The function of any economic system is to produce a set of solutions to the basic economic problem that human needs are unlimited, while the resources required to satisfy them are finite. All economies have to decide what to produce, how to produce and, finally, how to allocate the goods and services once they have been produced.
There are three types of economic system:
Free market economies;
Planned economies; and
Each type of economic system makes these decisions in different ways. Therefore, economic system is a term that describes the nature and methods of resource allocation used within an economy.
The Free Market Economy
The free market economy is also known by a variety of other names. Capitalist economy and the free enterprise economy are also terms used to describe this type of economic system. The six main characteristics of a free market economy are as follows:
In a free market system, the resources used to produce goods and services are owned by private individuals rather than by the state. Factories are owned and run by entrepreneurs, who obtain the labor they need to produce goods and services by paying workers’ wages. The individual workers decide which entrepreneur they wish to work for. Workers then use their wages to buy goods and services from the entrepreneurs. Individuals are given the freedom to choose in a free market economy. Taxes are very low and, as a result, the majority of spending in a free market economy is conducted by the individual rather than by the state. The government’s role is not to produce goods and services, but to enforce the property rights of the individual and remove any obstacles to free enterprise.
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Entrepreneurs produce goods and services for society because they are motivated by the desire to make profit for themselves. In a free market economy, entrepreneurs attempt to find ways of minimizing costs while maximizing revenue. Therefore, firms have an incentive to find new methods of production that are more efficient. If costs can be reduced, more profit can be made from the same revenue. They also have an incentive to supply the types of goods and services that consumers want to buy. The more popular a product, the higher the price it can be sold for relative to its costs of production.
Decision-making is decentralized. Individual decisions made by firms and consumers determine the market price levels. These decisions are not usually motivated by the desire to create an outcome that is good for society, but on the basis of what will be the best outcome for that individual. In his book ‘The Wealth of Nations’, the Scottish economist Adam Smith wrote “it is not to the benevolence of the baker, the butcher and the brewer that we owe our meal, but to their regard for their self interest”. By this, Smith meant that the baker does not produce bread out of an altruistic desire to bake good bread for people to enjoy. Instead, what prompts the decision to get up in the morning is the desire to sell bread for a price that will yield a profit. The market system, through changes in price, co-ordinates decentralized decisions such as this so that, despite the fact that they are motivated by self-interest, the final outcome should be in society’s favour. The following example illustrates this.
Suppose that the demand for private health insurance rises. The increased consumer demand for health insurance will push premiums upwards. This increase in price will act as a signal to insurance companies that private health insurance has become more popular. Insurance companies respond by deciding to increase their capacity in this area, prompted by the fact that the rising price has made this type of insurance more profitable to write. Adam Smith referred to this process as the ‘invisible hand’ of the market.
Consumers spend their income on goods and services. Therefore, in a free market economy, access to goods and services is determined by individual ability to pay market prices. Those with low incomes may want access to private healthcare but Lack the necessary financial resources and are forced to go without. Many criticize the free market economy as unfair. Is it morally acceptable that the rich should have a disproportionate share of what is produced? Surely the allocation of healthcare should be based on need rather than on one’s ability to pay the price charged?
Free market economies work best when there is competition. If insurance were sold by only one company, the consumer would almost certainly be exploited. Without an alternative source of supply the company could exploit its monopoly situation by charging high prices. Consumers would have no choice but to pay the prices charged if they wanted insurance. A lack of competition also discourages innovation and new product development.
The combination of profit motive and competition creates a dynamic and enterprising economy. As the American economist, Joseph Schumpeter wrote over 60 years ago: “The fundamental impulse that sets and keeps the capitalist economy in motion comes from the new consumer goods, the new methods of production and communication, the new markets and the new forms of organization that capitalist enterprise creates” He uses the term ‘creative destruction’ to describe the process by which the ‘old must be destroyed to make way for the new’. So, in present day:
General Motors…will close or downsize twelve plants in a desperate effort to avoid bankruptcy. Kodak is frantically trying to build its digital business as film declines…Several airlines have declared bankruptcy as their uneconomic cost structures cripple their ability to compete. Telecoms companies watch the value of their wires drop as mobile phones voice-over-internet and cable companies poach their customers. Blockbuster flirts with bankruptcy as new ways of delivering films make a visit to rental shop unnecessary. (Irwin Stelzer, The Sunday Times, 27 Nov 05.)
To this can be added news of the poor sales in specialist UK music shops of CDs at Christmas, as more and more people download their music from the internet or shop in supermarkets.
