Economics Notes - Economic Systems

Notes on economics systems.

Economics Notes

Economic Systems

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There are three main questions any economy has to answer:

  • What is to be produced?
  • How will it be produced?
  • Who will get what is produced?

These three fundamental questions have to be answered by any economy, whether it is a highly developed economy, the poorest of countries, or a small group of people stranded on a desert island.

To answer these questions, different economic systems have developed. These systems revolve around how people in those societies allocate scarce resources to satisfy competing wants and needs. In other words, an economic system attempts to find ways of solving the basic economic problem.

To think about how this works, imagine you were stranded on a desert island with a group of friends. You each know that you have to find some way of surviving. You have a meeting and Identify the basic necessities needed to survive - food, water, clothing, shelter - and then put your minds to working out how you are going to provide for these needs.

Beach huts on a large, deserted white beach

Stranded on a desert island - what sort of system would you set up to solve the economic problem? Copyright: Juha Blomberg, from stock.xchng.

You identify each person's particular talents and interests, and split up the tasks of providing for your needs by agreeing to exchange what you each produce. Some people in the group have an interest in fishing and agree to spend their time catching enough fish for all. Others have skills in design and technology and volunteer to build shelter and so on.

The common agreement to exchange is crucial to survival. There might also have to be some way in which the rate of exchange will be managed. For example, the people going fishing pointed out that what they were doing was so essential to survival that they ought to be allowed to keep more of the fish they caught, whilst another group felt the fact that they collected water pointed out that they were going to collect water and that was the most important thing, some agreed means of exchange would be essential.

This simple example highlights the three key questions any economy has to answer.

  • What is to be produced?
    • This refers to the food, clothing, shelter, water and so on, which the friends identified.
  • How is it going to be produced?
    • This is exemplified by the group discussions about their relative skills and what each person could contribute.
  • Who gets what is produced?
    • This is characterised by the discussions about how much each group should get in exchange for what they bring to the island.

In any economy, these questions remain, but the system to allocate scarce resources might be highly complex. We might not even recognise it as a 'system' but in reality, many developed economies run like well-oiled machines even if we sometimes think they are highly inefficient. There are, of course, problems in many economies: we see examples of shortage, glut, starvation, famine, excess and poverty across the globe. In such cases, it might be seen that the economic system to allocate scarce resources is not working properly for a variety of reasons.

In essence, there are three main types of economic system that can be identified. These are:

  • A command, or planned, economy
  • A market or free market economy
  • A mixed economy

We will look at each in turn.

The Command, or Planned, Economy

Huge two-storey covered arcade, with queues of people along each corridor

The famous GUM department store in Moscow in 1990. Lots of people and shops but not a lot to buy! Copyright: A.Ashwin.

Command, or Planned (referred to hereafter as planned) economies have been closely associated with the so-called communist regimes in Russia and Eastern Europe that arose from 1917 onwards, finally collapsing in the late 1980s and early 1990s. We say 'so-called' communist states because they were not the states that Marx and Engels would have recognised; however, they did have some characteristics of that philosophy.

The main feature of this type of economic system is the way in which resources are allocated. In a planned system, the three basic questions are answered through some form of central planning. In the former Union of Soviet Socialist Republics (USSR), the state central planning authority was called Gosplan. Its function was to identify what goods and services were needed by the people, how these goods and services would be produced and how the state output would be distributed.

It takes a considerable imagination to understand the complexity of such a task. Needless to say, it involved huge numbers of people involved in the planning process - bureaucrats shuffling paper and directing operations. In reality, it meant that factories, farms and so on were given directions about what they should be producing. They were also given the resources that the planners had worked out would be necessary for producing that output. Most factories and farms were given output targets to reach; once produced, it might be the job of another body to ensure that goods were distributed.

In return for the labour expended in producing this output, a wage was given. This wage, however, bore no relation to the value of the output being produced. The wage was planned to allow workers to be able to buy the things the planners had worked out they needed to live on. To enable this to happen, prices were also set by the planning authorities.

