American economist Paul A . Samuelson said that every society needs to answer three fundamental questions when we look at the world we find that there are only a limited number of ways in which societies have set about answering these questions:
1) What goods to produce? in what quantities
2) How shall the goods be produced? that is given we have scarce resources of land, labour etc., how should we combine them to goods and services we want?
3) For whom shall the goods be produced? Who is to enjoy and get the benefits of the nation’s goods and services? or to put it in another way, how is national product is to be divided among different individuals and families.
Economic systems refer to the ways of answering what goods to produce, how shall the goods be produced and for whom the goods are being produced thus resulting in three economic systems.
They are mixed economic systems, free enterprise systems and planned economic systems.
a) Mixed economy
There are no economies in the world that are entirely planned or market-based, all economies contain elements of both a free-market system and a planned economic system for example the USA economy which is typically worked based society but the government plans a range of public services such as defence, health and education for those who cannot afford
the degree of mix in any economy is the result of a complex interaction of political, social and economic factors
features of mixed economic system
- the government controls and operates the public sector, which typically consists of a range of public services such health and education as well as some local government services
- the private sector is controlled by the market forces of demand and supply and in practice controlled by certain rules and regulations laws
- some services may be subsidized, provided at a loss but kept for the benefit of society. for example, education or security may be provide for free but paid for through taxation system.
advantages of mixed economy
- necessary services are provided in mixed economy, services which were not able to make profit would not be provided
- incentives exist in mixed economy to help private sectors remain competitive and make profit
- competition: prices of good in private sector are kept down through competition taking place
disadvantages of mixed economy
- large monopolies can exist in the private sector a so competition does not really take place there is likely to be a lot of bureaucracy and red tape due to existence of a public sectors
b) Planned economy
this is a system where all major economic decisions are made by the government. the government will decide what is made, how it is made, how much is made and how distribution takes place. prices are fixed by the government not market forces
planned economies tend to be more self-sufficient and tend to take part in less international trade than market economies
b Features of planned economic system
- the economy is controlled by the government
- the government will decide what is made, how it is made and how distribution takes place.
- price levels are solely determined and fixed by the government
Advantage of the planned system
- centralized planning can lead to full and optimum utilization of all the factors of production hence reducing or ending unemployment of resources
- economies of scale are possible due to mass production being undertaken
- public services: natural monopolies such as the supply of domestic power or defense can be provided efficiently through central planning
- basic services there is concentration on making luxuries for those who can afford them and greater emphasis on providing a range of good and services for all the population
- there are less dramatic differences in wealth and income distribution than in market economy
Disadvantages planned system
- consumers have little influence over what is produced and people may have little to say in what they do as a career
- there is little incentive since competition between different producers is not as important as in the market economy there is no great incentive to improve existing systems of production or work
- workers are given no real incentives to works harder and so production levels are not as high as they could be
- centralized control because the state makes all the decisions there must be large influential government departments such departments can lead to inefficient planning and to problems of communication. Furthermore, government officials can become over privileged and use their position for personal gain rather than for the good of the rest of the society
the task of assembling the available resources and deciding on what to produce, how much to produce and how to produce and distribute can be too much for the central planning committee
c) Free enterprises
Free market is where the decision about what is produced is the outcome of millions of separate individual decisions made by consumers, producers and owners of productive services.
for free enterprise to operate there must be a price system /mechanism price mechanism refers to where vital economic decisions in the economy are reached through the workings of the market price
the free market thus gives rise to consumer sovereignty -a situation in which consumers are the ultimate dictators, subject to the level of technology, of the kind and quantity of commodities to be produced.
features of free-market system
- freedom of choice and enterprise- entrepreneurs are free to invest in a business of their choice, produce any product of their choice, workers are free to sell their labour in occupations of their choice. consumers are free to consume products of their choice
- ownership of means of production-individuals are free to own the means of production i.e. land, capital and enjoy incomes from them in the form of rent, interest and profits
- self-interest as the dominating motive– firms aim at maximizing their profits, workers aim at maximizing their satisfaction
- competition- an economic rivalry or competition envisages a situation where in the market for each commodity there are a large number of buyers and sellers .it is the forces of total supply and demand which determine the market price and each participant, whether buyer or sellers must take this price as given since it beyond his or her control
- Reliance on the Price Mechanism –Price mechanism is where the prices are determined on the market by supply and demand, and consumers base their expenditure plans and producers their production plans on market prices.
