The Market system
Lesson 3
Economic Systems
Basic questions
 Economic systems
Planned economy
• Advantages and
disadvantages
Market economy
• Advantages and
disadvantages
Mixed economy

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Basic Economic Questions

Any economic system must answer the three basic
questions (how do we allocate our resources?)
1. What is produced?
• What goods are services are produced?
2. How are those goods produced?
• What production methods are used?
3. For whom?
• Who gets which goods?
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Economic Systems

Each system answers the three basic questions
differently.
A market economy uses the price
mechanism to allocate resources
A planned economy uses the planning
mechanism to allocate resources
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Countries classified by economic
system

Market Economy

Command Economy

Mixed Economy
Economic Systems

Some standards used to distinguish
among economic systems are:
Who owns the resources?
What decision-making process is used
to allocate resources and products?
What types of incentives guide
economic decision makers?
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Countries classified by economic system
Economic system classified by the right mix of
ownership and control of the economy
Ownership means those who own the
resources engaged in economic activity---the
public sector, the private sector, or both.

Control
of economic activity refers to the fact
that resources may be allocated and controlled
by the public or the private sector.
Economic system

Market economy
One in which individuals and private firms make the
major decisions about production and consumption.
The resources are primarily owned and controlled by
the private sector, not the public sector.


Command economy (centrally planned economy)
One in which the government makes all important
decisions about production and distribution.
 The government owns and controls all resources.

Economic system

Mixed economy
Different degrees of ownership and control best
describe most countries.
Most market economies have some degree of
government ownership and control, whereas most
command economies are moving toward a market
economy and away from command concepts.

Summary
The three fundamental economic questions that all
societies have to consider are what to produce, how
to produce it and who receives what is produced
Economic systems can be classified as planned,
market, and mixed
• In a planned economy the government owns the
factors of production and makes the key
economic decisions
• In a market economy there is private ownership
of land and capital, consumers decide what is
produced and resources are allocated through
the price mechanism
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Economic Systems

A planned economy is also called
Command economy
Command and control economy
Centrally planned economy
Collectivist economy
Communism

In a planned economy the government decides what
to produce, how to produce it, and who gets to
consume it
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Economic Systems

Planned economy
Who owns the resources?
• The state
What decision-making process is used to allocate
resources and products?
• The state makes all decisions on production and
consumption using central planning
What types of incentives guide economic decision
makers?
• Central planners are supposed make decisions that
benefit society
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• Workers/firms have bad incentives
Economic Systems

To coordinate all activities in the economy, the
government uses a central planning system
Its function was to identify what goods and
services were needed by the people, how
these goods and services would be produced
and how the state output would be
distributed
Prices are not used to determine resource
allocation
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Advantages of the planned economy
Wasteful
Deal
competition is avoided
with the externalities
Equal
distribution of income and wealth
Effectively
control inflation
Disadvantages of the planned economy



Misjudge the preferences of the consume
Consumers get low priority and little freedom of
choice
Reduced incentive to work harder
Characterized by poverty and inefficiency partly
because of bad incentives

Lack of competition between companies

Inefficient resource distribution – surplus and
shortage
Economic Systems

In a market economy individual buyers
and sellers, as a group, decide what to
produce, how to produce it, and who
consumes it.

The state does not play a role in the
allocation of resources
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Economic Systems

Adam Smith, one of the Founding Fathers of
economics famously wrote of the “invisible hand
of the price mechanism”.

He described how the invisible or hidden hand of
the market operated in a competitive market
through the pursuit of self-interest to allocate
resources in society’s best interest.

This remains the central view of all free-market
economists, i.e. those who believe in the virtues
of a free-market economy with minimal
government intervention.
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Economic Systems

Invisible hand – the idea that self-interest and
competition promote economic efficiency
without any need for action by government.
 People working in their own interest creates
efficiency and prosperity.
 To earn money, you must provide a good or service
that someone wants to buy.
 Competition for buyers motivates producers to
improve quality and decrease cost.
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Economic Systems

Market economy
Who owns the resources?
• Private individuals
What decision-making process is used to allocate
resources and products?
• The price mechanism (supply and demand) in free,
competitive markets
What types of incentives guide economic decision
makers?
• Profit incentives: any income derived from selling
resources goes exclusively to each resource owner
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Economic Systems

In a market economy what is produced is
determined by consumers
This is because producers want to sell their
products. They can only sell their products if
consumers want to buy them. Therefore,
producers must produce what consumers want
to buy.
This is the idea of consumer sovereignty:
consumers decide what is produced.
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Economic Systems

In a market economy how to produce is
determined by firms
 To earn money, you must provide a good or service
that someone wants to buy.
 Firms a profit incentive. Competition for buyers
motivates producers to improve quality and
decrease cost. Thus, firms have incentive to produce
as efficiently as possible, output can be maximised
and waste is minimised
 Firms have incentive to innovate.
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Economic Systems

In a market economy who gets to consume ‘it’ is
determined by income and wealth
 This point is the most criticised of market economies.
 Income is determined by ability – if you have none, you
have no income
 Wealth can be concentrated in the hands of a few
people
 Those with no income or wealth live in poverty
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Economic Systems

Advantages of free markets
 More efficiency
• Resources are allocated automatically.
 Competition pushes businesses to be efficient: keeping
costs down and production high.
 Incentives are correct for firms and workers (profit
motive for high quality and low cost)
 The price mechanism transmits information to
reallocate resources cheaply and quickly
• Faster response to changes in consumer wants and real cost of
resources
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Economic Systems
 The price system encourages producers and consumers to
conserve scarce resources
 Higher level of wealth than planned economy
 Economic freedom (choose what you buy, what job to do,
where you live, etc.)
 The market gives producers an incentive to produce goods
that consumers want
 The market provides an incentive to acquire useful skills
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Economic Systems

Disadvantages of free markets
Market failure
Lack of information
• Buying too much of harmful products and not
enough of beneficial products
• Business may simply satisfy the wants they have
created through advertising
Difficulty enforcing property rights
Some people have few resources to sell
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Economic Systems
Monopolistic industries may restrict output
and drive up prices
Markets just do not work in some areas
(public goods, such as national defense)
Prices may give false or inadequate signals
to producers and consumers (externalities,
like pollution)
Market economies tend to produce a skewed
distribution of income (large gap between
the rich and the poor)
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Economic Systems

A mixed economy has characteristics of
both planned and market economies.
Both the government and private citizens
make decisions on allocating resources

The purpose of a mixed economy is to find a
balance between the advantages and
disadvantages of a market economy and a
planned economy
One can think of this as a balance between
efficiency and ‘equity’
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Economic Systems

Mixed economy
Who owns the resources?
• Individuals and the state
What decision-making process is used to
allocate resources and products?
• The price mechanism (supply and
demand) and the government
What types of incentives guide economic
decision makers?
• Profit incentives, ‘equity’ incentives, and
some bad incentives
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Economic Systems

Sometimes we much choose between
what is fair (equity) and what is efficient,
and it can be difficult to have both. Why?
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Economic Systems

There are no pure market economies

There are few if any pure command
economies

Most, if not all, economies are mixed
economies
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