Chapter 02 : Economic systems

Activity 2.1

Create an imaginary country of your own and place it anywhere in the world. Have you thought of the presence of factors of production in the country? How will these factors of production be rewarded when involved in economic activity (production)? How will the goods produced be distributed? Do you think the government has any economic role? Explain.

The concept of economic systems

An economic system is a mechanism by which an economy makes decisions on how to coordinate the production, distribution and consumption of goods and services. It is through an economic system that a society tries to solve the central economic problem resulting from scarcity of resources and unlimited wants. Recall that, every society faces three basic fundamental economic questions which are:

What to Produce? 

Due to scarcity of resources and unlimited wants, countries have to choose which goods and services to produce.

How to Produce? 

Given the scarce resources, countries have to decide the best production methods (production) that minimise the cost of production with which they can attain the desired production level.

For Whom to Produce? 

Since countries cannot meet all individuals’ wants, production decisions are made in order to meet specific needs of the market.

The way society answer these fundamental economic questions determines the type of economic system they have.

Forms of economic systems

There are four forms of economic systems. These are the traditional economic system; the centrally planned economic system; market economic system; and the mixed economic system.

Traditional economic system

A traditional economic system is one in which goods and services are produced and distributed based on customs, history, and time-honoured beliefs. The sole decision-makers in the traditional economy are residents of a society. Hunting, fishing, poultry, agriculture, and traditional industries are activities that countries rely upon to boost their economic condition. The traditional economic system mostly operates in developing countries and emerging markets such as Asia, Africa, the Middle East, and Latin America. In developing countries, the pockets of traditional economies are found scattered. All other economies started as traditional economies; therefore, economists expect that over time these economies will evolve into market, command or mixed economies. The societies that practise traditional economy rely on exchanging goods for goods. This traditional way of transaction is called the barter trade system. People’s traditions, rituals and habits determine what goods and services should be produced and how those goods should be produced and to whom the goods and services should be distributed. In the traditional economic system, production is only for subsistence with no or little surplus, and people’s needs determine what should be produced.

The traditional economic system works through the following assumptions: First, people are motivated by self-interest to produce and distribute goods and services given their cultural and traditional values. Second, the decision on the economy’s operation is the responsibility of only national individuals. Last, people have the freedom to change their decisions in response to certain beliefs and make changes for the welfare of all people in the society.

There are still many active traditional economies in the world today, including Hadzabe in Tanzania, Inuit tribes in northern Canada and Alaska, Amazon tribes in Brazil, Haiti, and Bhutan.

Characteristics of a traditional economic system

The important insight about the traditional economy is that it is not affected by external factors because it is highly isolated from external environment. People have the freedom to make decisions that maximise the welfare of their society. The other characteristics of a traditional economy is that a traditional economy consists of a nomadic society of hunters and gatherers involved: fishing, gathering, hunting, and agriculture. The primary mode of payment is barter trading, rather than using currency as a mode of transaction. In a traditional economy, people consider their benefits rather than profit when exchanging goods for goods. The goods produced are for subsistence with little or no surplus, meaning that all goods produced are consumed. Hunting in the traditional economy is a source of living for many people. People depend on hunting and then exchange hunted animals for other goods and services they need.

Advantages of traditional economic system

Even though no currency is involved in the transaction in a traditional economy, it has some advantages. The following are the advantages of the traditional economy. First, a traditional economy has no profit motive since people have different roles; they fulfil their roles, and the economy continues to flourish. Thus, eliminating any pressure to constantly compete and maximise profits. Second, the traditional economy is based on family or tribe, in which customs and traditional norms regulate the allocation and distribution of resources. Each family member contributes to producing goods and services required for the family. Third, the traditional economy is self-sustained and concentrates on producing goods available within their geographical locations. It does not rely on the external trade. Last, there is little conflict in the traditional economy because everyone knows their roles. For instance, if someone is responsible for fishing, they would not want to be involved in agriculture. Instead, they would exchange the goods they want with someone responsible for producing the goods they want.

Disadvantages of traditional economic system

The traditional economy lacks a workable balance, poor production efficiency, and a variety of jobs and skills. The traditional economy fits societies with small populations in which communities produce very little depending on their needs and no surplus to be regulated. The decision-making relies on elders, mostly local leaders.

Centrally planned economic system

A centrally planned economy also called command economy or socialist economy was advocated by Karl Marx. He led a revolt against market economy by arguing that allowing the economy to be controlled by individuals’ self-interests would lead to crisis and disorder. As a result, he emphasised on the role of the government in controlling and regulating the economy. Thus, under command economy, the government owns and controls all productive resources in their society’s overall interests.

