TYPES OF ECONOMIC SYSTEMS:

There are three kinds of economic systems:

1. Free Market Economy

2. Planned Economy
3. Mixed Economic System

The market economy

A market economy is owned and controlled by private individuals, there are no or little
government intervention. It is also known as a capitalist economy.
In a market economy, resources are allocated through the price mechanism. The price
mechanism works through the interactions of demand and supply.

Through the price mechanism, the consumers can inform producers about the goods they want to
buy. Producers who are motivated by large profits will produce the goods that the consumer
wants.

Advantages of market economy

1. Freedom Of Choice:
Producers are free to buy and hire any economic resources for the production of goods of their
own choice. Workers are free to enter and leave any occupation for which they are qualified.
Consumers are free to choose the goods and services they want to buy.and which firms to buy
from.

2. Wider variety of goods and services

In a market system, producers compete with each other by offering wider variety of goods,
therefore consumers have more choice, and this may even lead to lower prices.

3. Competition pushes businesses to be efficient: keeping costs down and production high.
The aim of firms in a market economy is to make as much profits as possible. In order to do this,
the firms need to be more efficient. Therefore they often use new and better methods for
production, this leads to lower costs and higher output.

4. Government does not have to take decisions on basic economic questions

The market system relies on producers and consumers to decide on what, how and for whom to
produce. Therefore it does not require the government to employ a group of people to take these
decisions
5. Market system automatically responds and adjusts to the people’s wants
In a market system, the price of goods and services are determined by the forces of demand and
supply. If consumers want a particular good or a service, they simply demand for it and the prices
go up, which gives signal for the producers to produce more of that good. If producers can
produce the required amount of that particular good, the price automatically comes down to
normal. Likewise, if people no longer wants a particular good, they simply stop demanding for
it, so that it is no longer profitable for producers to produce that good, so producers stop
producing that good.
Disadvantages of market system
1. Factors of Production is not employed if it is not profitable
In a market system, producers do not produce a good or a service if it is not profitable.
But sometimes it may be necessary to produce some goods even if it is not profitable.
Therefore Market system will fail in this aspect.

2. Market system may not produce certain goods and services

Private firms in a market system will not be willing to provide certain public goods like
street lights because it is almost impossible to charge any payment from the consumers.

3. Free market may encourage harmful goods

If there are people in the market who wish to buy dangerous goods like narcotic drugs,
the market will be ready to buy it since private firms will be willing to provide anything
that is profitable

4. Production may lead to negative externalities

When firms are always trying to maximize their profits, they may ignore external costs
like damages to the environment

5. Free market economy may increase the gap between the rich and the poor
When firms and individuals are able to produce and consume freely, it may make the rich
even richer because they have more decision making power, and the poor may become
poorer because they have less decision making power in the market. The market system
allocates more goods and services to those consumers who have more money than others.

The command or planned economy

In this type of economic system, the government answers all the basic economic questions.
What to produce – The government decides what will and must be the needs of the citizens.
Citizens have no choice but to accept it. How to produce – The government decides the method
of production. A typical answer by a command economy could be to produce it in a labour
intensive factory owned by the government. For whom to produce – Again the government
decides who will consume the products. Government controls everything. The factors of
production are all owned by the state and production is done for the welfare of the state.
Therefore, the choice of goods available to the people is much less, the people have to accept
what is produced.

The mixed economy

In a mixed economy, there are features of both the market and command economies. Some of the
factors of productions are owned by the government, while others are owned by private sector.
Almost all the economies today are mixed economies.

Advantages of Mixed Economy

1. Efficiency - There will be competition between public and private industries, which will
result in greater efficiency and production in a mixed economy.

2. Reduced inequality - The profit of public sector industries goes to the Government and as
a result inequalities of income will be reduced in mixed economy.

3. Systematic plan - In a mixed economy, economic activities are carried out as per plan.
The entire economic system is subject to systematic planning of the Government.

4. Economic Stability - The economic activities take place in a planned manner. So there
will be economic stability in mixed economy.

5. Consumer sovereignty - Goods are produced as per the wishes of the consumers, which
results in consumer’s sovereignty in a mixed economy.

6. Freedom - In mixed economy, freedom of enterprise and profit motive are the important
features. Further there is competition between public and private sectors. These factors
increase efficiency, initiative, innovation and productivity.

7. Promotion of social welfare - Mixed economic system gives importance to the promotion
of social welfare. Under this system, both private and public sectors work for the welfare
of people.

8. Rights of Individual - Under mixed economy, individual rights are protected. People have
freedom to buy any commodity.

