The Economic Systems

Chapter objectives

After reading and understanding the contents of this chapter, considering some of the

examination type questions, you should be able to:

1. Define the term, “Economic systems” and explain its basic components.

2. Explain the features, advantages and disadvantages of a free market command economy

and mixed economy.

3. Discuss the efficiency implications on how the basic economic questions are answered in

a command economy.

4. Account for the reasons why most countries are changing from the command to market

economies.

Economic systems are the institutional arrangements in various countries that assist in

solving the fundamental economic problems faced by societies.

The system must find answers to the following problems

1. What to produce?

2. What quantities to produce?

3. How and where to be produced?

4. For whom to produce?

5. How to produce more?

SIX BASIC COMPONENTS OF AN ECONOMIC SYSTEM

OWNERSHIP OF RESOURCES

1. The role of private sector

2. Allocation of resources

3. Ownership of means of production

4. Degree of freedom of choice

5. The role of the government.

1. THE FREE MARKET SYSTEM

In a free market system, the price system plays a critical role of allocating and distributing

resources and final commodities. The price performs the following functions:

a) Signals to customers the cost of purchasing a good or service, hence what to buy and

what not buy; and

hence what to produce and what not to produce.

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FEATURES OF A FREE MARKET

1. The resources are allocated by the workings of the price mechanism;

2. Resources are privately owned;

3. Factories are privately owned;

4. Producers are motivated by the need to earn private profits; and

5. Government has very limited part to play.

ADVANTAGES OF THE FREE MARKET ECONOMY

Consumer sovereignty

Consumers are able to tell producers what to produce through the price mechanisms. Since

there are many producers in the market, consumers are able to exercise their freedom of

choice, that is, decide which producers to deal with without any decisions being made on

their behalf by another economic agents.

Quality products and low prices

Producers are likely to improve on the quality of their products in order to attract a quality

conscious consumer. This increased competition results in improved product quality. In

addition, increased competition results in low prices being charged as producers compete

amongst themselves to attract additional custom.

INVESTMENT AND EMPLOYMENT

The free reign that is given to firms on the fundamental question of how, when and what to

produce promotes enterprise amongst the country’s citizens. This results in increased

investments which opens up employment opportunities. In addition to this, increased

investment results in economic growth.

STANDARD OF LIVING

Standard of living is likely to be high in a free market economy because of increased

product quality and accompanying low prices which results in low levels of inflation. Low

levels of inflation imply high purchasing power for the consumer. High purchasing power

translates into a large consumer basket.

EFFICIENCY
The free market economy is said to be more efficient in the allocation and distribution of

scarce resources. Producers produce goods which have high demand, and this means scarce

resources are employed where they are likely to be fully utilized.

DISADVANTAGES

INSTABILITY

The free market economy is associated with price instability. Prices change according to the

dictates of consumer tastes and preferences.

MARKET FAILURE

Market failure refers to the inability of the price mechanism to produce goods that have a

zero price, that is, public goods and to regulate the production of negative externalities such

as pollution. Public goods will not be produced by profit maximizing firms because they

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cannot be ‘sold’, producers are unable to prevent free riders from their consumption.

Negative externalities such as pollution will be overproduced, as a firm has no incentive to

internalise them. Social costs are therefore, very high under free market enterprise economy.

INEQUALITY IN INCOME DISTRIBUTION

The free market promotes inequalities in the distribution of income. The rich, that is, those

with factors of production become rich and those without become increasingly poor.

Consumer exploitation

Consumers are only able to exercise their freedom of choice if firms remain competitive.

However, since there is no government regulation small firms may be swallowed by large

firms culminating in monopolies. Once this situation obtains consumers can be exploited,

that is, charged high prices or face poor quality products since there are no longer

alternatives on the market.

CENTRALLY PLANNED/COMMAND ECONOMIES

Planned economies are characterized by the existence of central planning with regard to

resource allocation as well as the allocation of finally produced goods and services.

Features

1. Resources are allocated by a central planning authority.

2. Resources are owned and run by the state

4. Prices are controlled and regulated by the central planning authority.

ADVANTAGES OF THE COMMAND BASED ECONOMY

Low levels of inflation

Low prices can be maintained through the use of price controls. This results in low levels of

inflation. Low levels of inflation translates into high levels of standard of living.

Provision of public goods

The government through the imposition of tax can raise funds to provide public goods.

These would have been under produced or not produced at all under free market based

economy. The government can also subsidies the provision of merit goods.

Externalities

The government can also regulate the production through the manipulation of the taxation

tool. Social costs are therefore, are likely be low ceteris paribus.

Income Equality

The government seeks to bridge the gap between the rich and the poor. This can be done by

imposing high taxes on high-income groups and low tax on low-income groups. This is

known as progress tax system. The government can also promote through various initiative

programmes by the marginalised group (read poor) that seek to promote wealth generation.

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CONSUMER PROTECTION

Consumers enjoy high degree of protection from the government. The government ensures

low prices by setting price benchmarks (price controls) and regulates the standard of

products produced through its various acts. Monopoly power is restricted through antimonopoly
legislation.

DISADVANTAGES OF THE COMMAND ECONOMY

INEFFICIENCY

The economic system is characterised by high levels of inefficiency. The ‘visible hand’ of

the government can lead to mis- allocation of resources. This results when the government

orders the production of product even though there is no demand for it.

Poor quality products

There is no incentive for firms in a command-based economy to be innovative, hence,

Monopolies are well known for their abuse of the consumer since the consumer has no

alternatives.

LOW LEVELS OF INVESTMENT AND EMPLOYMENT

Government regulation can stifle innovation resulting in low levels of investments. No one

firm is comfortable with being dictated to on how to run its operations and hence local and

foreign investors will opt for other investment destinations where there is freedom of

enterprise. It follows therefore from low level of investments that employment opportunities

are low.

BUREAUCRACY

Several layers of decision-making will delay decisions being arrived at. This has the cost of

losing out business to competitors from other countries with free decision-making room. It

also contributes to high levels of corruption, which can destroy the social fabric.

Shortages and rationing

Shortages can also result especially if the government imposes price controls on private

enterprise. This is because producers may feel that the price controls erode their profit

margins and hence to protest this action, they can withdraw their products from the market.

N.B. Advantages and disadvantages treated here are not exhaustive; the reader is

advised to research more on these.

THE MIXED ECONOMY

This represents a blend of the command and free enterprise economy. It borrows features

from both economic systems in order to minimize the negative aspects of the two. The price

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system is to some extent allowed to allocate resources. The Government plays the crucial

role of producing and providing public and merit goods and services as well as providing a

legal framework within which private institutions conduct their business operations. Almost

all countries follow this economic system.

In Zimbabwe, for example, whilst individuals are free to participate in the production of

goods, the state still has a role in providing public goods and merit goods. It also regulates

the operation of private companies through the use of laws. The financial resources from

taxation for example individual tax, corporate tax and others normally fund these public
goods.

The rational behind mixed economic systems is to reduce the demerits of both command

and market economies. Otherwise the blend allows for competition to take place while the

government provides public and merit good