Characteristics of centrally planned economic system

In a centrally planned economy all means of production are owned by the government in the interests of society. That is, individuals have no right to own any property from which they could earn profit. The government makes decisions at macro level aimed at maximising social welfare rather than maximising individual profit, meaning that forces of demand and supply have no influence in the market. Economic planning is done centrally whereby the government makes all decisions concerning production and consumption, which ensure efficient utilisation of resources. The government makes decisions on what to produce and how much to produce, and these decisions are imposed on the society by law or by force, for example, by using production quotas.

Most modern economies practise both centrally planned and market economic systems. But, the most common examples of centrally planned economies are the Former Soviet Union, which was dismantled in 1991 and China in the late 1970s. However, Cuba and North Korea are the only countries which still practise centrally planned economy.

Advantages of centrally planned economy system

Centrally planned economy provides economic security since its main objective is to improve the welfare of all citizens and to ensure all resources are fully employed. As a result even the disadvantaged are able to get their basic needs. Unnecessary competition and income inequalities are reduced. That is, the government has the power to set the price levels that eliminate unnecessary competition and the levels of wages that reduce income inequality. Centrally planned economy enables rapid transformation of societies to conform to the government vision. This may involve shifting production of resources away from one sector to the sector of interest or increasing wages in sectors of interest in order to motivate workers. There are no industrial unrests in socialist economies because wagesare determined by the government. In addition, socialist economies put great emphasis on improving the quality of life rather than increasing quantity of goods and services. Centrally planned economies are able to reduce income inequalities through various means such as setting wages. This is possible because there is no right to owning private property and economic decisions are centralised. That is to say, no other economic agent other than the government is allowed to make economic decisions.

Disadvantages of centrally planned economic system

Centrally planned economy leads to lack of economic freedom for producers and consumers because the government determines what, how and for whom to produce. Consumers have limited choices in the market place. Moreover, centrally planned economy can cause economic inefficiency due to the fact that there is no price mechanism to determine optimal amount of goods and service to be produced. The country that practice centrally planned economy may fail to meet society’s needs, leading to shortages. In a centrally planned economy, business have little incentive to innovate because workers and managers are not motivated to take risks to improve production and there after to maximise profit. In addition, conflicts of interests may arise between the government and its people because what is produced does not always match what is demanded. Governments are made up of people too, subjecting interests of people to government implies subjecting interests of the majority to self-interests of few in the government.

Market economic system

A market economy is also called a free enterprise economy, or a capitalist economy, or a laissez-faire economy. Earlier classical economists led by Adam Smith advocates laissez-faire economics, which means freedom in economic decision-making, with little or no government intervention. Adam Smith argues that allowing individuals to pursue their self-interests would lead to an outcome beneficial to all. Thus, Smith advocates for market economy such that individuals are free to make their own choices. Producers’ choices are driven by the profit maximisation motive, whereas consumers’ choices are driven by utility maximisation motive. He refers to this coordination of economic activity as the “Invisible Hand” because self-interest of individuals, namely, profit maximisation and utility maximisation, guide these interactions between producers and consumers, and regulate market competition. Hence, no government interference.

In the free market economy, price mechanism with through forces of demand and supply. The market forces determine what to produce, how to produce and for whom to produce as well as the rewards for the factor services.

Characteristics of a market economic system

Within the market economic system, there is freedom to ownership of private property. Individuals are free to own properties such as factories, machines and land from which they can earn profit. There is also freedom to make production decisions. Individuals are free to make their own decisions in terms of the occupation they want and the kind of goods and services they want to produce, with the main aim of maximising their incomes. Moreover, people have freedom to make consumption decisions. Consumers are free to make their own choices on goods and services on which their income will be spent in order to maximise utility. This freedom is called consumer’s sovereignty.

Moreover, in market economic system, there is little or no role played by the government in economic activity. This helps markets to function freely and efficiently. Entrepreneurs are guided by the profit motive to maximise revenue and minimise cost. This motive brings about efficiency and self-regulation in a market economy. Moreover, there is presence of stiff competition in the market due to freedom of entry or exit. Market freedom allows prices to reflect what is actually happening in the market and what is desired by economic agents. Thus, prices are determined by forces of demand and supply. Furthermore, the fundamental economic questions of what to produce, how to produce and for whom to produce are answered by the private sector because economic decisions are made by individuals.

There are no countries that practice pure market economy in the world today. However, few economies known to be capitalistic countries include United Kingdom, United States of America, Germany, the Netherland, Australia, France and Canada with an active intervention of the government in economic development.

Advantages of the market economic system

In the market economy system, the decision-making process is greatly participatory because there is little or no government control. Producers are free to produce what consumers demand and consumers are free to spend their incomes according to their preferences. This allows producers and consumers to satisfy their self-interests. Moreover, there is market efficiency because resources are allocated to their mostprofitable use, prices are determined by market forces of demand and supply and what is produced is assumed to be entirely consumed. Therefore, the economy has neither shortages nor surpluses.

