Unit 1
Nature of economic system
An economic system, or economic order, is a system of production, resource allocation and distribution of goods and services within a society or a given geographic area. It includes the combination of the various institutions, agencies, entities, decision-making processes and patterns of consumption that comprise the economic structure of a given community.
As such, an economic system is a type of social system. The mode of production is a related concept. All economic systems have three basic questions to ask: what to produce, how to produce and in what quantities and who receives the output of production.
The study of economic systems includes how these various agencies and institutions are linked to one another, how information flows between them and the social relations within the system (including property rights and the structure of management).
The analysis of economic systems traditionally focused on the dichotomies and comparisons between market economies and planned economies and on the distinctions between capitalism and socialism. Subsequently, the categorization of economic systems expanded to include other topics and models that do not conform to the traditional dichotomy. Today the dominant form of economic organization at the world level is based on market-oriented mixed economies.
Economic System everywhere may perform similar functions. These functions may be traditional or non-traditional. The traditional functions include the following:
a. What to produce
b. How to produce i.e. what method of factor combination to adopt in order to maximize the use of the resources
c. For whom to produce
d. How to distribute the goods and services produced.
Economists have realized the importance of economic growth and the attainment of full employment, if the system must achieve the best use of its scarce resources. Attainments of full employment and high economic growth have become the non-traditional functions.
Economic System everywhere may perform similar functions. These functions may be traditional or non-traditional. The traditional functions include the following:
a. What to produce
b. How to produce i.e. what method of factor combination to adopt in order to maximize the use of the resources
c. For whom to produce
d. How to distribute the goods and services produced.
Economists have realized the importance of economic growth and the attainment of full employment, if the system must achieve the best use of its scarce resources. Attainments of full employment and high economic growth have become the non-traditional functions.
Merits of Capitalism:
The main merits and advantages of capitalism are as follows:
Production According to the Needs and Wishes of Consumers:
In a free market economy consumer needs and wishes are the upper most in the minds of the producers. They try to produce goods according to the tastes and liking of the consumers. This leads to maximum satisfaction of the consumers as obtained from his expenditure on the needed goods.
Higher Rate of Capital Formation and More Economic Growth:
People under capitalism have the right to hold property and pass it on in inheritance to their heirs and successors. Owing to this right, people save a part of their income so that it can be invested to earn more income and leave larger property for their heirs. The rate of capital formation increases when savings are invested. This accelerates economic growth.
There is Complete Freedom of Choice in a Capitalist Economy:
Economic freedom means the right to earn and retain property. It also means the freedom of enterprise and choice of occupation. This leads to the automatic channelization of the country’s man power resources in different vocations. There is no need to direct people or force them. Further, there is the freedom of contract which ensures smooth and flexible functioning of different production units.
Optimum Utilization of Resources Available:
The limited resources of the community are put to the most economical uses with as little waste as possible. There is keen competition among producers and entrepreneurs to produce and sell goods. Every producer and entrepreneur tries to use the productive resources at his disposal in the most economical manner in order to make maximum profit.
Efficient Production of Goods and Services:
Due to competition every entrepreneur tries to produce goods at the lowest cost and of a durable nature. Entrepreneurs also try to find out superior techniques of producing the goods consumers get the highest quality goods at the least possible cost because the producers are always busy in making their production methods more and more efficient.
Varieties of Consumer Goods:
Competition is not only in price but also in the shape design, colours and packing of products. Consumers therefore get a good deal of variety of the same product. They need not be given limited choice. It is said that variety is the spice of life. Free market economy offers variety of consumer goods.
In Capitalism there is no Need of Inducement or Punishment for Good and Bad Production:
A capitalist economy provides encouragement to efficient producers. The able an entrepreneur is, the higher is the profit he obtains. There is no need to provide any kind of inducement. The price mechanism punishes the inefficient and rewards the efficient on its own.
It Encourages the Entrepreneurs to Take Risks and Adopt Bold Policies:
Because by taking risk they can make higher profits, Higher the risk, more the profit.
They also make innovations in order to cut their costs and maximise their profits. Hence capitalism brings about great technological progress in the country.
It Provides the Best Atmosphere for Inventions:
Entrepreneurs are always on the look-out for new ideas to be applied to production. They try to beat each other in innovations. This leads to rapid expansion, greater employment and income. The investors are suitably rewarded with their royalties, through the copy right. Similarly, innovators enjoy the benefits of their research, through the system of patents and trade-marks.
