Microeconomics- Unit Two: The General Problem of Societies

Lesson 2 Handout- Economic Systems

Economic Systems

An economic system is defined as the way in which the economic resources of a country are
managed. It is a country’s plan for its services, goods produced, and the exact way in which its
economic plan is carried out.

Every economy has 3 basic questions:

• What gets produced?
• How is it produced?
• Who gets it?

These questions are answered based on the structure of the economy or the economic system.

The Classification of Economic Systems

In general, there are three major types of economic systems prevailing around the world. These
are:

The Free Market Economy The Command Economy The Mixed Economy

The Free Market Economy

Also known as; the market economy, the laissez- faire economy, or the capitalist economy. In a
free market economy the national and state governments play a minor role. Instead, consumers
and their buying decisions drive the economy. In this type of economic system, the assumptions
of the market play a major role in deciding the right path for a country’s economic development.

Free market economies aim to reduce or completely eliminate:

• Subsidies for a particular industry,
• The pre-determination of prices for different commodities,
• The amount of regulations controlling different industrial sectors

The absence of central planning is one of the major features of this economic system. Market
decisions are mainly dominated by supply and demand. The role of the government in a market
economy is to simply make sure that the market is stable enough to carry out its economic
activities properly. Some examples of free market economies are; The United States, Hong Kong
and Jamaica.
Advantages of the Free Market Economy

1. Market economies can adjust to change easily. If there is a demand for one thing,
companies have the ability to change what they produce instead of having to go through too
much government protocol first.
2. There is a great variety of goods and services for consumers ( If there is a demand for a good
or service, the demand will almost always be met in a market economy).

3. Market economy encourages a competitive environment. This competition encourages

innovation, productivity and the production of higher quality goods and services

Disadvantages of the Free Market Economy

1 In an absolute Free Market economy, certain essential goods and services, e.g., defence, law
and order, education and medical care are either not provided at all or inadequately provided
by private enterprise because in most cases the profits and benefits to the company are
insufficient and not worth their while.

2. The market system will allocate more goods and services to those consumers who have
more money than others. This is because it will be more profitable to do so.

3. The Free Market Economy will encourage the production of harmful goods. Products like
cigarettes and alcohol will be produced in higher quantities because there is profit to be made
by making them available to the public.

4. The environment, road conditions, air, water supply will be ignored, because it is not
profitable for private companies to focus on them.

The Command Economy

The command economy is also known as: the planned economy, controlled economy, centralized
economy or the communist economy. The most important aspect of this type of economy is that
all major decisions related to the production, distribution, commodity and service prices, are all
made by the government.
The planned economy is government directed, and market forces have very little say in such an
economy. This type of economy lacks the kind of flexibility that is present in a market economy,
and because of this, the planned economy reacts slower to changes in consumer needs and
fluctuating patterns of supply and demand.

On the other hand, a planned economy aims at using all available resources for developing
production instead of allotting the resources for advertising or marketing. Some examples of
command economies include; Cuba, Burma and North Korea.

Advantages of the Command Economy

1. The government focuses on the equal distribution of wealth among all people so there are
no inequalities.

2. Only products that are required are produced, hence the government prevents production
of socially harmful/ undesired products

Disadvantages of the Command Economy

1. The planned economy reacts slower to changes in consumer needs and fluctuating
patterns of supply and demand.

2. Lack of competition and innovation. The planned economy will have less variety of
goods and services available to the consumers

3. The goods produced are usually of inferior quality since consumers have little or no
choice

4. The government cannot detect consumer preferences accurately.

The Mixed Economy

The mixed economy is also known as the balanced economy. The mixed economy has elements
of both the free market economy and the command economy. The allocation of resources is
determined by central authorities, firms and consumers All economies are considered to be
mixed to some extent.

Advantages of the Mixed Economy

1. Provides freedoms such as: Enterprise/Business ownership, Social Welfare, Profit

Earnings, Political Freedom
2. More equal distribution/allocation of resources.

3. Mixed Economies have active government support and direction. However, the
government has limited control

4. Consumers are protected from consumption of harmful products.

5. High quality products and services due to competition.

6. Relatively stable prices.

Characteristics of a Free Market and Command Economy

Free Market Economy Command Economy

Characteristics
(Capitalism) (Communism)

Individual must make choices Central Authority makes choices

1. Security/Choice
because resources are limited because resources are limited

Central Authority makes trade-offs,

Individuals make trade-offs because
2. Trade-Offs choices made at government level
choices must be made between
not by individual
alternative uses of resources

Government determines price; price

3. Supply and Demand Supply and demand determines price;
determines who can purchase
price determines who can purchase

4. Private ownership Private individuals own resources Government owns resources

5. Consumer Consumer choice determines what is Government decides what is

Sovereignty produced produced

Competition and price determine Government determines production

6. Competition
how goods and services are produced methods and practices

Profit determines economic Government controls incentives and

7. Incentives
behaviour determines their use

8. Markets Buyers and sellers exchange goods

and services in free markets Buyers and sellers exchange goods
and services as determined by
government in controlled markets