The Four Types of Economic Systems
The concept of drawing budget is not a new phenomenon.
Almost everyone must have at one point, or another brought a budget; be it a weekly budget, a monthly one or any other seasonal budget.
You also might have realized that without breaking down your needs and assigning the spending amounts, you may end up over-spending on the “wrong items”.
They are not “the wrong items” per se; but they may be items that you want, however, you do not necessarily need them. In essence, the same concept applies to a country-level.
A country will have as many needs as you may have in a single month.
But same as your resources, the country’s resources are also scarce.
Consequently, the government is compelled to strike some of the items off their list and to rearranges others according to their level of significance.
Priority items should be identified and the scarce resources should be distributed over the various needs.
This is what forms the backbone of an economic system.
Different countries have different levels of needs and wants.
For instance, as some states are in dire want to curb some diseases, others are struggling to massage their super-power muscles by adding their weapon bankers.
Due to these differences, the governance of the different countries has to sit and decide how to run the country financially.
Commonly, consultations are made, and they determine the kind of goods and services to produce, how to go about production and deliberate on the intended consumer of the manufactured goods.
The decision made on…
- What to provide,
- Whom to offer it for,
- And how to create the products, i.e. the goods and services
…determines the kind of economic system a country will run.
Although lately there is a talk about a potential fifth type of economic system called sharing economy, the four major types of market economies are the traditional, the market, the command and the mixed economic system.
Let us look at the dynamics involved in each one of them.
THE TRADITIONAL ECONOMIC SYSTEM
Culture defines the traditional economic system. It is built around the ways of society: that is, the livelihood of the people determines the products and services.
The customs and beliefs of a community are considered in developing goods and services in the area.
The people in this economic system believe what was practiced by their ancestors is right and should not be questioned.
Therefore, they continue the habits from the past in their present days.
The roles of the individuals are defined by the customs of their elders and ancestors. It is in this kind of an economic system where monarchies are universal.
On the other hand, societal roles are divided based on the gender of the people in the community and their family or clan.
For instance, in some African countries, you will find the concept of the ruling tribes and monarchies.
The traditional economic system is characterized by the presence of barter trade instead of exchanging goods and services for a standard currency.
The financial activities are few and may include fishing, hunting, food gathering, and agriculture. People live in tribes.
There is no use of technology in this system; in fact, technology attracts negative criticism.
For instance, you will hear them say that using technology is in contrast with the will of their deities and ancestors. You will also learn that in this system, there is little or no profit made.
Since they practice subsistence farming, everything is produced for community use only. This means that the drive to create products is to survive; hence little is likely to be wasted. In other words, production is not done in surplus.
In addition to the above, people in this system live in the rural environment setting where communication and transport infrastructure is not well established.
Though not famous, the traditional economic system is still being used in Inuit countries of North America, in parts of the Middle East, Asia, and Latin-America, as well as by some Australian indigenous people.
Since this system is a tribe-based economy, the experience of the elder is handed down to younger generations.
Consequently, jobs can be completed based on the time-honored traditions.
Some practices like the art of healing, rainmaking and so on can be learned over time by younger generations through apprenticeship programs.
The traditional economic system will also guide the people as they perform their daily activities.
As we discussed earlier, roles are already defined. A young girl of about eight years of age has her roles pre-determined at every stage from the time they are as young to their adulthood. In some countries, young girls get advice from their mothers and aunts and from very young age, they know what is expected of them and have no say in choosing their career path.
It is also noticeable that there is a reasonably strong relationship between the people of the traditional economic systems and the natural environment.
The community produces goods and services available in that geographical area – same goes for food.
This makes them conserve their surroundings to ensure they maintain their food and products they exchange for products from other geographical areas.
If you rely on hunting and gathering, you have to stop clearing the forest and ensure it is well conserved. The water bodies also are maintained clean and in a good state – free of industrial wastage and untreated effluent from sewers.