It Provides a Good Deal of Flexibility:
This type of economy can automatically change with the circumstances. During war time market regulations are adopted to provide for the war machine. As soon as there is peace, the economy reverts to the free functioning of markets.
De-Merits of Capitalism:
The capitalist economy has been showing signs of stress and strain at different times. Some have called for a radical reform of the free-market economy. Others like Marx have considered capitalism economy to be contradictory in itself. They have predicted the ultimate doom of capitalist economy after a series of deepening crisis.
The main de-merits or dis-advantages of capitalist economy are as follows:
Inequality of Distribution of Wealth and Income:
The system of private property acts as a means of increasing inequalities of income among different classes. Money begets money. Those who have wealth can obtain resources and start big enterprises. The property less classes have only their labour to offer. Profits and rents less classes have only their labour to offer. Profits and rents are high.
Wages are much lower. Thus the property holders obtain a major share of national income. The common masses have their wages to depend upon. Although their number is overwhelming their share of income is relatively much lower.
Class Struggle as Inevitable in Capitalist Economy:
Some critics of capitalism consider class struggle as inevitable in a capitalist economy. Marxists point out that there are two main classes into which capitalist society is divided. The ‘haves’ which are the rich propertied class own the means of production. The “have not’s” which constitute the wage earning people have no property.
The ‘haves’ are few in number. The ‘have not’s are in majority. There is a tendency on the part of the capitalist class to exploit the wage-earners. As a result there is a conflict between the employers and the employees which leads to labour unrest. Strikes, lockouts and other points of tension. All this have a very bad effect on production and employment.
Social Costs are Very High:
A capitalist economy industrialises and develops but the social costs of the same are very heavy. Factory owners running after private profit do not care for the people affected by their production. The environment is polluted because factory wastes are not properly disposed of. Housing for factory labour is very rarely provided with the result that slums grow around big cities.
Unnecessary Multiplicity and too Much of Competition:
Consumers have to pay a high price for their freedom of choice and provision of variety. There is sometimes too much competition leading to unnecessary high costs of production because competitors bid the prices of resources too high. There is wasteful advertisement. Sometimes sub-standard goods are highly advertised and the consumer is deceived.
Instability of the Capital Economy:
A capitalist economy is inherently unstable. There is recurring business cycle. Sometimes there is a slump in economic activity. Prices fall, factories close down, workers are rendered unemployed. At other times business is brisk, prices rise, fast, there is a good deal of speculative activity. These alternating periods of recession and boom lead to a good deal of wastage of resources.
Unemployment and Under-employment:
A capitalist economy has always some unemployment because the market mechanism is slow to adjust to the changing conditions. Business fluctuations also result in a large part of the labour force going unemployed during depressions. Not only this, workers are not able to get full time employment except under boom conditions.
Working Class does not have Adequate Social Security:
In a capitalist economy, the working class does not have adequate social security, commodity, the factory owners do not provide for any pension, accident benefits or relief to the families of those who die in employment. As a result, widows and children have to undergo a good deal of suffering. Governments are not in a position to provide for adequate social security in over populated less developed countries.
Slow and Unbalanced Growth:
A free market economy may work automatically but the rate of growth is rather slow. Moreover as the economy progresses, there is no all round development. Some areas develop much faster while others remain backward. Industries may expand fast while there may be poverty in agriculture.
No Bargaining Capacity of Labourers hence Exploitation:
In a capitalist economy, workers are often paid a wage rate below their productivity. This is because; they do not have the bargaining power to get their due from the rich capitalist. Women and children are often paid a very low wage rate. There is no equal pay for equal work.
Growth of Monopolies with their Evils:
A capitalist economy is competitive only in theory. In practice, the few competitors often arrive at an understanding and exploit the consumer. Sometimes the bigger firms buy or eliminate the smaller firms to establish their supremacy in particular lines or production. They charge high prices and do not have any compulsion to improve efficiency of production. Thus, the much talked about efficient working of a capitalist economy becomes a myth.
Socialist Economy
In the 1840s a new type of economic theory emerged in the literary circles known as “The Communist Manifesto”. Written by Karl Marx with Fredric Engels it propounded a new and unique concept of an economy of a country. This came to be known as a socialist economy. Let us learn about it some more.
Socialist Economy
In a socialist economy, the setup is exactly opposite to that of a capitalist economy. In such an economy the factors of production are all state-owned. So all the factories, machinery, plants, capital, etc. is owned by a community in control of the State.
