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2.3: Economic Systems

  • Page ID
    3597
  • What you’ll learn to do: describe and differentiate between major different economic systems

    In this section, you’ll learn about the basic organizing principles of different types of economies. Understanding the characteristics of a competitive market, in particular, is an important foundation for understanding the mechanisms of supply and demand, which you’ll learn about later in this module.

    learning objectives

    • Distinguish between market, planned, and mixed economies

    Economic Systems

    A photo of visitors at Legoland in Billund, Denmark. The Lego city scene in the photo is a Norwegian fishing village.

    Consider how complex a modern economy is. It includes all production of goods and services, all buying and selling, all employment. The economic life of every individual is interrelated, at least to a small extent, with the economic lives of thousands or even millions of other individuals. Who organizes and coordinates this system? Who insures that, for example, the number of televisions a society produces is the same as the amount it needs and wants? Who insures that the right number of employees works in the electronics industry? Who makes sure that televisions are produced in the best way possible? How does it all get done? The answer to these important questions depends on the kind of economic system a society uses.

    On the right : Figure \(\PageIndex{1}\) Legoland, Billund, Denmark: Picture of a Planned Economy?

    In the modern world today, there is a range of economic systems, from market economies to planned (or command) economies.

    Market Economies

    A market is any situation that brings together buyers and sellers of goods or services. Buyers and sellers can be either individuals or businesses. In a market economy, economic decision-making happens through markets. Market economies are based on private enterprise: the means of production (resources and businesses) are owned and operated by private individuals or groups of private individuals. Businesses supply goods and services based on demand. Which goods and services are supplied depends on what products businesses think will bring them the most profit. The more a product is demanded by consumers or other businesses, the higher the price businesses can charge, and so the more of the product will be supplied. Consumer demand depends on peoples’ incomes. A person’s income is based on his or her ownership of resources (especially labor). The more society values the person’s output, the higher the income they will earn (think Lady Gaga or LeBron James).

    Examples of free-market economies include Hong Kong, Singapore, and to a large extent, New Zealand, and the United States.

    Free Markets

    In a market economy, decisions about what products are available and at what prices are determined through the interaction of supply and demand. A competitive market is one in which there is a large number of buyers and sellers, so that no one can control the market price. A free market is one in which the government does not intervene in any way. A free and competitive market economy is the ideal type of market economy, because what is supplied is exactly what consumers demand.

    Price controls are an example of a market that is not free. When government intervenes, the market outcomes will be different from those that would occur in a free and competitive market model. When markets are less than perfectly competitive (e.g., monopolistic), the market outcomes will also differ.

    practice question \(\PageIndex{1}\)

    Which of the following is a defining feature of free markets?

    1. There is a large number of buyers and sellers.
    2. The government does not interfere in any way with the economic decisions of buyers and sellers
    3. The means of production are owned by government, not private individuals.
    Answer

    b is correct - This is the key defining feature of free markets. The government allows the forces of supply and demand to determine quantity and price.

    a is incorrect - This is not a necessary feature for a free market. A market in which a limited number of buyers or sellers control the market would still be a free market just not a competitive market.

    c is incorrect - Private ownership of the means of production (labor, factories, businesses,etc.) is a defining feature of market economies and therefore free markets.

    practice question \(\PageIndex{2}\)

    The economy of Atlantia is defined by the private ownership of the means of production by Atlantia’s citizens. While owners are usually free to utilize their property as they see fit, the government does intervene to ban certain harmful products (i.e. addictive drugs, lead paint, etc) from entering the market. Atlantia’s parliament has recently passed a minimum wage law setting minimum hourly compensation at $5.00 per hour. Atlantia is an example of a ________ economy.

    1. mixed market
    2. free market
    3. command
    Answer

    a is correct - Private ownership of the means of production along with limited government intervention are characteristics of a market economy.

    Planned (or Command) Economies

    The Sphinx and the Great Pyramid of Khufu at Cairo, Egypt

    Command economies operate very differently. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: A large part of economic life was devoted to building pyramids (like the one at the left), for the pharaohs. Medieval manor life is another example: The lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lord’s bidding. In the last century, communism emphasized command economies.