Have you ever realized that with achievement comes pride and confidence?
Yes. It is so in this system.
Personal satisfaction and confidence are born when one has an outstanding event.
In the traditional economic system, you can see the results of your labor and get to be appreciated whenever an excellent job is done.
Traditional economy portrays the importance of community groups. Every person supports each other because a specific community is known for its peculiar skill set.
The assortment of skills is crucial for the whole community to be thriving.
Some of the disadvantages of the traditional economic system include the fact that the conventional system may separate people instead of bringing them together.
For instance, being born in the ruling clan, you are automatically classified to be a leader even though you may lack charisma and leadership skills.
On the other hand, some people who may also have better leadership traits may miss out as they have a lower rating in the community.
Furthermore, the traditional economy gives very few lifestyle choices and may not be too appealing. Look at it this way: in this system, if your father was a farmer, then you, most probably will also be a farmer. You are bound to learn the farming skills from him. Change of any trend is actively resisted and threatens survival.
This type of economy is vulnerable to weather and climatic conditions. Say the community is reliant on food crop farming.
How will they survive floods or a drought? What about pest invasions and crop failure?
It is not like in other innovative systems where if one leg fails, the other continues to be functional.
In addition to this, migration is widespread, and this creates unpredictability and survival uncertainty. For example, if there is drought, the families have to move regions in order to survive.
This system is also characterized by the low living standards. Even after toiling too hard and surviving the scorching sun on the farm, the citizens are still forced to live small. The tribesmen and women work so hard in their different fields; it is evident that their life is about the survival.
Lastly, as the saying goes, “if you can’t beat them, join them”.
For the reason, only a small number of people are left actively practicing the traditional economic system as the widespread economical systems quickly overwhelm them.
However, the traditional economy shows that there is a foundation for growth when the group practicing it settles down and focuses on the development of their skills.
THE MARKET ECONOMIC SYSTEM
Ever thought about how the jails and prison cells feel? It must be very uncomfortable, and most inmates probably live in constant fear.
It is a total opposite of the great pleasure that is found in freedom.
Freedom makes people feel free to do their daily activities and interact with others without any constraints.
Just like people who enjoy the freedom and its benefits, the market economic system experiences the same – it is also known as the free market economy. This type of system was first proposed and promulgated by Adam Smith.
It is a capitalist economic system where production of goods and services is driven by the consumer practices. The demand pushes supply.
It also makes good use of the Laissez-faire belief that a market will work best under no government interruptions.
Therefore, in a free market economy, there is no government interference. Free entry to market also characterizes this financial system.
This means any industry can join the market freely without any restrictions or barring.
The prices of the products are also not determined any artificially created structures.
You must be wondering how the pricing is done then, right? The market mechanism determines the price of the goods that are produced in the free market economy.
Smith described this concept as the “the invisible hand“. This “hand” refers to the effects of competition in the market.
A company’s goal is to make maximum profit, so in this case, the assumption is that the company have undertaken the required market research and identified the market gap.
After that, it will only produce goods and services that will be readily consumed and would like to sell as many of them as possible. But, this company is not the only one in the market, others are producing same or similar products.
Due to their competition, these enterprises will try their best to woo as many customers as possible. Of course, they will use means such as reducing the prices of their products, producing goods of higher quality and providing products that closely meet the needs of the market.
The demand and supply forces drive the market, so there is no need for governmental or other market movement regulations. Individuals are also allowed to own resources in this market system – for example, natural and capital resources like buildings and equipment.
Due to the freedom, the competition leads to an efficient and effective use of resources. The seller also determines what to produces, how much to produce and what to pay the employees. Market forces are reflected in prices against in quantity of goods produced as shown below.
The extent of demand and supply also determines the amount and pricing.
When demand is low, and quantity of goods is high, there is a surplus of excess products and when demand is very high, and amount of goods is low there is a shortage of products. In the below graph, at point Pe (also called the equilibrium) there is enough supply of goods and the charged price is the correct price.
