Economic Systems

The economy of India is expanding, thanks in large part to growth in industries like call centers and software development. The economies of many other nations are changing as well, while others, like that of the United States, have remained relatively stable for many years. In this section, you’ll learn that each nation’s economy depends on how that nation chooses to use its resources to satisfy people’s wants and needs.


Three Basic Questions

All economic systems face the same basic questions: What should be produced? How should it be produced? For whom should it be produced?

Economics & You

Do you think it’s fair that some people have more than others, or should everyone share equally in what a society produces? Read on to learn about this and other questions that all economic systems must answer.

The way a nation determines how to use its resources to satisfy its people’s needs and wants is called an economic system. Although nations have different economic systems, each one is faced with answering the same three basic questions: What goods and services should be produced? How should they be produced? Who should share in what is produced?

What Should Be Produced?

As you’ve learned, we live in a world of scarcity and trade-offs. If more of one particular item is produced, then less of something else will be produced. If the government decides to use resources to build new roads, then fewer resources are available to maintain national parks. If a city decides to hire more police officers, fewer funds are available to add teachers to classrooms. Similarly, an automobile manufacturer must decide whether to produce pickup trucks, minivans, sport utility vehicles, or luxury cars—and how much of each.

How Should It Be Produced?

After deciding what to produce, an economic system must then decide how those goods and services will be produced. How many laborers will be hired? Will skilled laborers or unskilled laborers do the work?

Will capital goods be used to manufacture the products, thereby reducing the number of laborers needed? What kinds of technology will be used in the production process? For each good and service produced, there are always trade-offs possible among the available factors of production. Decisions must be made as to what the best combination of available inputs will be to get the job done for the lowest possible cost.

For Whom Should It Be Produced?

After goods or services are produced, the type of economic system under which people live determines how the goods and services will be distributed among its members. Who receives new cars?

Who benefits from a new city school? Who lives in new apartment buildings? As you will read, the answers to these economic questions vary greatly depending on where you live. In the United States and in many other countries, most goods and services are distributed to individuals and businesses through a price system. Other economies may distribute products through majority rule, through a lottery, on a first-come-first-served basis, by sharing equally, by military force, and in a variety of other ways.

Types of Economic Systems

There are four basic types of economic systems: traditional, command, market, and mixed.


Economics & You

How would you feel if the government told you where you could work and how much income you would make? Read on to learn about the four types of economic systems and the differences among them.

Economists have identified four types of economic systems. They differ from one another based on how they answer the three basic questions of what, how, and for whom to produce. The four general types of economic systems are traditional, command (or controlled), market (or capitalist), and mixed. Keep in mind that the four systems described here are theoretical representations of economies found throughout the world. No “pure” systems really exist—they are all mixed economies to some degree.

Traditional System

A pure traditional economy answers the three basic questions according to tradition. In such a system, things are done “the way they have always been done.” Economic decisions are based on customs and beliefs—often religious—handed down from generation to generation. If you lived in a traditional economic system, your parents would teach you to perform the same tasks that they learned from their parents. As a male, if your father was a fisherman, you would become a fisherman. You would learn to make fishing nets the same way that he was taught, and you would distribute your catch in the manner that it had always been done.

An advantage of living in a traditional economy is that you know what is expected of you. In addition, family and community ties are usually very strong. Disadvantages include an economy in which change is discouraged and perhaps even punished, and in which the methods of production are often inefficient. Consequently, choices among consumer goods are rare. Also, people living and working in traditional economies rarely experience an increasing level of material well-being. Things tend to stay the same.

Traditional economies exist to some extent in very limited parts of the world today. The Inuit of North America, the Mbuti of the Democratic Republic of the Congo, and the Aborigines of Australia are organized into traditional economic systems.

Command System

The pure command economy is somewhat similar to the traditional economy in that the individual has little if any, influence over how the basic economic questions are answered. However, in a command or controlled system, government leaders—not tradition—control the factors of production and, therefore, make all decisions about their use.