All citizens get the benefits from the production of goods and services on the basis of equal rights. Hence this type of economy is also known as the Command Economy.
So basically in a socialist economy, private companies or individuals are not allowed to freely manufacture the goods and services. And the production occurs according to the needs of the society and at the command of the State or the Planning Authorities. The market and the factors of supply and demand will play no role here.
The ultimate aim of a socialist economy is to ensure the maximization of wealth of a whole community, a whole country. It aims to have an equal distribution of wealth amongst all its citizens, not just the welfare of its richest companies and individuals.
Socialist Economy
Features of a Socialist Economy
1] Collective Ownership of Resources
In a socialist economy, the entire foundation is based on socio-economic objectives. The welfare of the people takes precedence over the profit motive and so all major factors and resources of production are in the ownership of the state itself. Only small farms and trading firms are kept under private ownership.
2] Central Economic Planning
In a socialist economy, there is always a central planning committee. This is the authority who will decide what is to be produced using the state resources. They will also decide the quantity and the method of production. The ultimate aim of such authority is to fulfill the socio-economic aims of the State.
3] No Choice for Consumers
Every coin has two sides. So in a socialist economy, every citizen is guaranteed basic goods like food, clothing, shelter, etc. But the consumers do not have absolute freedom of choice. They cannot demand the products they wish, they must choose from the products the state manufactures.
Since there is no free market, there is no concept of preference or demand and supply. Also while every citizen will get work, he is not able to freely choose his occupation.
4] Equal Distribution of Income
This is one of the main features of a socialist economy. The setup does not allow one person to accumulate a lot of wealth. So the gap between the rich and the poor is much narrower. And all their citizens enjoy equal opportunities and facilities like education, public healthcare, etc. So there is no discrimination between different classes of people.
5] Absence of Market Forces
The motive here is the welfare of the people. Since there is no profit motive price mechanism will not influence any product decisions. The pricing structure in a socialist economy is ‘administered pricing’ which is set by the planning commission on the basis of their socio-economic objectives.
Demerits of a Socialist Economy
Socialism is a breeding ground for corruption, red-tapism, and favouritism. The State and the Central Planning Authority hold too much of the power which they often abuse for their personal gains.
It essentially restricts the freedom of its citizens. They do not have a choice in the products they wish to buy, or the jobs they want to do. Their freedom is further curtailed by the inability to own any private property.
Every citizen has the guarantee of a job. So socialism does not promote hard work or any creativity in its citizens.
Administered prices are not the most efficient. They are not based on market forces. Thus the economic and scientific allocation of resources is impossible in this system.
Sometimes under socialism, we end up creating state monopolies which can get very dangerous with time
Mixed Economy
Did you know that all economies of the world are in essence mixed economies! Capitalism and socialism are both two ends of the spectrum. In the real world, we take the middle road. Combining features of both the capitalist economy and the socialist economy we arrive at a mixed economy. Let us look at some features and advantages.
Mixed Economy
As the name suggests a mixed economy is the golden combination of a command economy and a market economy. So it follows both price mechanism and central economic planning and oversight.
The means of production are held by both private companies and public or State ownership. And while market forces decide the price, demand, supply, etc there is some government oversight to prevent monopolization and discrimination.
The idea behind a Mixed Economy is to tackle the demerits of both a capitalist economy and a socialist economy and come up with a unique system. It appreciates the concept and the freedom of private ownership of properties and resources.
But at the same time, it understands the disadvantage of unchecked capitalism. Hence it proposes government oversight and economic planning so there is no discrimination against the poorest citizens.
Image result for mixed economy
Features of Mixed Economy
Coexistence of All Sectors: In a mixed economy all three sectors coexist in harmony, i.e. private sector, public sector, and joint sector. The joint sector is jointly run by the government and private companies, with at least 51% ownership belonging to the state.
Cooperative Sector: In a mixed economy another sector exists, the cooperative sector. The main aim of the formation of this sector is so that the government can provide financial assistance to cooperative societies involved in warehousing, agricultural, dairy industry, etc.
Freedom and Control: Here all individuals have the freedom to produce goods and products, hold property, choose their occupation and choose or demand products/services they want. But to keep a check on monopolistic practices and discrimination of the lower sectors of society the state maintains some control.