In theory, everyone had enough to live on. Wage differentials were minimal - whether you were a highly qualified university professor or a street cleaner, wages only varied by a small amount. In the late 1980s to early 1990s, it was estimated that the average income in a city like Moscow was between £18 and £38 per month. As such, the income distribution could be seen as being very narrow, with few 'rich' and few 'poor'. Most people had a job if they wanted one, regardless of the type of job; unemployment was therefore zero. Inflation did not exist as we know it because of the system of price fixing and there were very few homeless people - the state provided housing.

Train tracks in the foreground, large housing blocks in the background

Housing estate outside Moscow, 1990. Homeless people were rare in Soviet Russia but the quality of housing and of housing accommodation was not necessarily of the highest quality! Copyright: A. Ashwin.

To understand this type of system, it is important to try to appreciate the political assumptions underpinning it. There was an expectation that each person was not working for their own benefit but for the good of the state. If everyone worked hard and excelled, the state would also excel and the collective pride that resulted was the reward for all this hard work. The power of the state was everything and in many cases, would dictate how resources were allocated. This helps to explain the investment in sport, military and space technology that occurred in the USSR. A nation that could go to the Olympic Games and compete successfully with the Americans was seen as being an important political statement: communism could outdo the corrupt and selfish capitalist philosophy. Equally, the status bestowed on space pioneers such as Yuri Gagarin, the first man in space, was extraordinary. He personified what a planned economy could achieve.

These assumptions, however, did not always manifest themselves in reality. People did not always work as hard for the common good as might be expected. Factories found that if they met their targets or even excelled them, they were given higher targets next year but not necessarily the resources to do so, nor any extra wages - so what was the point? Targets soon appeared to become subject to what has been called 'Goodhart's Law' , where targets used to manage something become corrupted to the extent that they cease to be able to be used to measure what you want them to measure!

The communication between the different sectors of the economy was not always good. It was estimated that something of the order of 40% of all agricultural produce rotted before it could be processed or reach its intended markets. Price fixing meant that the pressure of supply and demand was contained, shortages and surpluses developed and were not eliminated. Product quality fell, negative externalities like pollution increased and inefficiency was endemic.

A scuffed wall poster of Lenin

The planned system in the USSR was founded on egalitarian principles; the reality tended to be inefficient and wasteful. Copyright: Paal Gladso, from stock.xchng.

Some examples of how this inefficiency crept in can be highlighted as follows.

  • At one stage, there was a massive surplus of rubber. At the same time, planners were alerted to a shortage of shoes and boots. The obvious answer was to divert resources and use the rubber to produce shoes. Millions of pairs of rubber shoes were produced but were so uncomfortable and unhygienic that they were left piled high in warehouses across the USSR.
  • Many roads in the USSR and even in the capital, Moscow, suffered from potholes. Gangs of workers would be tasked to go and repair these potholes; indeed, that is what they did. They would arrive with a lorry full of tarmac, shovel some into the offending hole and flatten it out with the back of their shovel. Job done and off they went. The next car that came along very quickly dislodged the tarmac and Muscovites were back to square one.
  • Workers were told to go and decorate hotel rooms in a Moscow hotel. The woodwork, including the windows, needed painting. That is what the workers did - they painted the windows. There was no preparation of the woodwork, no masking of the windows, just paint applied to the wood and most of the window as well! Still, the job had been completed as requested.
  • Four women all have jobs - their job is to sweep leaves and litter in a local park. They are each given their allocated section to clean. They do this by sweeping the leaves and litter from their section onto another section. It does not take much imagination to work out the futility of this process, but it does mean that everyone has a job!

Some of these examples come from personal observation - as ridiculous as they might sound. At the other extreme were examples of amazing achievements - the space programme for one, but also the move from a backward, agrarian-based economy to one of the most powerful nations on earth, all in the space of just 40 years. Additionally, the metro and public transport systems in Moscow were to be envied - and at ridiculously low prices. Despite this, the pressures of the inefficiencies in the system did mean that something had to change and with the accession of Mikhail Gorbachev to the presidency in 1985, things changed very rapidly indeed.