Price mechanism rations the scarce goods and services in that, those who can afford the price will buy and those who cannot afford the price will not pay.
6 Role of Government – In these systems, apart from playing its traditional role of providing defence, police service and such infrastructural facilities as roads for public transport, the Government plays a very limited role in directly economic profit-making activities.
Resource allocation in a free enterprise
Although there are no central committees organizing the allocation of resources, there is supposed to be no chaos but order. The major price and allocation decisions are made in the markets. The market being the process by which the buyers and sellers of a good interact to determine its price and quantity.
If more is wanted of any commodity say wheat – a flood of new orders will be placed for it. As the buyers scramble around to buy more wheat, the sellers will raise the price of wheat to ration out a limited supply. And the higher price will cause more wheat to be produced. The reverse will also be true.
What is true of the market for commodities is also true for the markets for factors of production such as labour, land and capital inputs.
People, by being willing to spend money, signal to producers what it is they wish to be produced. Thus, what things will be produced will is determined by the shilling votes of consumers, not every five years at the polls, but every day in their decisions to purchase this item and not that. The “How?” questions are answered because one producer has to compete with others in the market; if that producer cannot produce as cheaply as possible then customers will be lost to competitors. Prices are the signals for the appropriate technology.
The “for whom?” question is answered by the fact that anyone who has the money and is willing to spend it can receive the goods produced. Who has the money is determined by supply and demand in the markets for factors of production (i.e. land, labour, and capital). These markets determine the wage rates, land rents, interests rates and profits that go to make up people’s incomes. The distribution of income among the population is thus determined by amounts of factors (person-hours, Acres) owned and the prices of the factors (wages-rates, land rents).
Advantages of a Free Market System
- Incentive: People are encouraged to work hard because opportunities exist for individuals to accumulate high levels of wealth.
- Choice: People can spend their money how they want; they can choose to set up their own firm or they can choose for whom they want to work.
- Competition: Through competition, less efficient producers are priced out of the market; more efficient producers supply their own products at lower prices for the consumers and use factors of production more efficiently. The factors of production which are no longer needed can be used in production elsewhere. Competition also stimulates new ideas and processes, which again leads to efficient use of resources.
- A free market also responds well to changes in consumer wishes, that is, it is flexible.
- Because the decision happens in response to change in the market there is no need to use additional resources to make decisions, record them and check on whether or not they are being carried out. The size of the civil service is reduced.
Disadvantages of a Free Economy
The free market gives rise to certain inefficiencies called market failures i.e. where the market system fails to provide an optimal allocation of resources. These include:
- Unequal distribution of wealth: The wealthier members of the society tend to hold most of the economic and political power, while the poorer members have much less influence. There is an unequal distribution of resources and sometimes production concentrates on luxuries i.e. the wants of the rich. This can lead to excessive numbers of luxury goods being produced in the economy.
It may also result in social problems like crimes, corruption, etc.
- Public goods: These are goods which provide benefits which are not confined to one individual household i.e. possess the characteristic of non-rival consumption and non-exclusion. The price mechanism may therefore not work efficiently to provide these services e.g. defense, education and health services.
- Externalities: Since the profit motive is all important to producers, they may ignore social costs production, such as pollution. Alternatively, the market system may not reward producers whose activities have positive or beneficial effects on society.
- Hardship: Although in theory factors of production such as labour are “mobile” and can be switched from one market to another, in practice this is a major problem and can lead to hardship through unemployment. It also leads to these scarce factors of production being wasted by not using them to fullest advantage.
- Wasted or reduced competition: some firms may use expensive advertising campaigns to sell “new” products which are basically the same as may other products currently on sale. Other firms, who control most of the supply of some goods may choose to restrict supply and therefore keep prices artificially high; or, with other suppliers, they may agree on the prices to charge and so price will not be determined by the interaction of supply and demand.
- The operation of a free market depends upon producers having the confidence that they will be able to sell what they produce. If they see the risk as being unacceptable, they will not employ resources, including labour and the general standard of living of the country will fall.
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