There is improvement in the quality of the products. Stiff competition motivates firms to improve their products’ quality in order to compete in the market. Stiff competition prevents firms from selling the products at higher prices, and hence, consumers benefit from low prices. In addition, stiff competition stimulates firms to invent new techniques that will maximise their profits and make them competitive in the market.

Disadvantages of the market economic system

Within the market economic system, producers tend to produce only goods and services that yield the highest profit. This is because producers in market economies are driven by a profit maximisation motive. Therefore, goods and services that do not yield the highest profit but are essential to the public, for example, street lights, traffic lights and national defence which are public goods may not be efficiently produced.

Consumers could be charged high prices even for essential goods. This could happen because there is little or no government interference in price determination. There are high income inequalities between the rich and the poor. Since these economies tend to be self-regulating, the rich are more likely to get richer and the poor are more likely to get poorer.

If the market economy is not well regulated, there can be over-production and/or over-consumption of demerit goods such as illegal drugs, cigarettes, and alcohol. These are results of freedom of producers to decide what and how much to produce and consumers to decide how to spend their incomes. Since producers are free to decide on what and how much to produce, they are likely to focus only on profit maximisation motive and ignore the negative impacts of their production processes. Figure 2.1 shows the differences between market and centrally planned economies based on ownership, incentives, prices, efficiency, and equality.

Mixed economic system

A mixed economy, also called hybrid economy, was advocated by John Maynard Keynes who argues that in order to expand aggregate demand and restore people's confidence the government should take some control over a market economy. This is not done by controlling wages and prices like in centrally planned economy, but by running budget deficits and increasing government expenditure on public works. This type of economic system is referred to as a mixed economy because it combines some features of both market and command economic systems. Individuals enjoy freedom of choice but the government also intervenes to protect the welfare of its citizens, especially the disadvantaged/ marginalised ones.

Characteristics of mixed economic system

Mixed economic system is characterised with co-existence of private sectors and public sectors. This fact implies that the economy is not driven by both profit maximisation motive and social welfare improvement motive. In theseeconomies, the government regulates the private sectors through policies such as monetary and fiscal policies.

There is freedom of individuals to choose any occupation that serves their income and any good or service they want to consume and produce, keeping in mind people's welfare. Thus, the government intervenes by putting some restrictions on consumption and production of certain items that are harmful to people. The government can intervene in the market by setting price ceiling or price floor to improve people's welfare. The government can also intervene through redistribution of income to reduce income inequality. This can be done through various means such as setting minimum wages and imposition of progressive taxes. Moreover, economic planning is done by the government through indicating roles to be played by both public sectors and private sectors. To motivate the private sector, the government provides incentives and subsidies to ensure that national priorities are met. Prices are determined by the forces of demand and supply.

Most countries are now considered to be mixed economies because of the active role of the government and private sector. Some examples of countries that are now practising mixed economies include China, Vietnam, India as well as Scandinavian countries namely Sweden, Norway, Finland and Denmark.

Advantages of mixed economic system

The government can protect its people from unfair practices by setting laws that restrict such practices and thus, improve social welfare. Mixed economic system also allows the government to play a big role in mobilising resources for public goods such as defence, which could otherwise be neglected.

The mixed economy encourages innovation because the most efficient producers are rewarded, creating a strong incentive for them to further improve their performances. Moreover, there is improvement in service quality, since public and private sectors cooperate in providing certain services such as education and health care to people. Thus, the quality of these services is likely to improve and hence, improving the social welfare of people.

Disadvantages of mixed economic system

Too much government intervention can diminish the essence of free market. If the government always sets price ofcommodities, markets will not clear, that is, there may arise excess demand or excess supply, which in the long-run may distort the whole economy. Mixed economies can lead to creation of monopolies, for example, the government can grant a monopoly power to a company to be a sole producer and supplier of electricity to improve provision of the services. In case the company fails to achieve efficiency in production, in the long-run the entire economy can be negatively affected by such inefficiency.

Transition period

A transition period is a period in which a country economy is transformed from one economic system to another, mostly from centrally planned economy to a market or a mixed economy. In Tanzania this happened twice: in 1967 Arusha declaration where the country was moving from private ownership of all major means of production and also from 1990s when the country decided to move back to market system.

The economy in transition period is characterised by features of both, the new economic system, which is being introduced and the old system which is replaced out. There are different policy reforms in different economic aspects. On one hand, if an economy is moving from a command economy to a market economy, policies like privatisation and liberalisation of the market are adopted. On the other hand, if the economy is moving from market to centrally planned economy, nationalisation policy is adopted.

Most of economies are in transition from a state controlled economy (socialism) to market controlled economies. This has necessitated these countries to embark on major programmes of economic reforms. The reform programmes involve the following key elements: freeing prices and withdrawal of subsidies, adaptation of privatisation policy, budget deficit and development of budgetary and fiscal system.