Chapter 2

The Classification of Economic Systems

Learning Objectives
The Classification of Economic Systems
• The common economy
• The free-market economy
• The mixed economy

All societies are faced with the problem of scarcity. They differ considerably, however,
in the way they tackle the problem. One important difference between societies is in the degree
of government control of the economy. At the one extreme lies the completely planned or
command economy, where all the economic decisions are taken by the government. At the
other extreme lies the completely free-market economy. In this type of economy there is no
government intervention at all. All decisions are taken by individuals and firms. Households
decide how many labor and other factors to supply and what goods to consume. Firms decide
what goods to produce and what factors to employ. The pattern of production and consumption
that results depends on the interactions of all these individual demand and supply decisions. In
practice, all economies are a mixture of the two. It is therefore the degree of government
intervention that distinguishes different economic systems. Thus, in the former communist
countries of Eastern Europe, the government played a large role, whereas in the USA, the
government plays a much smaller role.
Centrally planned or command economy: An economy where all economic decisions are
taken by the central authorities.
Free-market economy: An economy where all economic decisions are taken by individual
households and firms and with no government intervention.
Mixed economy: An economy where economic decisions are made partly by the government
and partly through the market.
2.1 The command economy
The command economy is usually associated with a socialist or communist economic
system, where land and capital are collectively owned. The state plans the allocation of
resources at three important levels:

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 • It plans the allocation of resources between current consumption and investment for the
future. By sacrificing some present consumption and diverting resources into
investment, it could increase the economy’s growth rate. The amount of resources it
chooses to devote to investment will depend on its broad macroeconomic strategy: the
importance it attaches to growth as opposed to current consumption.
• At a microeconomic level, it plans the output of each industry and firm, the techniques
that will be used, and the labor and other resources required by each industry and firm.
In order to ensure that the required inputs are available, the state would probably conduct
some form of input–output analysis. Input–output analysis shows, for each industry,
the sources of all its inputs and the destination of all its output. By using such analysis
the state attempts to match up the inputs and outputs of each industry so that the planned
demand for each industry’s product is equal to its planned supply.
• It plans the distribution of output between consumers. This will depend on the
government’s aims. It may distribute goods according to its judgment of people’s needs;
or it may give more to those who produce more, thereby providing an incentive for
people to work harder.
Assessment of the command economy
With central planning, the government could take an overall view of the economy. It
could direct the nation’s resources in accordance with specific national goals. High growth
rates could be achieved if the government directed large amounts of resources into investment.
Unemployment could be largely avoided if the government carefully planned the allocation of
labor in accordance with production requirements and labor skills. National income could be
distributed more equally or in accordance with needs.
In practice, a command economy could achieve these goals only at considerable social
and economic cost. The reasons are as follows:
• The larger and more complex the economy, the greater the task of collecting and analyzing
the information essential to planning, and the more complex the plan. Complicated plans are
likely to be costly to administer and involve cumbersome bureaucracy.
• If there is no system of prices, or if prices are set arbitrarily by the state, planning is likely
to involve the inefficient use of resources.
• It is difficult to devise appropriate incentives to encourage workers and managers to be
more productive without a reduction in quality.