Where there is an increase in demand, the curve shift to the right as shown below:
The movement of the curve from D1 to D2 shows that increased demand for the goods thatare brought about by other factors of production except for the price.
Among these factors can be: increase in population, increase in an individual’s income, favorable government policy, desirable climatic condition, promising change in fashion and taste.
A free market economy is advantageous because of the following reasons – firstly, there are efficiencies. Due to significant competition in the market, competitors lower prices and reduce expenses to curb the competition. They attract buyers.
Secondly, foreign investors are much attracted since they find a free market economy an opportunity to invest and earn high profit. Furthermore, most individuals work hard so they do not lose their jobs. The market economy, therefore, serves as an excellent motivator for many people.
The system also allows for innovations and hence it is prominent among individuals. It gives a fair chance to firms to research and to come up with new and better product to sell and to produce in a more cost-effective way.
Through this, many people acquire the required knowledge and skills needed in manufacturing.
Compared to command economy systems, a free market system has a wide variety of consumer goods.
Therefore, it is possible to make them available to those who want to buy them.
Among the shortcomings of a free market economic system are first, it may lead to overproduction of goods since there are no regulations. This can also be attributed to the fact that the workers have low wages and hence cannot afford to consume all the products that are being manufactured.
Secondly, there is over-exploitation of workers as the faster, harder and longer you work – the more you are paid in the free market economy. Employers wanting to compete with their competitors might be overworking the employed laborers leading to their exploitation.
Unemployment is also prevalent in this economic system. Contrary to the traditional economic system, the free market system is open to technology, so machines do most of the task of individuals.
Growing economic and social inequality are also noticeable in such an economy.
THE COMMAND ECONOMIC SYSTEM
The command economic system is also known as the centrally planned economy.
It is among the theories of politics and economy of Karl Marx. In this economic system, the government owns and runs all central resources.
Among other unique features is that the government makes all decisions regarding what to and how is being manufactured.
In this case, the government is not only involved in making all decisions but it is also included in the price formulation and control.
In command economic system people work for the public goods. The interests and profits are shared amongst the citizens. Socialist and communist theories apply; also, there is a lot of dictatorship from the government.
As for the Communist arguments, the government owns all the factors of production (labor, land, capital, entrepreneurship). Karl Marx referred to is as “from each according to its ability, to each according to its needs.”
“From each according to its ability” meant that you could work at a workplace you are good at and you loved. “To each according to its needs” means that you could take care of those who could not work and care for themselves.
This, therefore, encouraged a belief that you could be happy to contribute your skills to support the people in the community and that opportunities and welfare are equally distributed to the people – also known as socialism.
The advantages of a centrally planned economy include – firstly, the government and the society are streamlined meaning there is harmony between these units.
Secondly, mobilization of resources is effective; production is made active and efficient hence having a considerable scale that leads to quick progress achievement.
Thirdly, the social welfare is a significant priority in the command economic system, as there is free and equal access to education, housing and healthcare for everyone in this system.
The disadvantages of command economic system can be found in the following: the freedom and entrepreneurial spirit are restricted as the government has full control of major industrial resources.
The government own all the strategic property and does not encourage any form of competition but instead eliminates it.
In addition to that, unlike a free market, that promotes innovation and changes in the economic system, the command financial system does not. Market innovation is not encouraged.
Due to the existence of so many restrictions, there is a probability that black markets would rise. It is likely that there shall be a lack of coordination since there are no planners to coordinate the economic decisions. This leads to supply-demand mismatch, seen as fall in production, food stocks imbalance, and transport disorganization.
There is also the emergence of export problems because it is difficult for the government to regulate the price and products that will best perform in the international market.
In addition, there is ignorance of the needs of the society – in this system, you are not given an opportunity and choice on where you can move or work as most workplaces belong to the government.
Problems exist in balancing the amount of good produced.
This is because the government does not get information on your needs leading to rationing of resources.
