. However, even in the United States the government has determined a "minimum wage," has set rules and regulations for environmental protection, has provided price supports for agricultural products, restricts the imports of items that might compete with local production, restricts the exports of sensitive output, provides for public goods such as a park system, and provides health and retirement services through Medicaid and Medicare. All of these detract from the essential nature of a capitalist economy. However, most decisions continue to be left to free markets, leaving the United States as a mixed economy that leans heavily toward the capitalist economic system.
In contrast, the economy of the former Soviet Union is generally considered to be communist. However, the strict controls of the central planning unit of the country tended to be more intensely focused on heavy industry, including the defense and aerospace industries, than on agricultural industries. Farmers often had significant freedom to produce and sell (or barter) what they wished.
Countries have scarce resources. The economic systems of countries are designed to allocate those resources, through a production system, to provide output for their citizens. The fundamental questions that these systems answer are:
- What and how much will be produced?
- How will it be produced?
- For whom will it be produced?
Market economies leave the answers to these questions to the determination of the forces of supply and demand while command economies use a central planning agency to direct the activities of the economy. Pure capitalist economies are market economies in which the role of government is to ensure that the ownership of the resources used in production are privately held. Socialist economies are primarily command economies where most non-human resources are owned by the state but human capital is owned by the individual. Communist economies are also command economies but all resources, both human and non-human, are owned by the state.
In practice, all economies are actually mixed economies, incorporating some facets of both market and command economies. The relative importance of the particular economic system in the country is the determinant of the type of economic system that it is generally considered to be.