What is an economy? What are three basic economic questions? Do you know the main economic systems?
This article will help you to identify the economic systems of command economies, market economies and mixed economies.
What is an economy?
A system involved in the production, distribution and consumption of resources. Its goal is to handle the economic problem. It does this by making the best choice when using limited resources to satisfy unlimited human wants.
To solve this problem, the three basic economic questions must be asked:
- What is to be produced?
- How is production to be organized?
- For whom is production to take place?
The basic economic questions
Let’s apply the three basic questions to solve the economic problem.
Question 1: What is to be produced?
An economy needs to decide what to produce using the scarce resources it possesses. Decisions need to be made so an economy can provide the needs and wants of individuals. Needs are very important and wants are problematic because you cannot provide for all. In a command economy what is to be produced is decided by the government. In a free market economy different economic agents own and control resources. Therefore they will decide what to do with them based on what they perceive to have the greatest benefit.
- Government – Provide education, defense or UFO research.
- Business – Supply what goods or services, expand into new country or new product type?
- Personal – Buy new windows or go on holiday.
Of course an economy can divide its resources to produce several different goods at the same time.
Question 2: How is production to be organized?
How to organize production is concerned with the most efficient way to use resources. Decisions must be made about where, how and what inputs will be used in production. A company can choose to be labor-intensive or capital-intensive to manufacture its goods. For example, a manufacturer would find labor costs very cheap if its factories were in Asia, but maybe find better technology skilled workers in Europe. Other concerns could be what materials should be used?
For example, should wood or plastic be used to produce a firm’s furniture goods? Governments decide how production is organized by deciding how to organize the economy, i.e. command economy or free market economy.
Question 3: For whom is production to take place?
Production should produce benefits. The producer needs to decide how these benefits should be allocated. Another way of saying this is, once something has been produced – how should it be distributed?
For example, governments provide public services. Should they be free, provided at cost or priced according to market forces? For example, a business will provide the outputs of production to those who are willing and able to pay the market price
Main economic systems
The way a government organizes its economy will have an impact upon all other economic agents within the borders controlled by that government. Nowadays, there are three main ways a government can organize its economy: Free Market Economies, Command (Planned) Economies and Mixed Economies.
1. Free Market Economies
Individuals make decisions about what is produced, but the government influences these decisions through law and legislation. Consumers, producers, Private Property Owners (PPO), and the government are the economic agents involved.
Individuals and organizations are motivated by profit and self interest. Consumers want a better life and producers and Private Property Owners (PPOs) want to maximize profits. The government is the ‘guardian’ of the system and should create fairness and promote welfare.
The characteristics of the economy are:
- Private enterprise – Individuals may set up businesses.
- Private ownership – Individuals can own resources such as land and capital and make decisions about what type of work they do.
- Competition – Different businesses fighting for consumers’ spending and loyalty leads to an efficient allocation of resources.
- Decentralized decision making – Individuals and private firms make decisions about what to produce, how it is produced and for whom.
- Consumer sovereignty – The power consumers have in directing market economies because goods and services are produced and exchanged mostly to satisfy consumer needs and wants.
- Quality and Innovation – Profit motive means that companies strive to be superior to competitors leading to the invention of new products and services.
- Distribution and wealth – Although income distribution may be unfair in a market economy, the profit motive encourages all to participate.
- Efficiency – Producers produce based on what people want and consumers use their own resources to get what they want leading to an efficient allocation of resources.
Answers the economic questions:
- WHAT? Customers cast their ‘dollar vote’ (produce what people will pay for).
- HOW? Producers use the lowest cost method.
- FOR WHOM? Those with the highest incomes. The level of income is determined by the value of the resources we have to sell.
2. Command (Planned) Economies
All decisions are made by the government; this is called ‘central planning’. The government, consumers, and workers are the economic agents involved. None of these groups are motivated by profit. Instead they work for society and the common good. In order to achieve these goals everything is owned by the state (public ownership). The government plans resource allocation, who can decide what a factory makes and even what job a person does. Essentially, consumption is controlled.
The characteristics of this type of economy are:
- Inefficiency – Providing for needs may mean employing more labor than necessary or neglecting projects that would be very profitable for the few.
- No or little choice – Production is based on needs, not wants. Therefore consumers don’t have the choice seen in market systems.
- Beneficial for society – If the needs of all are catered for.
- Equality – A command economy should not have the problems associated with a wealth gap (the division between the rich and the poor).
- No competition – The government is the only provider.
Answers the economic questions:
- WHAT? Decided by central planners/committees, representing the state. Targets specific work units.
- HOW? Specified by central planners. May vary according to a political agenda – not necessarily the cheapest method, e.g. if low unemployment is a goal, the government may want to use a labor intensive method.
- FOR WHOM? Production is for the benefit of all and the greater good.
3. Mixed Economies
In reality all economies are mixed. We use the term command economy or market economy, if an economy strongly shows the characteristics of each economy.
A market economy will still have a government that implements law. To maintain the law the government pays for police, the armed forces and contributes to schools and health care. A command economy still pays its workers wages (although their choice of goods will be limited).
Command economies also have ‘black markets’, which inspire the type of profit motive associated with market economies. Black markets are markets in which products are bought and sold illegally.
In short, the economic questions to answer the economic problem are: What to produce? How to produce? For whom to produce?
An economy centrally planned by the government is a command economy, whilst those economies with individuals organizing production are known as free market economies. Most economies actually contain elements of both, with a public sector organized by the government and a private sector organized by individuals.
