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Economic Systems

Concept Map: Economic Systems

Definition

An economic system refers to the way in which the resources of a country are used to produce goods and services, and the manner in which these goods and services are distributed for consumption.

Characteristics

Economic systems are characterised by the following:

- role of government
- freedom of choice
- ownership of resources
- price determination
- who gains the profits earned

Functions of Economic Systems

- the allocation of resources
- the organisation of production
- the distribution of finished goods and services
- the promotion of economic progress
- the maintenance of economic stablility

Fundamental Economic Questions

All economies are faced with the same economic problem, that of limited resources and unlimited wants. Therefore every society has to choose how to make the best use of their limited/scarce resources.

This decision is determined by answering these three fundamental economic questions:
- WHAT to produce?
- HOW to produce?
- FOR WHOM to produce?

What to produce?
Concerns allocation of resources among alternatives, i.e. the economy must allocate the varieties of goods and services which yield the greatest satisfaction to the consumers.

How to produce?
This deals with utilizing the most efficient process to produce the goods and services. Production is said to be inefficient when it is possible to reallocate resources and, as a result, produce more of at least one good without producing less of any other good.

For whom to produce?
The ideal distribution of goods and services is equal distribution among all members in the economy. However, in the real world this is never achieved.

Types of Economic Systems

The FOUR main types of economic systems are:

- Traditional Economy
- Free market/Capitalist Economy
- Planned/Socialist/Command Economy
- Mixed Economy

Traditional Economy

Features:
- existence was primarily based on traditions and customs
- barter was the main form of trading
- individuals existed on a subsistence level
- the decision of what, how and for whom was determined by customs and traditions
- resources were owned or controlled by a sovereign or feudal lord.

Examples of this economic system:
- Remote tribal areas in South America, Africa and Asia

Advantages:
1. Every member of the society knows exactly what they are to do.
2. There is a strong social network.
3. Positions within society are already established.
4. Basic Economic questions are already answered by traditions and customs.
5. Life is generally stable, predictable and continuous.

Disadvantages:
1. This type of society is often very slow to change.
2. It does not take advantage of technological change.
3. There is relatively little promotion of intellectual and scientific development.
4. There is inefficient provision of goods and services.
5. There is inadequate use of skill in relation to the factors of production.
6. No upward movement of labour takes place.

Free Market/Socialist Economic System

Features:
- The government plays little role in economic activity
- Emphasis is on freedom of the individuals (consumers and producers)
- The private sector (private firms and individuals) answer the basic economic questions.
- There is consumer sovereignty.
- Profit maximization is the main goal in this economy.
- The price mechanism determines price in this economy.

The Price Mechanism:
This is a basic regulation of economic activity. it determines the types of goods and services to be produced, the method used to produce them and the allocation of finished products among the people. Through its operation, changes in prices of goods and factors bring about changes in resource allocation. Consumers make known their choices and preferences through the amount of money they are willing and able to spend on them.

Only the economically most efficient method of production is employed, and goods will be produced where labour is cheapest.

Example of Free Market:
There is no real life example of a purely free market economy, this only exists in theory.

Advantages:
1. Manufacturers are free to produce what the consumers demand and the consumers in turn are free to spend their money as they see it fit.
2. The decision of what to produce is not controlled by government or any single individual/firm. Hence, there is greater participation in the decision-making process.
3. A large variety of goods and services are produced to satisfy the needs of consumers.
4. Prices are determined by the forces of demand and supply (the price mechanism).
5. There is freedom from government interference.
6. Efficient production is promoted since resources are allocated to their most profitable use.
7. Competition among firms improves quality, keeps prices low and spurs new technology and innovation.

Disadvantages:
1. Since the making of profits is the dominant motive of the private sector, only goods and services that yield the highest profit will be produced.
2. Since there is no government intervention in this type of system, consumer could be exploited through the charging of high prices for essential goods and services.
3. This system leads to great inequalities as the few rich get richer and the many poor get poorer.
4. There is much pollution associated with this system especially when industrialization begins to develop.
5. There tends to be an over-consumption of demerit goods such as alcohol, cigarettes and drugs.

Planned/Command Economic System

Features:
In this type of economy the state:
- controls all economic activity
- makes all decisions regarding economic activities
- decides what goods are produced, how much of each good to produce and how much the people should get.

Examples of this economic systems:
- The former Soviet Union (now 15 countries including Russia and Ukraine) dismantled their planned economies from 1990.
- China until the 1980s and 1990s
- Cuba until the 1990s
- North Korea – present day

Advantages:
1. The welfare of all citizens is the primary goal
2. Full employment of all available resources
3. Government possess the information to be able to direct resources where they are most needed.
4. Wasteful competition is avoided
5. There is no industrial unrest such as striking, as the government controls wages
6. Greater emphasis on quality of life than on quantity produced.

Disadvantages:
1. No freedom of choice for consumers or producers
2. System is too rigid to adjust when changes occur, can result in shortages
3. Lack of incentive for workers results in low morale and efficiency. Managers also are not motivated.
4. There are too many officials, and too much unnecessary procedure and paperwork (red-tape or bureaucracy)
5. Conflicts of interests can arise because what the country needs may not be what the people want.
6. There is wastage of manpower because large numbers of people are required for central planning.

Mixed Economic System

Features:
- Economic decisions are taken by the price mechanism system and also by the state
- The private business sector operates along the lines of the free market economy, where the price mechanism determines allocation of resources.
- The aim of the private sector is to maximise profits while the aim of the public sector is to maximise social welfare
- The public sector produces goods and services that the private sector is unable or unwilling to produce, with a bureaucratic set up like the planned economy

Examples:
Caribbean Region
United States of America

Advantages:
1. The state can intervene in areas of the economy through the passing of laws to protect citizens from unfair trading practices.
2. Both the government and the private sector can cooperate in offering certain services; e.g. transportation, health care.

Disadvantages:
1. Too much government regulation may dampen the free enterprise spirit.
2. Some state-owned industries are allowed to operate inefficiently, thus wasting resources.
3. Where government intervenes in the market by setting maximum and minimum prices, this may cause excess demand or supply, which may be difficult to regulate in the long-run.
4. Since the private sector helps to answer the economic questions, there can be the creation of monopolies.
5. Inequitable distribution of wealth can also arise.

Decision makers in this economy:
1. A Consumer is one who uses goods and services to satisfy his/her wants. The goal of the consumer is to maximise his/her satisfaction.

2. A Firm is a producer of goods and services. The goal of the firm is to maximise profits.

3. A Factor owner is one who owns the various factors of production. These are the resources needed to produce goods and services to satisfy wants.

4. The government functions as a guide in economic activities of a country. Governments intervene by either nationalising or regulating policies of industries.

Comparison of Economic Systems


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