In what type of economic system are the decisions on what to produce and what to consume made mostly by the government?
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Economic Systems: Command, Market, and Mixed Show
The way in which a society answers the three fundamental economic questions is called an economic system. More formally, an economics system is a process or mechanism for answering the three fundamental questions. We can classify any type of economic system by two characteristics: who owns the resources? And who answers the fundamental questions? There are three main types of economic systems: command, market, and mixed. We will briefly describe each of these three types. Command Economy In a command economy, what goods and services are produced, how they are produced, and for whom they are produced are all questions answered by government planning. The government makes economic decisions for the good of society. In a pure command economy, all resources are owned by the government, so the government can direct them to produce what is best for society as a whole, rather than what might be in the interests of private individuals. So government owned the land, government owned the businesses, and government even told people what their occupations would be. Historically, command economies were associated with a political system known as communism, where the goals of society as a whole were given priority over individual goals. The Soviet Union until its breakup in the late 1980s was an excellent example of a command economy. Cuba and North Korea are good examples in today�s world of command economies. One of the biggest changes in the world in the last 15-20 years has been the fall of communism and command economies. The number of command economies in the world has fallen dramatically in the last decade. While the theoretical objective of a command economy is to use economic resources for the good of the whole society, as a practical matter command economies didn�t do that very well. In a command economy, government-owned producers are not allowed to go out of business, so they had little incentive to produce quality products at low cost. Since private individuals could not own means of production, they had no incentive to search for better ways of serving consumers� wants and desires. Rather than growing and prospering, command economies typically were stagnant. Market Economy In a market economy, resources are owned by private individuals. The goods and services that are produced are not determined by the government. Rather, production is determined by businesses responding to the wants and desires of consumers. (This process occurs through the interaction of demand and supply, about which we will have much more to say starting next week.) Consumers determine what will be produced. (You might have heard the expression �consumer sovereignty,� which suggests that in a market economy, consumers are king.) Adam Smith is often regarded as the first economist. In his famous book published in 1776, An Inquiry into the Nature and Causes of the Wealth of Nations (often referred to simply as The Wealth of Nations), Smith described the advantages of a market economy. Smith said that a market economy is controlled as if by an invisible hand � producers produce the things that consumers want without government telling them what to do. The invisible hand expression suggests that if the economy allows people to pursue their own individual interests, the result will be the best for society as a whole. Producers who want to make as much profit as they can will have to produce the things that consumers want. Profit thus is an incentive for producers to satisfy consumers wants and desires. Critics of a market economy argue that while it might do a good job of answering the first two fundamental questions (What to produce, How to produce), it does not do so well answering the third question (For whom to produce). Critics argues that producers satisfy the wants and desires of consumers who have the money to express those wants and desires, while those people without money are not served. In a market economy, critics say, there may be a wide gap between rich and poor. Mixed Economy A mixed economy is a blend of market and command economies. In a mixed economy some parts or sectors of the economy are left to private ownership (market) while in other sectors there is substantial government ownership or government-directed production (command). In a mixed economy, government intervenes in those sectors where private ownership is believed to be not in the best interests of society as a whole. For example, in a mixed economy the government might control the production and distribution of health care (as in Great Britain and Sweden). Mixed economies are relatively common in Western Europe, in countries such as France, Sweden, and Italy. Learning Objectives
To appreciate how a business functions, we need to know something about the economic environment in which it operates. We begin with a definition of economics and a discussion of the resources used to produce goods and services. Resources: Inputs and OutputsEconomics is the study of the production, distribution, and consumption of goods and services. Resources are the inputs used to produce outputs. Resources may include any or all of the following:
Resources are combined to produce goods and services. Land and natural resources provide the needed raw materials. Labor transforms raw materials into goods and services. Capital (equipment, buildings, vehicles, cash, and so forth) are needed for the production process. Entrepreneurship provides the skill and creativity needed to bring the other resources together to produce a good or service to be sold to the marketplace. Because a business uses resources to produce things, we also call these resources factors of production. The factors of production used to produce a shirt would include the following:
Input and Output MarketsMany of the factors of production (or resources) are provided to businesses by households. For example, households provide businesses with labor (as workers), land and buildings (as landlords), and capital (as investors). In turn, businesses pay households for these resources by providing them with income, such as wages, rent, and interest. The resources obtained from households are then used by businesses to produce goods and services, which are sold to the same households that provide businesses with revenue. The revenue obtained by businesses is then used to buy additional resources, and the cycle continues. This circular flow is described in Figure 1.3 “The Circular Flow of Inputs and Outputs”, which illustrates the dual roles of households and businesses:
Figure 1.3 The Circular Flow of Inputs and Outputs
