5 TYPES OF ECONOMY

An economic system is the way an economy produces and allocates resources. There are three economic systems:
A free market economy, a mixed economy and a command economy.

Within an economic system, there are various 'actors'.

Individuals They are consumers and workers. They may own factors of production, which they supply for
production purposes.
Groups Firms, political parties, families and charities are just some of the groups that might exist in an
economic system.
Government Government might range from a local council, to a local police authority, to a national parliament
or supranational organisation like the European Commission. One key role of government is to exercise
power. It establishes or influences the relationships between individuals and groups, for instance, through the
passing of laws or implementing those laws.

THE ALLOCATION OF RESOURCES

In rich industrialised economies, over the past 100 years, there have been two main ways in which resources
have been allocated.

The market mechanism The market mechanism allocates resources through bringing together buyers and
sellers who agree on a price for the product or resource being sold.

Planning Planning allocates resources through administrative decisions. Planning occurs within families when
individuals make decisions about who in the family is to get what.

Free Market : A free market economy is an economic system which resolves the basic economic problem
through the price mechanism. Basically market demand and supply determine prices and then whoever can afford
goods at the market prices can buy them. A rise in the demand for a good means its price increases and firms
switch more resources into producing that good. The government’s role is limited to providing the legal
framework (property rights) and providing public goods (police).

A free market economy has the following characteristics:

1) Main Agents: The main agents include consumers, producers, owners of private property and the
government.

2) Private Ownership: Most of the factors of production (land and capital) are owned by private
agents. The government must enforce property rights to protect private agents’ property.

3) Motivation: Motivation in a free market system is pure self-interest. Consumers maximize their
own welfare, firms maximize their profits, private individuals maximize their own returns (wages,
rents, interest and profit) and the government maximize social welfare.

4) Free Enterprise: Firms can sell basically anything they want to sell, consumers can buy nearly
anything they wish to buy and people can work for whoever they choose to.

5) Competition: Basically all markets are competitive because there are many buyers and sellers.
Buyers compete with each other to buy goods and firms compete with each other to sell goods.

6) Decentralized Decision Making: Agents are free to choose what they want to do, so decision
making is decentralized, that is, the governments do not allocate resources.
Advantages of free market economy

1. CONSUMER SOVEREIGNTY

In a free market, producers produce what consumers want at a reasonable price. It gives the consumer more choice
for their purchases.

2. ABSENCE OF BUREAUCRACY

Free markets reduce cost, lead to more innovation and research & development through the absence of red tape.
Entrepreneurs don’t have to wait for the government to tell them what to make. They study demand, research
trends and meet the customer’s needs through innovation. This also encourages competition amongst firms to
improve their product and service.

3. MOTIVATIONAL INFLUENCE OF FREE ENTERPRISE

Guided by the invisible hand, entrepreneurs take risk to fulfill consumer demand. Those entrepreneurs who
succeed are rewarded with profits. (The invisible hand is an economic concept where market demand act as
signals for producers, i.e. because consumers want and are willing to pay for bread, a baker has incentive to
produce bread).

4. OPTIMUM ALLOCATION OF RESOURCES

Resources in the market are better distributed and allocated. Since consumers are willing to pay for a certain
quantity of a product, producers are willing to pay to acquire raw materials. Otherwise, producers produce too
much of a good that no one wants. It also encourages firms to be more efficient as they seek to produce at the
lowest price possible to maximize their profit.

Disadvantages of free market economy

1. POOR QUALITY

Since profit maximization is the biggest motivation for firms, they may try to reduce their costs
unethically by polluting the environment or by exploiting workers.

2. MERIT GOODS

Goods and services that are not profitable will not be produced/run. Rural communities will suffer as a result e.g.
in terms of transport and post. For example: Rural hospitals may not be profitable to run but are necessary.

3. FIRM POWER

Large firms can still dominate certain markets, even where there is competition, and exploit suppliers (by
squeezing their prices down) and consumers (by charging higher selling prices) to maximize profits. Amazon has
done this in the book industry by dictating unfair terms to publishers.
4. UNEMPLOYMENT

Certain members of society will not be able to work like the elderly or the unemployed (because their skills aren’t
marketable). They will be left and will fall into poverty (remember if there is no government, they cannot be
helped).