To inject the element of efficiency into the system, a whole culture change was necessary. The acceptance of some form of profit motive as a means to improve the allocation of resources and improve quality and efficiency, along with the abandonment of price fixing, was a key part of the programme. When price fixing was removed, it was invariably followed by rapid inflation as the pent-up demand and shortage of supply began to feed through into the system. For many ordinary Russians, the move to a capitalist economy meant hardship, uncertainty and economic collapse. Gone were the certainties of the old planned system.

A street by the sea in Havana

A rubble-strewn street in Havana

Cuba - still ruled by Fidel Castro as a planned economy. Inefficiencies in the system, as well as sanctions by the US, have not helped the country to develop as its potential might suggest. Copyright: Niels Jansen and Machamr, both from stock.xchng.

Planned economies still exist in some parts of the world, most notably in Cuba and some states in Africa. In most cases, these economies are high on political rhetoric about equality but low on economic benefits to the population. It must be remembered that there are elements of a planned system that have some benefit, notably in the provision of public goods. However, as an economic system in answering the basic questions of the economic problem, it has been found wanting.

The Market Economy

Pure market economies rarely exist but in theory, a market economy answers the three questions that form the economic problem through a market system. The market system is based on the demand and supply of products. Demand and supply determine prices and prices act as signals to both producers (suppliers) and consumers (who create demand).

The market system relies on a number of factors to ensure that it works efficiently.

  • The profit motive - the incentive for a reward for enterprise
  • Good levels of information being available to both producers and consumers
  • Price accurately reflecting the costs and benefits of consumption and production
  • The ease with which resources can move to different uses

At the heart of the market system is the profit motive. Entrepreneurs (those who organise resources into production) are stimulated to take risks and produce goods and services by the prospect of seeing some return on their efforts. The extent to which they achieve this success is dependent on identifying the level of demand for the good or service, as well as their ability to manage production efficiently. If the costs of providing the good or service is less than the revenue that they receive from selling those goods and services, they will make a profit. If they can maximise revenue whilst reducing costs to a minimum, the level of profit they make will be higher.

To maximise revenue and reduce costs, producers rely on high quality information to enable them to access supplies at minimum cost, find ways of organising production in the most efficient way and finding resources at minimum cost. Equally, consumers rely on information to give them the guidance about what is available and what they are getting for their money.

To enable this to happen, price has a central role. It acts as a signal to both consumers and producers. For consumers, it tells them whether what they are being asked to give up in terms of money reflects the value or the level of satisfaction that will be gained from consumption. If I buy a CD priced at £12.99 but do not like the music on it, I might decide that I was not getting £12.99 worth of value - I could have used that £12.99 to better effect by buying something else that would have given me more satisfaction.

For consumers, price tells them something about the relationship between the cost of production and the level of profit they are making. If prices are falling then this suggests demand is also falling. As a result, the revenue being received from sales set against the cost of supplying the good will narrow. There will come a point where that difference is so small that the producer might decide that they would be better placed moving onto some other line of production.

Price will only act as an accurate signal to consumers and producers if it properly reflects the costs and benefits of production and consumption. This implies that prices will include all the positive and negative externalities that are associated with production and consumption - in many cases, this does not occur. When this happens, we get what is called market failure - an inefficient allocation of resources.

If we assume that prices accurately reflect costs and benefits, decisions made by both producers and consumers will lead to an efficient allocation of resources. This can only happen if resources are able to move from one use to another. The ease with which resources can transfer from one use to another is therefore important. How does this work?

Imagine a company that used to produce typewriters before computers and word processors came along. Demand was high and prices, as a result, enabled the firm to make healthy profits. As PCs and word processing software became more accessible, demand for typewriters starts to fall. As demand falls, prices will also start to fall. The profit margins - the difference between price and cost of production - start to narrow. The firm can continue but things are getting more difficult. This process will continue and eventually it will be not worth the firm's while to continue to produce typewriters. They start to look instead at moving into production of PCs where there is clearly demand and profits to be made. If they are able to transfer their resources relatively easily, then they can switch production and move into a new area.