Decisions in government may be made by one person, a small group of leaders, or a group of central planners in an agency. These people choose what is to be produced and how resources are to be used at each stage in production. They also decide how goods and services will be distributed. If you lived in a command economy, you would be paid according to what the central planners decide, and you might not be allowed to choose your own career. Through a series of regulations about education, the government guides people into certain jobs.

Disadvantages of such a controlled economy include a lack of incentives to work hard or to show inventiveness, as well as a lack of consumer choices. Because the government sets workers’ salaries, there is no reason to work efficiently.

Only a few countries in the world today still have much of a command economy. North Korea and parts of the People’s Republic of China are the two main examples because so much economic activity there is government-planned.

Market System

The opposite of a pure command economy is a pure market economy—also called capitalism. In a market system, economic decisions are made not by government, but by individuals looking out for their own and their families’ best interests. A limited government makes it possible for individuals to decide for themselves the answers to the three basic questions. Individuals own the factors of production and therefore choose what to produce and how to produce it.

Individuals also choose what to buy with the income received from selling their labor and other resources. All of these choices are guided not by tradition or a central planning agency, but by information in the form of market prices.

A market is not necessarily a place. Rather, it is the voluntary exchange of goods and services between buyers and sellers. This exchange may take place in a worldwide market for a good such as crude oil. It may also take place in a neighborhood market for services such as paper delivery, snow shoveling, and babysitting.

Prices in a market coordinate the interaction between buyers and sellers. As prices change, they act as signals to everyone within the system as to what should be bought and what should be produced. A high price for a good generally means that it is relatively scarce. A low price suggests that it is relatively abundant. The freedom of prices to rise and fall results in a neutral, self-organizing, incentive-driven system.

The circular flow of economic activity shows the relationship between different economic groups in a market system

Figure 2.2 Circular Flow of Income and Output

The flow of resources, goods and services, and income in a market system are actually circular, as shown in Figure 2.2 above. Economists use this model, called a circular flow of income and output, to illustrate how the market system works. Note how dollars flow from businesses to individuals and back to businesses again. The factors of production flow from individuals to businesses, which use them to produce goods and services that flow back to individuals.

The advantages of a pure market system are many. People have freedoms—to choose a career, to spend their income how they wish, to own property, and to take risks and earn profits.

Also, the existence of competition provides consumers with a wide array of goods and services from which to choose, as well as an efficient system of determining costs. One disadvantage of a pure market system involves concern about those too young, too old, or too sick to work. Many fear that survival for these people would be difficult unless the government, churches, family members, or other organizations stepped in to provide goods and services for them.

Mixed System

A mixed economy combines basic elements of a pure market economy and a command economy. Most countries of the world have a mixed economy in which private ownership of property and individual decision making is combined with government intervention and regulations. In the United States, most decisions are made by individuals reacting as participants within the market.

Federal, state, and local governments, however, make laws protecting private property and regulating certain areas of business. Such regulations include certain environmental protections, safety guidelines for workers, and laws to protect consumers. In Section 2, you’ll learn more about the United States’s mixed economy, and the role of government in it.

To summarize, consider why society has one type of economic system and not another. The goals that individuals set for their society help determine their economic system. The amount of government involvement in allocating scarce resources also determines a society’s economic system. 

  • economic system: the way in which a nation uses its resources to satisfy its people’s needs and wants
  • traditional economy: system in which economic decisions are based on customs and beliefs that have been handed down from generation to generation
  • command economy: system in which the government controls the factors of production and makes all decisions about their use
  • market economy: system in which individuals own the factors of production and make economic decisions through free interaction while looking out for their own and their families’ best interests
  • market: the process of freely exchanging goods and services between buyers and sellers
  • circular flow of income and output: the economic model that pictures income as flowing continuously between businesses and consumers
  • mixed economy: system combining characteristics of more

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