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 • Complete state control over resource allocation would involve a considerable loss of
individual liberty. Workers would have no choice where to work; consumers would have no
choice what to buy. • The government might enforce its plans even if they were unpopular.
• If production is planned, but consumers are free to spend money incomes as they wish,
there will be a problem if the wishes of consumers change. Shortages will occur if consumers
decide to buy more; surpluses will occur if they decide to buy less.
2.2 The free-market economy
In a free market, individuals are free to make their own economic decisions. Consumers
are free to decide what to buy with their incomes: free to make demand decisions. Firms are
free to choose what to sell and what production methods to use: free to make supply decisions.
The demand and supply decisions of consumers and firms are transmitted to each other through
their effect on prices: through the price mechanism. The prices that result are the prices that
firms and consumers have to accept. This price, where demand equals supply, is called the
equilibrium price. The price where there is no shortage or surplus. Equilibrium A position
of balance: A position from which there is no inherent tendency to move away.
Even though all individuals are merely looking to their own self-interest in the free-
market economy, they are in fact being encouraged to respond to the wishes of others through
the incentive of the price mechanism.
Assessment of the free-market economy
The fact that a free-market economy functions automatically is one of its major
advantages. There is no need for costly and complex bureaucracies to coordinate economic
decisions. The economy can respond quickly to changing demand and supply conditions. When
markets are highly competitive, no one has great power. Competition between firms keeps
prices down and acts as an incentive to firms to become more efficient. The more firms there
are competing, the more responsive they will be to consumer wishes.
The more efficiently firms can combine their factors of production, the more profit they
will make. The more efficiently workers work, the more secure will be their jobs and the higher
their wages. The more carefully consumers decide what to buy, the greater the value for
maoney they will receive. Thus people pursuing their own self-interest through buying and
selling in competitive markets helps to minimize the central economic problem of scarcity, by
encouraging the efficient use of the nation’s resources in line with consumer wishes.

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 In practice, however, markets do not achieve maximum efficiency in the allocation of
scarce resources, and governments feel it necessary to intervene to rectify this and other
problems of the free market. The problems of a free market are as follows:
• Competition between firms is often limited. A few giant firms may dominate an
industry.
• Lack of competition and high profits may remove the incentive for firms to be
efficient. • Power and property may be unequally distributed. Those who have power and/or
property (e.g. big business, unions, and landlords) will gain at the expense of those without
power and property.
• The practices of some firms may be socially undesirable. For example, a chemical
works may pollute the environment.
• Some socially desirable goods would simply not be produced by private enterprise.
What firm would build and operate a lighthouse, unless it were paid for by the government?
• A free-market economy may lead to macroeconomic instability. There may be periods
of recession with high unemployment and falling output, and other periods of rising prices.
• Finally, there is the ethical objection, that a free-market economy, by rewarding self-
interested behavior, may encourage selfishness, greed, materialism and the acquisition of
power.

2.3 The mixed economy

Because of the problems of both free-market and command economies, all real-world
economies are a mixture of the two systems. In mixed market economies, the government
may control the following:
• Relative prices of goods and inputs, by taxing or subsidizing them or by direct price
controls.
• Relative incomes, by the use of income taxes, welfare payments or direct controls
over wages, profits, rent, etc.
• The pattern of production and consumption, by the use of legislation (e.g. making it
illegal to produce unsafe goods), by direct provision of goods and services (e.g. education and
defense), by taxes and subsidies or by nationalization.
• The macroeconomic problems of unemployment, inflation, lack of growth, balance of
trade deficits and exchange-rate fluctuations, by the use of taxes and government expenditure,

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the control of bank lending and interest rates, the direct control of prices and the control of the
foreign exchange rate.
. Note, however, that governments are not perfect and their actions may bring adverse
as well as beneficial consequences.

Summary
1. All societies are faced with the problem of scarcity. One important difference between
societies is in the degree of government control of the economy. At the once extremer lays the
completely planned or command economy, where all the economic decisions are taken by the
government. At the other extremer lies the completely free-market economy.
2. Centrally planned or command economy: An economy where all economic decisions
are taken by the central authorities.
3. Free-market economy: An economy where all economic decisions are taken by
individual households and firms and with no government intervention.
4. Mixed economy: An economy where economic decisions are made partly by the
government and partly through the market.
5. Relative prices of goods and inputs, by taxing or subsidizing them or by direct price
controls.
6. Relative incomes, by the use of income taxes, welfare payments or direct controls over
wages, profits, rent, etc.

Key Terms
Degree of government control Economic Decisions
Centrally planned Command economy
Free-market economy Mixed economy
Taxing Subsidizing
Relative prices Relative incomes

Questions for Discussion and Review

1. What do you understand by the common economy? Explain.
2. Discuss the free-market economy and explain the assessment of the free-market
economy.
3. Briefly explain the mixed economy.