Three Economic Systems
Definition
Economic system: the set of institutions and processes through which a society decides what, how and for whom to produce.
- The three main types are the market economy, the planned economy and the mixed economy.
- They differ mainly in who makes the decisions: private consumers and firms, the state, or a blend of both.
Key Idea
- In a market economy the price mechanism guides decisions, an idea associated with Adam Smith and Hayek.
- In a planned economy the state makes the decisions, an idea associated with Marx, while a mixed economy blends the two.
Who Decides
- Market economy
- Prices and the pursuit of profit guide firms and consumers, with little role for government, as in a near-market economy such as Hong Kong.
- Planned economy
- The state owns the factors of production and plans what is produced and for whom, as in the former Soviet Union.
- Mixed economy
- Markets allocate most resources, while the state provides public goods and corrects market failure, as in the UK today.
Note
- A mixed economy is any blend of market and state, not a precise fifty-fifty split.
- Most real economies are mixed, with markets trading most goods while the state provides services such as public healthcare and national defence.
What, How And For Whom
- A market economy answers what and how through prices and profit, and for whom through ability to pay.
- A planned economy answers all three through central planning and political priorities.
- A mixed economy uses markets for most decisions but lets the state override them where society judges it necessary.
Example
- Suppose consumers in a market economy begin buying far more electric cars than before.
- The rise in demand pushes the price of electric cars upward, say from £40,000 to £45,000.
- The higher price signals to producers that consumers now want more electric cars, and raises expected profit.
- Firms respond by bidding resources such as labour and batteries away from other uses to expand output.
- Resources therefore flow towards electric cars and away from goods consumers want less, all without central instruction.
Price Mechanism Versus State
- In a market economy the price mechanism signals what consumers want and rations scarce goods to those willing to pay.
- Rising prices act as an incentive for firms to supply more, coordinating decisions without any central direction.
- In a planned economy the state replaces this signalling by setting output targets and prices directly.
Example
- Now suppose the same rise in demand for electric cars occurs in a planned economy.
- There is no free price to rise, so no automatic signal reaches producers.
- Planners must first detect the change and then rewrite output targets and input allocations.
- Any delay or error in the plan can leave shortages of electric cars and surpluses of unwanted goods.
- A mixed economy would let prices adjust while the state intervenes only where it judges the outcome unfair or inefficient.
Evaluating Who Decides
- Market economies tend to be efficient and offer wide choice, but can leave the poorest without essentials.
- Planned economies can pursue equity and stability, but often lack the incentives and information that prices provide.
- Because each has strengths and weaknesses, almost every economy is mixed, differing only in the balance struck, so which is best depends on society's priorities.
Exam technique
- Define each system by who allocates resources: the market, the state, or both.
- Show how each answers the three basic questions of what, how and for whom.
- Frame real economies as mixed and focus on the balance between market and state.
Common Mistake
- Do not treat a mixed economy as an exact fifty-fifty split, since it is any combination of market and state and the balance varies widely between countries.
- Do not describe any real economy as purely market or purely planned, since pure systems are theoretical benchmarks rather than real cases.
Self review
- Name the three types of economic system.
- Who allocates resources in each system?
- How does a market economy answer for whom to produce?
- Why is a mixed economy not a fifty-fifty split?