Some items are provided massively, while others are not enough to support economic needs.
THE MIXED ECONOMIC SYSTEM
The mixed economic system combines the command economy and free market economy, so it has the features of both of these two economic systems.
It is also known as Keynesian economic system or dual economic system.
The mixed economic system is characterized by government interference but not to the extreme. Freedom to choose and opportunities to innovate are offered.
Owning private property in this system is allowed and encouraged.
There is economic planning and individuals have the freedom to enter the market. Unlike the free market where the price is formed by supply and demand, in this system, the price is controlled as there is the motive to make a profit and at the same time ensure social welfare.
Economic planning in the mixed economic system means that the government can impose some regulations. These rules should be agreeable but should ensure the private sector is free to operate.
This enhances the promotion of the economy. Social welfare is established by either public partnership program or via federal enterprises.
Freedom to enter the market is enhanced although government plays a part in regulating the prices of the goods. In case of national emergencies, costs are controlled, and distribution of public resources is made effective.
In the mixed economy, the government provides environmental protection, employment standards maintenance, competition maintenances, and standardized welfare system.
The government and private sectors provide social security and amenities such as schools, hospitals, water, and medicine. These securities are done either by insurance policies or via the government.
There is an equal distribution of resources and wealth; this is by the government trying to collect taxes such as income tax, and value-added tax, and invest the collected tax money to the least developed areas and communities.
The law of demand and supply determine the price scheme.
However, the government insists on control and fixation of some common commodities, for example, fuel, medicine, electricity, and education.
The advantages of the mixed economy include points such as – first and foremost, it encourages lesser income inequality since the public sector tends to provide basic utility benefits to the public. This leads to the reduction of difference in income.
Secondly, there is the provision of freedom to own a private sector – individuals are free to hold property and start businesses that lead to the idea and encouragement to work even harder. This in return will promote fast economic development, especially in industry and agriculture.
Thirdly, there is the promotion of fast economic development where the private and public sector can operate equally hence making economic growth quicker. The economic resources are utilized efficiently, and there is a slow depression of resources.
Fourth, there is the creation of region balance developments in the country. This is facilitated by the planning commission which creates a policy for improvement in every region of the country.
The government can also try to develop several sectors of the population. Markets that are the only producers’ of certain goods are allowed under the watch of the government. This ensures that entrepreneurs in the same field to succeed.
The major disadvantage of the mixed economy system is that it can lead to high taxes.
Now that there is a government intervention, the government invests more and would need more funds that come mostly from taxes revenue.
This means that there is consistent pressure on the individual to increase their income so there is enough money to pay for all the living expenses along with the taxes.
Secondly, in the mixed economic system, there is a fear of nationalization. Since private and public sectors co-exist, the government can nationalize and own any industry; this, therefore, means that the private areas have to be constantly alerted so that their business cannot be nationalized.
Thirdly, mixed economy leads to low economic growth. This is because the government tries to mobilize resources to produce goods and services that are beneficial to the society rather than the betterment of the economy. This consequently can lead to economic decline.
A mixed economy has a likelihood to have more wastages. Some of the funds allocated to the different projects in the public sector go to the pockets intermediaries.
This is the misuse of resources. The wastage benefits those in authority.
The black market scenario and corruption can be imminent. Self-interested individuals take advantage from public sector hence leading to the emergence of several evils like the bribe, tax evasion, and illegal activities. These criminal acts deteriorate the country economic growth and low standards of living.
There is a lack of efficiency in both sectors because, in public sector, workers of the government do not perform their duties with responsibility and in private sector, there is less effective because the government imposes a lot of restrictions in the form of control, licenses, and permits.
The four major types of economic systems are the traditional, free market, command/planned and the mixed economic system – each is explained above and each has its advantages and disadvantages.
The traditional system is dying out, both the free market and planned economies are typically theoretical, while the mixed economy is the most common one nowadays.
Which one do you think would function the best?
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