Further Points:

The advantages of a market economic system

A market economic system has the potential to provide some significant, connected advantages.

• A market economic system should be very responsive to changes in consumer demand. In fact, in this
economic system, consumers are said to be sovereign. This means that it is consumers who have the power to
determine what is produced.

• Resources should change automatically and quickly to reflect changes in consumer demand. This is for three
reasons. One is that the price mechanism in a market economic system provides information on which
products are increasing in demand and which ones are falling in demand. The second is that the market
economic system provides an incentive for resources to move in response to changes in demand. For example,
if demand for books is increasing, whilst the demand for cinema tickets is falling, profits and wages will be
rising in the publishing industry, while they will be falling in the film industry. These changes will encourage
some firms to switch production and some workers to change their jobs. The third reason is that the market
economic system punishes those firms, workers and owners of capital and land who do not respond to
changing demand. For example, if a firm continues to produce a product which is falling in demand, it will
make a loss.

• There is choice. Consumers can choose which products to buy and which firms to buy from. Firms can also
decide what they want to produce and workers can choose who to work for.

• Costs and prices may be low. The profit motive and competition promote efficiency. Those firms which
produce at the lowest costs, and so which are able to charge the lowest prices, are likely to sell more and earn
more profit. In contrast, those firms which produce products of the same quality at a higher price are likely to
go out of business. Indeed, by rewarding efficiency, and punishing inefficiency, the market economic system
should encourage the production of the goods and services that consumers want and are prepared to pay for,
in the right quantities and at the lowest possible cost per unit.

• Quality may be high. Market forces can promote the improvement of methods of production and a rise in
the quality of products made. It does this by putting competitive pressure on firms, and by providing them
with the profit incentive to try to gain more sales by making their products more attractive to consumers.

The disadvantages of a market economic system

There is a risk that the market forces of demand and supply may not work well. In fact, market failure may
occur, with market forces failing to ensure the maximum benefit for society. There are a number of reasons
for this.
• Consumers and private sector firms may only take into account the costs and benefits to themselves, and
not the costs and benefits of their decisions to others. For example, some people may smoke, even if it annoys
and endangers the health of those around them. Another example is that to keep their costs and prices down,
firms may dump waste material in local rivers rather than process it.

• Competition between firms should ensure efficiency but, in practice, there may be little competition. A
market may become dominated by one or a few firms. These firms have considerable market power leading to
limited or no choice for consumers. They can raise the prices of their products and produce poor quality
products, as people have no choice but to buy from them.

• Even when there is competition and firms want to respond to desires of consumers, they may not be able to
do this. This may be because they cannot attract more workers as workers lack the right skills or are
geographically immobile.

• Firms will not make products unless they think they can charge for them. There are some products, such as
defence, which most people may want, but know that if they are provided for some, they will have to be
provided for all. In such cases, people can act as free riders. They can benefit from the product even if they do
not pay for it. When it is not possible to exclude non-payers, private sector firms do not have the financial
incentive to produce the product.

• Advertising can distort consumer choice. It can persuade people to buy products they would not otherwise
have wanted or encourage them to buy larger quantities. Consumers and producers may also lack information
and hence may make inefficient choices.

• As well as market forces sometimes failing to achieve efficiency, they can also result in what may be
regarded to be inequitable (unfair) outcomes. In a market economic system, some consumers will have a lack
of income. There can be a very uneven distribution of income, with some people being very rich, and others
being very poor. The sick and disabled may find it difficult to earn incomes. The old may not have made
adequate financial provision for their retirement. Some workers may become unemployed and may find it
difficult to find new jobs.

• Differences in income will increase over time. Those earning high incomes can afford to save and buy shares.
Their savings and shares will earn them interest and dividends (a share of profits). In contrast, the poor cannot
afford to save. The children of the rich will be more likely than the children of the poor, to earn high incomes.
This is because their parents are able to spend more on their education, provide better equipment such as
computers at home for them and thus they have high hopes of what they can achieve.
Mixed Economy

A mixed economy is an economic system which allocates resources partly by the price mechanism and partly by
the government. The government provides public goods, subsidizes merit goods, regulates monopolies, sets
minimum wages and provides social safety nets.