Disadvantages of mixed economy:

• Taxes will be imposed, which will raise prices and also reduce work incentive.
• Laws and regulations can increase production costs and reduce production in the
economy.
• Public sector organizations will still be inefficient and will produce low quality goods
and services.
Allocative efficiency
It is when resources are allocated in a way that maximizes consumer satisfaction. That is, firms
produce the products that consumers demand in the right quantities. The figure below shows
allocative efficiency:

Productive efficiency
It occurs when products are produced at the lowest possible cost and making full use of its
resources. If a firm is productively efficient, it means that it is not wasting its resources.
If all producers in a country are productively efficient, the economy will be able to make full use
of its resources and hence, will be producing on its PPC as shown below

Dynamic efficiency
It refers to efficiency occurring over time as a result of investment and innovation.

MARKET FAILURE
Market failure occurs when market forces fail to produce the products that consumers demand in
the right quantities and at the lowest possible cost.
In other words, market failure arises when the markets are inefficient.
Market failure could result in productive inefficiency which means the firms are not producing
the best output from the resources they have.
Market failure could also result in allocative inefficiency. This means that businesses are not
producing those goods which are most wanted and needed by the consumers. In this case
satisfaction of wants of the people will not be as good as it ought to be.

Why do market failure occur in an economy? / causes of market failure

1. Case of public good
Public goods usually have two characteristics:
• Non excludable – cannot exclude someone from using the product
• Non rivalry – consumption of one person does not affect consumption of another
person

Because of these characteristics, private sector firms do not have the incentive to make
public good as they cannot charge for them directly and also they cannot exclude
nonpayers from taking advantage of such products (free riders). Therefore, the market
fails.
 2. Case of merit good
Merit goods are products that are more beneficial to the consumers (to themselves and
others) than they themselves realize. For example, education and health care.
For instance some people does not realize the importance of free medical check-ups.
Hence, they are unlikely to take into accounts the benefits of their fitness to themselves
and others. This failure to acknowledge the true value means that these products would
be under-consumed and hence, under-produced if left to market forces.

3. Information failure
Market failure may also result from the lack of appropriate information among the buyers
or sellers. This means that the price of demand or supply does not reflect all the benefits
or opportunity cost of a good. The lack of information on the buyer’s side may mean that
the buyer may be willing to pay a higher or lower price for the product because they don’t
know its actual benefits.
On the other hand, inadequate information on the seller’s side may mean that they may
be willing to accept a higher or lower price for the product than the actual opportunity
cost of producing it.

4. Monopolies
A monopoly is a situation where there is only one seller in the market, and everyone else
is a buyer. Free markets sometimes result in monopolies, which can charge high prices
from consumers and there is under-production of the particular goods that the monopoly
provides

5. Failure to take into account all costs and benefits

The consumption and production of products affect both people who are involved and
not involved in the economic activity. An economic activity involves both costs and
benefits. The failure to take into account all costs and benefits leads to market failure.

COSTS AND BENEFITS

 Private cost
Private costs are those costs borne by those who are directly producing and consuming a product.
 Private benefit
Private benefits are benefits received by those who are directly producing and consuming a
product

PRIVATE COSTS PRIVATE BENEFITS

Examples: consumption side: cost of the chocolate Satisfaction derived
a person buys a (Rs 10)
chocolate at Rs 10
production side: Cost of raw materials Revenue earned /
a company produces Cost of labour profits
cars
  External cost (positive externalities)
These are costs imposed on a third party, that is, those not directly involved in consuming or
producing a product. (Non-doer of an economic activity)

 External benefit (negative externalities)

These are benefits to those not directly involved in consuming or producing a product.
External COSTS External BENEFITS
a person is listening His neighbor is being disturbed by the loud His neighbor enjoying
loud music music and cannot sleep the music as well
Driving a car Greater congestions, air and noise pollution Saves time
Setting up of a Air and water pollution Provide jobs
chemical factory
 Social cost
Social costs refers to the total costs to a society of an economic activity Social
costs = private costs + external costs
 Social benefit
Social benefit refers to the total benefits to a society of an economic activity Social
benefits = private benefits + external benefits

Government measures to address market failure

1. Taxes – this reduces supply and therefore increases price which in turn discourage to
discourage production /consumption of a good that has negative externalities.

2. Subsidy – this increases supply and therefore reduces price, to encourage production
/consumption of a good with positive externalities.

3. State provision - Government directly provides a good or service, funded through tax
revenue, in order to provide goods which have positive externalities or are public goods.

4. Regulations - Government imposes rules regarding the production, sale or use of a

good/service, and backs this up legally by fines/ prison sentences. This aims to tackle negative
externalities.

5. Nationalization – to benefit the public and to improve economic performance, a government

may set up an industry or nationalize a private sector industry. Nationalization is moving the
ownership and control of an industry from the private sector to the government.