The Questions Economists AskEconomists study the interactions between households and businesses and look at the ways in which the factors of production are combined to produce the goods and services that people need. Basically, economists try to answer three sets of questions:
Economic SystemsThe answers to these questions depend on a country’s economic system—the means by which a society (households, businesses, and government) makes decisions about allocating resources to produce products and about distributing those products. The degree to which individuals and business owners, as opposed to the government, enjoy freedom in making these decisions varies according to the type of economic system. Generally speaking, economic systems can be divided into two systems: planned systems and free market systems. Planned SystemsIn a planned system, the government exerts control over the allocation and distribution of all or some goods and services. The system with the highest level of government control is communism. In theory, a communist economy is one in which the government owns all or most enterprises. Central planning by the government dictates which goods or services are produced, how they are produced, and who will receive them. In practice, pure communism is practically nonexistent today, and only a few countries (notably North Korea and Cuba) operate under rigid, centrally planned economic systems. Under socialism, industries that provide essential services, such as utilities, banking, and health care, may be government owned. Other businesses are owned privately. Central planning allocates the goods and services produced by government-run industries and tries to ensure that the resulting wealth is distributed equally. In contrast, privately owned companies are operated for the purpose of making a profit for their owners. In general, workers in socialist economies work fewer hours, have longer vacations, and receive more health care, education, and child-care benefits than do workers in capitalist economies. To offset the high cost of public services, taxes are generally steep. Examples of socialist countries include Sweden and France.
Free Market SystemThe economic system in which most businesses are owned and operated by individuals is the free market system, also known as capitalism. As we will see next, in a free market, competition dictates how goods and services will be allocated. Business is conducted with only limited government involvement. The economies of the United States and other countries, such as Japan, are based on capitalism. How Economic Systems CompareIn comparing economic systems, it’s helpful to think of a continuum with communism at one end and pure capitalism at the other, as in Figure 1.4 “The Spectrum of Economic Systems”. As you move from left to right, the amount of government control over business diminishes. So, too, does the level of social services, such as health care, child-care services, social security, and unemployment benefits. Figure 1.4 The Spectrum of Economic Systems
Mixed Market EconomyThough it’s possible to have a pure communist system, or a pure capitalist (free market) system, in reality many economic systems are mixed. A mixed market economy relies on both markets and the government to allocate resources. We’ve already seen that this is what happens in socialist economies in which the government controls selected major industries, such as transportation and health care, while allowing individual ownership of other industries. Even previously communist economies, such as those of Eastern Europe and China, are becoming more mixed as they adopt capitalistic characteristics and convert businesses previously owned by the government to private ownership through a process called privatization. The U.S. Economic SystemLike most countries, the United States features a mixed market system: though the U.S. economic system is primarily a free market system, the federal government controls some basic services, such as the postal service and air traffic control. The U.S. economy also has some characteristics of a socialist system, such as providing social security retirement benefits to retired workers. The free market system was espoused by Adam Smith in his book The Wealth of Nations, published in 17761. According to Smith, competition alone would ensure that consumers received the best products at the best prices. In the kind of competition he assumed, a seller who tries to charge more for his product than other sellers won’t be able to find any buyers. A job-seeker who asks more than the going wage won’t be hired. Because the “invisible hand” of competition will make the market work effectively, there won’t be a need to regulate prices or wages. Almost immediately, however, a tension developed among free market theorists between the principle of laissez-faire—leaving things alone—and government intervention. Today, it’s common for the U.S. government to intervene in the operation of the economic system. For example, government exerts influence on the food and pharmaceutical industries through the Food and Drug Administration, which protects consumers by preventing unsafe or mislabeled products from reaching the market. To appreciate how businesses operate, we must first get an idea of how prices are set in competitive markets. Thus, Section 1.4 “Perfect Competition and Supply and Demand” begins by describing how markets establish prices in an environment of perfect competition. Key Takeaways
Exercises
1According to many scholars, The Wealth of Nations not only is the most influential book on free-market capitalism but remains relevant today. What is an economic system where the decisions on what to produce and what to consume are made by individuals and businesses in the market?Market Economies
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.
What type of economic system does the government make the decisions on what to produce and what consumers will buy?The Command Economy
In a command economy, the government planning groups make the basic economic decisions. The government determines which goods and services are to be produced, the prices and the wage rate. The government, not the people, own farms and businesses.
What are the 4 types of economic systems?Each economy functions based on a unique set of conditions and assumptions. Economic systems can be categorized into four main types: traditional economies, command economies, mixed economies, and market economies.
Which type of economic system does the government make all decisions?A centrally planned economy, also known as a command economy, is an economic system where a government body makes economic decisions regarding the production and distribution of goods.
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