Market mechanism: where decisions on price and quantity are made on the basis of demand and supply alone.

List of Advantages of Mixed Economy

1. It promotes a quick economic development.

In this type of economic system, both the public and private sectors can operate equally, which means that
economic development will be quicker. This is especially true considering that economic resources will be
utilized efficiently. Also, depletion of resources will be slowed down.

2. It creates a balance in regional developments.

The planning commission of a country will be able to create policies for the improvement of every region. In
addition, the government would also try to develop each sector of the population.

3. It encourages lesser income inequality.

With a mixed economy, there will be lesser inequality when it comes to income, where the inheritance law is
applied to enable members of society to become richer. As for the public sector, it would try to provide
economic utility to the general public, leading to further reduction of inequality in income.

4. It provides the freedom to own a private property.

People are free to obtain property in a mixed economy, which means that the idea to work even more will be
encouraged. Again, this will help in the fast economic development, especially in the areas of industries and
agriculture.
List of Disadvantages of Mixed Economy

1. It brings about the fear of nationalization.

As the private and public sectors coexists, the government would have the ability to own and nationalize any industry.

This means that private entities will have to stay on the psychological apprehension that their business would be

nationalized or taken over by the government.

2. It could risk the government to go too far.

In a mixed economy, determining the exact role of the government in the private sector would sometimes
become a guessing game that would result to unfair practices in both sides. It is believed that the government
would manage the economy poorly, so its involvement is usually regarded as inappropriate.

3. It observes lesser use of resources.

While the interest of the society is important in this system, it also hinders maximum use of available resources.
This is primarily because of the government trying to mobilize resources to produce products and services that
are generally beneficial for society, rather than doing it for the betterment of the economy.

4. It can lead to higher taxes.

With more state intervention in the economy, it would mean that the government would invest more and would
get their funds largely from tax revenues. More taxes would be required from the people, which can lead to
negative consequences.

Basically, the success or failure of a mixed economy would still depend on how it is managed. However, based
on the advantages and disadvantages listed above, we will be able to know whether it will do our country any
good or just make situations even worse.
Command Economy

In a command economy the government directs resource allocation. Central planning is used, that is, the
government decides where every input and output is allocated. Jobs are allocated by the government and goods
like food and housing are rationed. Basically the government decides what, how and who to produce for.

Five Characteristics of Command Economy

• The central plan is closely adhered to and is created by a central government through rules, regulations
and laws.
• The government is responsible for creating a central economic plan for the country. To implement a
command economy, short-term goals are set in order to quickly mobilize and shape the economy.
• All goods and services production is set through the central plan. The main goal is to ensure employment
and see that all basic needs are met for every person within the society.
• There is a monopoly owned by the government in industries that are the most important in meeting the
needs of the society.
• The regulations and laws created are for the good of the economy and regulate wage and price controls.

Advantages of command economy include:

1. Resources are quickly and effectively mobilized on a large scale.

2. Industrial power is created and massive projects completed while attaining imperative social goals.
3. Individual self-gain is no longer the driving force of success among businesses. The greater good of the
society is the focus of the economy. The society as a whole benefits from the success and not just a select
few individuals.
4. This type of economy is able to transform the society to conform to the government’s vision for the country
or society.
Disadvantages of command economy include:

1. The needs of the society are often ignored for the betterment of the economy. Workers are not given options
on where they can be employed or where they can move.
2. The black market explodes in a command economy. Due to the governmental restrictions, good and
services that are not offered in the command economy begin being offered on the black market.
3. The amounts of goods being produced are not balanced. One item will be mass produced whereas another
will not have enough to support the economic needs. The government entity that controls the economy has
difficulty obtaining up-to-date information about the needs of the consumers. Many times rationing
becomes a way of life within a command economy.
4. Exporting goods becomes problematic because it is difficult for the controlling entity to determine which
products and prices will be most successful within the global market.