Table of Contents |
We have learned that an economy is a system, or a collection of interacting parts designed to achieve a purpose. The purpose of an economic system is to coordinate the interaction of economic agents and determine answers to three fundamental economic problems given society’s resource limitations.
For example, one arrangement that society must agree upon is how to get owners of scarce resources to make them available for productive use. In societies where markets operate, a change in the price will influence whether the owner decides to make resources available or not.
EXAMPLE
As the price of crude oil climbs above 120 dollars a barrel, more landowners of shale oil deposits become ready and willing to make their land available for drilling.To get a sense of how different nations coordinate interaction and determine answers to the three economic problems, we must understand the fundamental building blocks of every economic system and how different configurations create different types of economic systems.
Every economic system is composed of a set of agreed upon arrangements regarding who can own property, how to move resources into production, and an acceptable set of incentives to influence behavior. These arrangements serve as building blocks in the foundation of an economic system and define the relationships of economic agents to resources, production, and income.
Property rights establish the types of ownership permitted by society. By definition, property rights imply legal ownership. Ownership is important. The owner not only controls the use and transfer of property but also the income generated from its use and sale. If a property has high economic value, then its owner will be highly compensated for its use or sale. In most nations, it is the responsibility of the government to protect property rights.
A society can choose to assign property rights to private individuals and this is characterized in economics as capitalistic ownership, or capitalism. Individuals are permitted to own resources as well as the means of production, businesses and factories.
EXAMPLE
In the United States your individual right to set up a small business or own hundreds of acres of trees is protected by law.A society may choose to assign property rights to the government. This is characterized in economics as socialism. In this case, resources and production facilities may be government owned.
EXAMPLE
The Tennessee Valley Authority (TVA), a federally-owned electric utility corporation, was established in 1933 to control floods in the Tennessee Valley. It provides electricity to households in seven adjoining southeastern states. The TVA is self-funding and receives no taxpayer dollars for its operation.A society may choose to assign property rights as a common good, that is, shared by all members of the community. In economics, this is characterized as communistic ownership, or communism. Both resources and the means of production may be held in common—owned by the larger community rather than assigned to a single individual or small group of individuals.
In the first Challenge of this Unit, you learned about Principle 4, which says that economic systems influence choices through the use of incentives. Incentives are rewards that either make us better off or penalties that make us worse off. For society to achieve its goals, it must find ways to motivate individuals to work together for the greater good. One of those goals is to fulfill the wants and needs of its people. Given that resources are limited, every society must motivate owners of resources to make those resources available for production of goods and services.
Three common methods of distributing resources and goods and services in an economy are traditions, prices, and plans. Each method will use a different approach to motivate or incentivize owners to give up their stock of resources.
Tradition is a method of resource allocation that relies on moral persuasion to motivate resource owners to meet current societal needs. Social roles and expectations have been passed from one generation to the next. While today this is a rare method of resource allocation, it was much more common in earlier time periods. Even today, many regions include smaller societies of people–such as the indigenous peoples of the Amazon rainforest and the Arctic–who use tradition as a means to address the economic problems particular to their environments. In doing so, what gets produced is decided by what can be drawn from the local environment. Past experience anchors decisions of how goods and services are produced (such as by hunting, growing, or through handmade production) and who gets what is produced.
Prices are a method of resource allocation that rely on financial incentives to motivate owners to respond to societal needs and wants. With this method, buyers are the driving force behind what gets produced. Buyers signal through prices what they are willing to pay and what business firms should produce. When buyers are excited about purchasing a product, its price will rise, drawing the attention of producers. Producers, on the other hand, determine how something will be made based on the price of the factors of production they purchase. If the cost of hiring workers rises sufficiently, producers will consider replacing workers with machines. Once goods and services enter the market, household income will determine who gets what. Most nations have some market elements.
Planning is another method for allocating resources that relies on the dictates of a central authority, often the government, to carefully plan the mapping of available resources onto societal needs and wants. In doing so, a detailed plan will specify what and how much of a good or service must be produced, as well as how the good or service will be produced. The central authority, often the government, will then decide who gets what: whether individuals, other production facilities, or the government itself. While nations such as North Korea, Russia, and China operate with some elements of central planning, so do all governments and most large businesses.
The table below summarizes how three methods of allocation work to solve basic economic problems.
| Economic Problem | Traditions | Prices | Plans |
|---|---|---|---|
| What to produce? | Traditions drive decisions about what to produce. | Prices guide consumer decisions about what to produce. | A central plan drives what to produce. |
| How to produce? | Traditions drive decisions about how to produce. | Prices guide producer decisions about how to produce. | A central plan drives how to produce. |
| Who gets what’s produced? | Traditions drive decisions about who gets what’s produced. | Income earned from sale of resources determines who gets what’s produced. | The central authority determines who gets what’s produced. |
There are three “pure” forms of economic systems: a traditional economy, a market economy, and a command economy.
