An economic system is the result of individuals (consumers and producers), groups (firms, trade unions, political parties, families etc) and the government coming together and interacting in a legal and social society. The function of an economic system is to resolve the basic economic problem – scarcity which means that the resources are limited but wants are infinite. This distribution has three dimensions:
* What is to be produced
* How is it to be produced
* For whom is it to be produced.
There are 2 economic systems which are commonly used world-wide. There are: the free market system in which the role for the government is limited and the planned system where the government takes viturally total control. In both of these systmes there are different methods of resource allocation used. There are economies that use a mixture of these systems in particular the planned and free market system also known as the mixed economy in which some of the decisions resource allocation are done by the government and other by the public.
In a free market economy:
*The factors of production are owned by 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.
*Everyone is motivated by pure self interest. Consumers maximise welfare, firms maximise profits and privated individuals aim to maximise rents, wages interest and profit.
*Firms can sell anything they want. They respond to the consumers who are allowed to by anything that is sold by the producers.
*The level of competition is very high. Firms are competing desperately for customers and the consumers are competing with each other for the goods on offer
How are resources allocated under a market mechanism?
What is to be produced?
In a pure free market, it is the consumer which determines the allocation of resources. Consumers are sovereign. Each consumer has a free choice on the amount of money to spend on goods and services. Firms with the money recieved, buy the factors of production needed to produce goods and sercives. In other words in a free market a firm will only produce what the consumers are prepared to buy.
The consumers are the ones to dicate the goods that should be produced. For example the public decides that they want to buy more product X than product Y. The increase in demand for product X will increase the price at first. The production of product X will increase since many new first will get attracted with the idea of profit and at the same time the level of competition will increase. On the other hand for product Y the demand will fall along with profits. In general there is a transfer of resources from one industry to another.
How will it be produced?
There is competition between the various firms. Consumers will buy from the producers which offer the lowest price. So producers must produce at lowest cost. This then determines how goods are produced. The firms will adpot the lowest cost technique of production hence resulting in productive efficiency and allocative efficiency
For whom will it be produced?
The amount of money the consumers spend is determined by their income. This affects the factors of production since those with high invomes will be able to consume more of the goods whlist those with low income can only buy few goods and services.
There are some advantages in a free market economy:
*Resources are allocated more efficiently.
*There will be a much larger choice of goods and services
*Firms will keep on innovating and produce better quality products since there is a high level of competition
*Higher economic growth rates – Economic systems with a free market model have grown much faster than those with a command economy.
For example with the restaurant Mac Donald’s the demand is high because the consumers find it convenient to just drop by and have a meal within a matter of minutes, and since the consumers demand more the supply of it is also large.
A command economy has a very powerful government sector and the workets and consumers are subordinate. The resources are allocated through a planning mechanism. Some goods and services are prvided free and some rationed or sold
The characteristics of a command economy:
* Factors of prodction are owned publicly by the government
* No one think of himself – Everyone is assumed to be working for the common good
* There are no free enterprise
* There is very little competition which gives rise to black markets
* Since there is no competition there is no price mechanism. The authorities set the prices, and they are forced to set the prices low to make sure that it is affordable to everyone
* The government has the responsability of planning how all the resources should be used. The decide what should be produced and in what quantities. In other words they set the output and price levels.
What is to be produced?
The consumer does not have any control at all on what will be produced. The planners or the government decide what will be produced, but the main problem which arouses is that the government does not know what exactly the consumers need. In other words supply is dictated by a governing body which tries to predict demand however this process is very difficult and it leads to heavy losses.
How will it be produced?
There is no such thing as firms in a planned economy. The government direct the resources into producing “units” They have no autonomy, so basically the government decides the quantities of output and the methods of production
For whom will it be produced?
The government tries to distribute the output of the economy more fairly. Wages are determined by the planners and so are the prices of the goods produced. So the government is effectively determining how much each consumer can consume. They also believe that all consumers get equal amounts.
Advantages of a planned economy:
* The strong government will make sure that public and merit goods are consumed that the right levls and that demerit goods are banned or taxed heavily
* The government will try to make sure that nobody falls through the safety net. It will be a fairer economy even though it is likely to be less successful overall.
* Command economies can make sure that the prodction processes that they chose are as environmentally friendly as possible. They should be able to make sure that the level of output is the socially optimal level of output.
For example in Russia the government decided to produce jeans at a large scale but people were importing levis jeans and were selling them for a much cheaper price. this meant that the government lost a lot of money since they predicted that the people needed jeans but in reality they did not and even though they lowered the prices there were still huge amounts of stock which was not sold.
A mixed economy as the name implies is a mixture of a planned economy and a free enterpirse economy. In pure practice no pure planned economies or free enterprise economies exist in the world. It is a mixture of the two extremes and the degree of mixing depends and varies from one society or country to another.
Characteristics of a mixed economy:
* The government owns some of the country’s factors of production publicly and some are owned privately
* The market part of the economy will be motivated by self interest. First will maximise profit consumers will maximise their welfare and the factor owners will maximise rent interest and profit. The government on the other side has the common good goal.
* There are only free enterprises in the free market part of the economy
* The level of competition will vary on the degree of mix. and it will depnd on the market structure.
* The price mechanism operates in the private sector. its efficiency depends on how competitive the market structures are. The government run activities.
Many countries or economic systems have attempted to solve the resource allocation problem by reaching a compromise between the free market and planned economy systems. For example a governing body may decide that the production possibility frontier (ppf) has potential to increase if education and health services are provded to the public and thus enforces this, thus supplying it for free – this must be paid for by taxes which encourage a planned economy approach. However the remainder of the economy follows a free-market model
The government needs to decide the perfect balance between these two factors. If people are healthier then they are more educated and the more educated the healthier. This means that they firms will be able to have better qualified workers. This in turn will mean that the taxes will increase and the government will get more money. This money can be invested into improvements in technology and resulting in an increase in the ppf. For example the UK offers free NHS this means that more money can be spent on education and train people and this can lead to an improvement in techonology. On the other hand the better the education means that people are better qualified and more people can become doctors and thus it will improve health services.
Though there are 3 main types of economic systems which sue three different methods of resource allocation, there is often, in developed countries a tendency to use mixed economic methods in which both aspects of the free market and the planned economy are present. In developing countries there are approaches to the problem of resource allocation using all 3 methods.
In a free market economy supply is dictated by demand, the bigger the demand the bigger the supply and thus the price of the product is given. In a planned economy the governing body makes those decisions, supply is dictated by a governing body which tries to predict demand however this proves very difficult and it supplies goods to its wish and in a mixed economy supply of certain guds is dictated by a governing body and the others by demand.