Economic Planning: In a mixed economy we have a central planning authority. All sectors of the economy follow the economic plan of the state to achieve various targets and goals. The plan is not rigid but more of a general guideline for economic growth and prosperity of the nation.
Social Welfare: One of the main aims of a mixed economy is social welfare. It aims to reduce the wealth gap in the country and fight the inequalities of our society. The aim is to reduce poverty and unemployment. And at the same time also improve social security, public health care, public education system, etc.
Merits of a Mixed Economy
Freedom the citizens enjoy. The economic freedom of ownership of property and choice of goods and services.
Ownership and existence of private producers also increase capital formation in the country. There is an incentive to do better and innovate as well.
Price mechanism prevails. So the allocation of resources is more scientific and beneficial to the economy.
Also enjoys the advantages of central economic planning. This will help the economy grow rapidly and in the correct direction.
There is healthy competition in the market. There is no cut-throat competition and adverse tactics due to government oversight. Also, there is no absolute lack of competition which is disadvantageous.
Demerits of Mixed Economy:
The main demerits of mixed economy are as follows:
Un-stability:
Some economists claim that mixed economy is most unstable in nature. The public sector gets maximum benefits whereas private sector remains controlled.
Ineffectiveness of Sectors:
Under this system, both the sectors are ineffective in nature. The private sector does not get full freedom, hence it becomes ineffective. This leads to ineffectiveness among the public sector. In true sense, both sectors are not only competitive but also complementary in nature.
Inefficient Planning:
There are no such comprehensive planning in mixed economy. As a result, a large sector of the economy remains outside the control of the government.
Lack of Efficiency:
In this system, both sectors suffer due to lack of efficiency. In public sector it is so because government employees do not perform their duty with responsibility, while in private sector, efficiency goes down because government imposes too many restrictions in the form of control, permits and licenses, etc.
Delay in Economic Decisions:
In a mixed economy, there is always delay in making certain decisions, especially in case of public sector. This type of delay always leads to a great hindrance in the path of smooth functioning of the economy.
More Wastages:
Another problem of the mixed economic system is the wastages of resources. A part of funds allocated to different projects in public sector goes into the pocket of intermediaries. Thus, resources are misused.
Corruption and Black Marketing:
There is always corruption and black marketing in this system. Political parties and self- interested people take undue advantages from public sector. Hence, this leads to emergence of several evils like black money, bribe, tax evasion and other illegal activities. All these ultimately bring red-tapism within the system.
Threat of Nationalism:
Under mixed economy, there is a constant fear of nationalism of private sector. For this reason private sector does not put into use their resources for the common benefits.
A centrally planned economy, also referred to as a command economy, is an economic system within which a central authority, like a government, makes economic decisions regarding the manufacturing and therefore the distribution of products. Centrally planned economies are different from market economies, during which such decisions are traditionally made by businesses and consumers.
The production of products and services in command economies is usually done by state-owned enterprises, which are government owned companies. In centrally planned economies, which are sometimes mentioned as "command economies", prices are controlled by bureaucrats.
In a centrally planned economy, major economic decisions are made by a central authority.
Centrally planned economies stand in contrast to promote economies where large numbers of individual consumers and profit-seeking private firms operate most or all of the economy.
Centrally planned economies are criticized by many economists as affected by various economic problems associated with poor incentives, informational constraints, and inefficiency.
Centrally Planned Economy
Understanding Centrally Planned Economies
Most developed nations have mixed economies that combine aspects of central planning with the free market systems promoted by classical and neoclassical economists. The bulk of these systems skew heavily toward free markets, where governments intervene only to implement certain trade protections and coordinate certain public services.
Theory of Central Planning
Advocates of centrally planned economies believe central authorities can better meet social and national objectives by more efficiently addressing egalitarianism, environmentalism, anti-corruption, anti-consumerism and other issues. These proponents think the state can set prices for goods, determine what percentage items are produced, and make labor and resource decisions, without necessarily expecting private sector investment capital.
Central economic planning naysayers believe central entities lack the required bandwidth to gather and analyze the financial data required to form major economic determinations. Furthermore, they argue that central economic planning is in line with socialist and communist systems, which traditionally cause inefficiencies and lost aggregate utility.
Free market economies run on the idea that people seek to maximise personal financial utility which businesses strive to get the most possible profits. In other words: all economic participants act in their own best interests, given the consumption, investment, and production options they face before them. The inherent impulse to succeed consequently assures that price and quantity equilibrium are met which utility is maximized.