The oldest type of economic system is the traditional economy. A tradition is an inherited or customary pattern of behavior. A traditional economy organizes economic affairs according to ways of the past, that is to say, things are done the way they have always been done. Children will learn to hunt, fish, herd, or farm based on knowledge and tools developed over the ages. Medicines drawn from the local environment will be applied by those with the specialized knowledge passed down from one healer to the next.
As previously mentioned, an entire economy built on tradition is rare, though there can be small groups conducting their affairs based on past practices. In the United States, some orders of the Amish people rely on tradition as a means to address their economic problems. In a traditional economy, the roles of a medical provider, farmer, herder, or leader stay within the family. Sons are taught the trade of their fathers and go on to assume the role of fathers, and daughters are taught the trade of their mothers and go on to assume the role of their mothers. In this way, society is assured of having the necessary functions fulfilled. In a traditional economy, you produce what you consume or exchange with another group. Because tradition drives the way of life, there is little need for economic progress or sustained development.
Traditional economies have these attributes:
A market economy is an economy in which economic decisions are decentralized and guided by financial incentives. A market is an economic institution that brings together buyers and sellers of goods or services, who may be individuals, businesses, or organizations.
A yard sale, a farmers market, and the New York Stock Exchange are examples of markets that bring buyers and sellers together. However, there are no examples of a pure market economy because all economies mix in some elements of the other styles of resource allocation.
Market economies are based on these attributes:
A command economy is an economy where economic decisions are centralized and guided by the development of a detailed central plan. Few nations use this cumbersome method of directing their economies because it tends to be inefficient, leaving usable resources outside of the production process. As a result, overall production is lower than in market-based economies.
Command economies are based on these attributes:
There are no pure economic systems. Most economies in the real world are mixed. A mixed economy is an economy that combines the building blocks of property rights, resource allocation methods, and incentives in different ways to varying degrees.
Taiwan, Singapore, Hong Kong, New Zealand, Switzerland, and the United States are considered among the top market economies in the world. As such, they are positioned toward the market-oriented end of the spectrum of mixed economic systems. But elements of central planning do occur in big business, while the government does own some means of production. Elements of tradition also dot the economic landscape such as in the case of some orders of the Amish who live in communities that operate by tradition.
Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than the U.S. economy. Meanwhile, while China and Russia have over the past several decades introduced markets to their previously command-oriented economies, they remain closer to the command economy end of the spectrum of mixed economic systems, with government ownership of large sectors of the economy.
As you have learned, there are no pure economies and every economy is a mixed economy. Societies are free to pick and choose among the building blocks to build their own unique economic system by making decisions about property rights and allocation methods:
Mixed economies can be classified by mixing the type of allocation method with the type of property rights. There are three major classifications of mixed economic systems: planned socialism, market socialism, and market capitalism.
When the resource allocation in an economy is planned by the central authorities, the type of resource allocation method is referred to as planned. An economy in which the government owns property rights is referred to as socialism. If you combine planned resource allocation and socialist property rights, you can classify the specific type of mixed economic system as planned socialism. Planned socialism is an economic system that is planned by central authorities to determine allocation methods and the government owns and controls the means of production.
Use the following Try It activities to combine allocation methods and property rights to classify the two other major categories of economic systems.
Combine the terms market and socialism to classify the specific type of mixed economic system described in the Try It above based on the property rights and allocation methods. Market socialism is an economic system that relies on prices (market) to determine allocation methods and government ownership of the means of production (socialism).
Combine the terms market and capitalism to classify the specific type of mixed economic system described in the Try It above based on property rights and allocation methods. Market capitalism is an economic system that relies on prices (market) and private ownership of the means of production (capitalism).
As you have learned, mixed economies can be classified. We’ve classified three types based on combining allocation methods with property rights. Economic systems can be further classified using other attributes such as social equity versus production efficiency or environmental justice versus private wealth because these things compete with one another. The possibilities are endless.
Source: THIS TUTORIAL HAS BEEN ADAPTED FROM OPENSTAX “PRINCIPLES OF ECONOMICS 2E”. ACCESS FOR FREE AT https://openstax.org/books/principles-economics-2e/pages/1-introduction. LICENSE: CC ATTRIBUTION 4.0 INTERNATIONAL.
