What is meant by an economic system Essay

Custom Student Mr. Teacher ENG 1001-04 20 July 2016

What is meant by an economic system

Each society is faced with a problem concerning their economic state. The economic problem is that there are limited resources in relation to unlimited wants. This problem brings about the need for a system to answer questions like what to produce, how to produce, how much to produce and how to distribute production. An economic system is the organisational and institutional pattern through which choices are made about which wants to satisfy, and how to allocate resources to do this. The different economic systems include planned economies, market economies and mixed economies. Australia has a mixed-market economic system in which there is a mixture of control by the government and freedom of individual enterprise and in which the basic economic questions are answered in the market place.

An economic system must answer the questions ‘what to produce?’, ‘how much to produce’, ‘how to produce’ and ‘for whom to produce’. The economic problem creates a situation where economies must decide which good or service to produce at the cost of another good or service not being produced, as a result of the limited resources available. For example, toffee apples are produced at the opportunity cost of fantails. The decision of the quantities the good will be produced in must also be determined. The question of ‘how to produce’ refers to the combination of resources used to produce a good or service. For example, a particular confectionary item can be produced by human effort (labour) or machines (capital), hence, the decision of which is the more efficient means of production must be made. Who gets the goods and services that are produced is the final decision that is made in production; it determines to whom the goods and services will be distributed to. There are two theoretical extremes of how these questions may be answered – the planned and the market economies. This does not fully exist in reality though.

Different economies handle the economic problem in different ways depending on what type it is and how it operates. In a planned economy, there is social ownership of resources, which are controlled by the state (communism). A central bureau or group of people who fix prices to encourage or discourage consumption makes the basic economic decisions, which is done for the ‘good of the community’. Individuals play a minor role in deciding
what is produced as the group sets plans for the production of capital and consumer goods. Methods of production are determined by what is socially desirable, so the central bureau may not necessarily choose the method of least cost because the profit motive is not as important.

Income distribution in a planned economy is much more equal than in others because decisions are based on the social good of the community. Although the state determines incomes and prices, workers have some freedom to choose where to work, according to their skills and qualifications. Price or market mechanism has little influence on allocation of resources -once again, it is largely dictated by the central bureau. The government is involved in most aspects of the economy and there are more social and moral incentives for individuals rather than material ones. However, the few remaining communist countries (China, Vietnam and Cuba) have been encouraging a more market- orientated approach lately.

On the other end of the economic spectrum, the market economy (also called capitalism, free enterprise and laissez-faire) is characterised by individuals and private firms that are motivated by self-interest and profit motive. It denotes an economic system with a high degree of economic freedom and minimalist government intervention. The role of government in economic life is restricted to the provision of infrastructure required for economic activity and welfare. In the classical model of capitalism, individuals have the right to earn incomes in the form of rent, interest, and profit from their own business. Freedom of enterprise in market economy allows anyone to undertake any production of goods and services they wish.

Above all, comsumer sovereignty most defines a market economy. Consumers are free to choose how to spend their income in order to satisfy their wants and so ultimately, they decide what goods and services will be produced. Consumers determine the answer to the question of what to produce and how much should be produced.

The essential element of the market is the price mechanism whereby prices adjust to ensure that the supply of goods and services is equal to the demand. Price mechanism conveys the wishes of consumers to the producers through a movement in price.

The Australian economy is neither of these two extremes. Although the private sector makes most of the economic decisions, the government plays an important role in providing collective goods, redistributing income, regulating, and stabilizing economic activity through macroeconomic and microeconomic policies. In Australia, governments have traditionally played an active role in the economy, although its influence has been slowly declining towards a market with less intervention from the government.

The reason for government intervention is that, in practice, market economies are not entirely successful in achieving maximum satisfaction. This is due to market failure, which arises when the market system fails to achieve efficient outcomes. There are income inequalities when dealing with a market economy. If the economy was left entirely to the market, then the rich would get richer and the poor would get poorer. Freedom of enterprise, the profit motive and comsumer sovereignty lead to wasteful and unnecessary production of non-essential goods. Collective wants will not be produced because it does not yield profit.

Hence, if the government played a minimal role, then there would be inadequate healthcare, education, public transport or welfare for disadvantaged groups. Externalities are inflicted on the community by firms in their pursuit of maximum profits; governments need to force firms to reduce those externalities. In addition, the market system may lead to the emergence of monopoly power and reduce consumer sovereignty through controlled output and higher prices, and less choice e.g. Microsoft. Finally, the regular fluctuations in economic activity, known as the business cycle, may cause excessive levels of unemployment in recessions and excessive inflation in booms, leading to lower community standards. All of these form the basis of government intervention.

The three main tasks of governments in modified market economies are the reallocation of resources, redistribution of incomes, and economic stabilization and growth. Some goods and services may not be provided under a pure market economy such as public transport and parks. Governments provide those goods that are beneficial to the community. It is also sometimes better for essential goods and services to be provided by government, rather than being left to private individuals such as defence and security. The government may also choose to influence the public sector through grants and subsidies. For example, specific sectors that are in need of assistance can be assisted through industry assistance and development spending.

The government also reallocates resources to public sector agencies that provide services to the community such as Australian Bureau of Statistics. The government can set regulations to prevent the exploitation of consumers and legislate to ban the production of undesirable goods and services e.g. illicit drugs. The government can impose safety standards and production methods that will not harm the environment. Australian individuals have quite a lot of economic freedom however the Australian economy works within an overall framework of government regulations, which safeguard society. The government legislates hours of work and minimum wages, sets prices for some products and pays subsidies and social service benefits. The allocation of resources and the distribution of what is produced still takes place, largely through the market or price mechanism but the government intervenes to grant cash subsidies, charge taxes, borrow money and run its own businesses.

The government can influence what people buy as levels of taxation can influence the price of goods and services. The government may choose to tax goods and services differently to alter the pattern of consumption such as the exercise on cigarettes and alcohol. Obviously, government intervention can change the way resources are used.

From progressive income tax, the government also causes an overall redistribution of income in order to achieve a more equitable sharing of produced output. Under such a system, high-income earners pay proportionally more tax and so evens out the distribution of income.

Welfare is designed to ensure a minimum standard of living for people who cannot work, or cannot find work. The system transfers income from taxpayers through taxation in the form of transfer payments. These include unemployment benefits, pensions, and disability allowances. This ensures for a more even distribution of income.

Economies change and grow in an unstable way. The government can use monetary and the fiscal policy in its macroeconomic stabilization methods. This is to attempt to achieve full employment, price stability and economic growth, by countering the effects of severe fluctuations in the business cycle. When the economy is stabilized, leading to higher living standards overall. The government intervention on the economy ensures that resources are utilized and attempts to solve the economic problem in the ways mentioned above.

The economic problem will always create the need for an economic system. Australia’s mixed system is quite a good balance of economies and is quite successful is answering the questions of production. However, problems still arise and the efficiency and reliability of this system is questioned. As long as the economic problem exists people will strive to create the ultimate “perfect” economic system, causing us to ponder upon the thought of whether that is really ever possible.


Dixon, T. (2005) The market economy: preliminary course 2005 Sydney: Leading Edge Education.

Riley, T. Year 11 economics


Notes from Enoch Lau

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