    In a command economy, resources and businesses are owned by the government. The government decides what goods and services will be produced and what prices will be charged for them. The government decides what methods of production will be used and how much workers will be paid. Some necessities like health care and education are provided for free, as long as the state determines that you need them. Currently, North Korea and Cuba have command economies.

    The primary distinction between a free and command economy is the degree to which the government determines what can be produced and what prices will be charged. In a free market, these determinations are made by the collective decisions of the market itself (which is comprised of producers and consumers). Producers and consumers make rational decisions about what will satisfy their self-interest and maximize profits, and the market responds accordingly. In a planned economy, the government makes most decisions about what will be produced and what the prices will be, and the market must follow that plan.

    Most economies in the real world are mixed; they combine elements of command and market systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than in the U.S. economy. China and Russia, while they are closer now to having a market-oriented system than several decades ago, remain closer to the command-economy end of the spectrum.

    practice question \(\PageIndex{3}\)

    Jane Doe is a shop owner in the fictional country of Xanadu. Every month the government’s planning ministry sends her a large booklet (which resembles a phone book) regulating the price of essential commodities including milk, flour, and eggs. In response to these regulations Jane Doe has reduced her inventory of essential goods and switched to selling luxuries such as cakes, pies, and soft drinks. Luxury goods are not price controlled. Does Jane Doe reside in a command economy? Why or why not?

    1. Jane resides in a command economy, as the government regulates some prices
    2. Jane does not reside in a command economy. Prices and money have no real place in a real command economy.
    3. Jane does not reside in a command economy. She owns her own business and is free to make some production and price decisions
    Answer

    c is correct - The government's extensive intervention in the economy combined with private ownership and limited independent market activity allows us to best characterize Xanadu's economy as 'mixed'.

    a is incorrect - While Xanadu's government intervenes extensively in the economy, Jane's business is still privately owned and free to make some independent decisions. These are not features of a total command economy.

    b is incorrect - While Jane does not reside in a command economy, lack of money is not a defining feature of command economies.

    practice question \(\PageIndex{4}\)

    You are the leader of a revolutionary movement which has recently overthrown the government of the tiny country of Tropico. During the 3rd Party Congress, which was held shortly before your glorious victory, the party committee decreed that “to free Tropico’s struggling masses from the jackboots of capitalism and reactionary imperialism, it is necessary to immediately enforce a command economy upon realization of our final victory.” Which of the following actions would betray your mandate to create a command economy in Tropico?

    1. Create a Ministry of Planning which will set prices, wages, and production targets.
    2. Immediately expropriating all private property, which will now be state-owned
    3. Maintain private ownership, but legalize labor unions which will now be free to bargain with private businesses for improved wages and benefits.
    Answer

    c is correct - This form of government intervention is limited and allows for the continued independence of privately owned businesses and resources. Their continued existence is a betrayal of the decrees issued during the 3rd Party Congress.

    The following Crash Course video provides additional information about the broad economic choices that countries make when they decide between planned and market economies. The narrators talk fast, so you’ll need to listen closely and possibly watch the video a second time!

    To recap, economic systems determine the following:

    • What to produce?
    • How to produce it?
    • Who gets it?

    In a planned economy, government controls the factors of production:

    • In a true communist economy, there is no private property—everyone owns the factors of production. This type of planned economy is called a command economy.
    • In a socialist economy, there is some private property and some private control of industry.

    In a free-market (capitalist) economy, individuals own the factors of production:

    • Privately owned businesses produce products.
    • Consumers choose the products they prefer causing the companies that product them to make more profit.

    Even in free markets, governments will

    • Maintain the rule of law
    • Create public goods and services such as roads and education
    • Step in when the market gets things wrong (e.g., setting minimum wage, establishing environmental standards)

    In reality, economies are neither completely free-market nor completely planned. Neither exists in “pure” form, since all societies and governments regulate their economies to varying degrees. Throughout this course we will consider a number of ways in which the U.S. government influences and controls the economy.