Equally, we can see similar things happen when a business hits upon a new winning idea for a product. As the only producer, they command all the market share. Demand is high and sales revenue strong and as a result, profits are very healthy. Other businesses start to notice that there is a demand for this product and profits to be made. They will look at moving resources to producing a competing product and as more firms move into the industry lured by the prospect of profit, supply will increase. Consumers will now have more choice and firms in the industry have to adjust prices to compete. Prices start to fall and as a result, profit levels start to shrink. The process will continue until the market becomes saturated. Some firms will barely survive in this competitive environment and may leave the industry. Equally, it is likely that other firms and businesses will be looking to develop new and better products and services that will make this product obsolete, and so the whole process starts again.

Consumer decisions about what to buy and crucially, about what not to buy are vitally important to the market system. A decision to choose a can of Coke rather than a can of Pepsi is a small signal to the two companies about the relative value placed on the consumption of the drinks in relation to the price being charged. If enough people choose Coke rather than Pepsi, Pepsi have to do something about their product or their price, or possibly both. This is how competition and the profit motive provides the mechanism through which the market system operates and which is absent in the planned market system.

From the description above, it should be clear that the whole market system is extremely dynamic - it is constantly changing and evolving as products and services come and go and new ideas and innovations take over. The pace of change can be bewildering at times and, if there is a lack of information, lead to market failures occurring. The constant lure of the chance to strike it rich is what drives individuals and makes the system so dynamic and relatively efficient in allocating scarce resources.

The efficiency of the market system is not always matched in reality. There are significant weaknesses in the market system that we can identify - weaknesses that are collectively referred to as market failure.

The market system can fail in a number of ways:

  1. The provision of public goods - public goods are goods that could not be provided under a market system because it is not possible to charge a price for them. This is because it is not possible to exclude those who do not pay from getting the benefits. For example, how could the provision of a defence system that by definition protects all citizens be charged for individually? If just one person pays then it would not be possible to exclude all others from the protection - what reason do they have to pay if they are all being protected anyway?
  2. The provision of merit goods - merit goods are goods and services that could be provided by a market system but if they were, there is a possibility that some people who need these services would either not be able to afford to pay for them or would not believe that they need them. There is a danger, therefore, that such goods and services would be under-consumed. Examples of merit goods are health and education.
  3. Income inequalities - market systems tend to throw up individuals who become very very rich whilst there are others that struggle to survive. Such wide income inequalities may lead to a range of social and economic problems and tensions.
  4. Existence of shortages and surpluses - imperfect information tends to lead to shortages and surpluses not being erased. A classic example is unemployment. In theory, unemployment should not occur because wages would adjust to get rid of the surplus labour; in reality, wages may not adjust in this way. In addition, there may be a number of factors preventing labour resources moving from one type of job to another.
  5. The existence of externalities - externalities are the effects of decision making on third parties - individual and groups who are not involved in the initial decision.

The Mixed Economy

The vast majority of countries around the world have some form of mixed economy where some resources are allocated through the price or market mechanism and others are allocated by the state. In theory, such a system is able to combine the best elements of both a planned economy and a market economy. In reality, the proportion of planned and market varies, with some countries placing more emphasis on market solutions to resource allocations and others favouring a greater role for state planning.

Whatever the proportions, there is never a 'best' combination; it will depend to a large extent on the aims and objectives of the government concerned. Even with the existence of both a planned and a market element to an economy, there can still be problems and there will be aspects of market failure and government failure. The latter is where the government attempts to intervene in the market, to try to solve problems that might be caused by the market mechanism. In so doing, this creates other problems that do not ensure an efficient allocation of resources.

The UK is a typical example of a mixed economy. We have a private sector where goods and services are allocated on the basis of the market mechanism and a public sector where the government provide goods and services funded through tax revenue (for the most part) for the general public as a whole.

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