The Planned Economy
In the free market system, resource allocation decisions are decentralized. In a planned economy these decisions are made by government in a centralized manner. Today, due to the political revolution that took place in Eastern Europe in the late 1980s, the planned economy is almost a thing of the past. It is difficult to find an example of an economy that has all the characteristics of a planned system. Perhaps North Korea is the closest to the planned economy model. Certainly, in the past, the best examples of planned economies were often found in countries with Communist political regimes. The main characteristics of this type of economic system are outlined as follows:
Factories are owned and run by the government. There is no private property, for political reasons. Decisions about what goods and services to produce are made by a team of central planners. Like everyone else in this type of economy, the central planners are employed by the state. The state has a mix of priorities: political, economic and social, and plans accordingly. For example, central planners may try to anticipate the type of goods the population will wish to consume before setting factory production targets. To enable the factories to achieve their targets the government allocates the necessary resources. These include labour in addition to raw materials. Often, however, strategic and political priorities take precedence over social needs and wants, It is possible that when or if they have met their quotas, individuals may be allowed to sell any surplus on the open market, but that would be the limit of ‘free enterprise’. Prices within the planned economy are not determined by market forces. Instead, the government sets them from the centre. The objective behind this approach may be that the basic essentials of life such as food, heating and housing should be available to all, regardless of their income. By setting very low prices for these commodities they are affordable for all. In practice, this creates an additional problem as low prices set usually result in shortages. This has meant that popular goods and services such as cars and flats were allocated by a system of queuing and waiting lists rather than by market prices.
The Mixed Economy
As the name implies, the mixed economy is a combination of a free market economy and a planned economy. This means that some resource allocation decisions are made by the market, while other resources are allocated by the government. All mixed economies are composed of two sectors. The public sector is owned and run by the government and the private sector is owned and run by entrepreneurs, although the government can also regulate the private sector without actually gaining ownership (Gaining ownership, i.e. nationalizing an industry or a business).
The aim of the mixed economy is to try to achieve the strength and dynamism of the free market while trying to avoid the problems created by market failure. In practice, market forces do not always produce outcomes that are favorable for society as a whole. When this occurs the market is said to have failed. Governments that run mixed economies use the public sector and its activities to combat the problems presented by market failure. Examples of market failure include the following:
Inability of markets to deal with unforeseen or extreme natural disasters and political or economic shocks. More generally, the supply side of the economy may lack flexibility and cannot always respond readily to changes in demand; and demand itself may lack flexibility if, for example, there is a tack of consumer confidence in the markets, as there will be during an economic recession. Governments may be obliged to take direct measures to promote both supply and demand. The existence of natural monopolies. These are industries where it is only economically viable for one firm to supply the market. In this situation, the government may wish to nationalize or, at least, regulate the operation to prevent high prices and consumer exploitation. Firms in the private sector may be overly concerned with their internal profits. As a result, they may make decisions which are positive for them but negative for society as a whole. For example, a firm may decide to dump its waste rather than treating it property in order to keep costs down and profits up. Other types of goods and services might be inadequately provided for by the private sector. For example, the private sector only provides schooling for those wealthy enough to pay the fees. This could affect the economic performance of the country as, eventually, many people may remain uneducated. In this situation, the state may decide to use the public sector to provide education free of charge at the point of delivery.
Attitudes towards Mixed Economies
In practice, all economies are mixed to a greater or lesser extent. Even the constituent states of the old Soviet Union allowed their citizens to sell privately vegetables that they had grown on their own land. However, there is considerable disagreement between economists on the degree of mixing that should take place within a mixed economy. In some countries the public sector is still larger than the private sector.
As suggested above, it can be said that all economies in the real world are, in fact, ‘mixed’. There is a wide range of possible models from one extreme, where the government has relatively little input (close to being free market economies), to the right wing or left wing dictatorship where there is little room for individual choice or decision-making (basically planned economies). One might expect the former to be fully democratic regimes, but in recent years some authoritarian regimes have fostered free market principles to achieve economic growth and prosperity. The problem here may be the trade-off between prosperity and human rights. On the other hand, one clear possibility is that as countries like China become richer, the people will demand not only their share of the wealth but also increasing freedom of choice in how they use it. However, this is not a foregone conclusion and in a recent poll in Russia (reported in ‘The Observer’ 23 December 2007) only 20% of Russians favoured what they understood as democracy and the market economy.
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Evaluation: A change in the balance of power
By the mid-1970s, the weaknesses of the planned economies were apparent. The task faced by the central planners was proving to be almost impossible. Due to time lags and unexpected changes in consumer tastes, planners frequently decided to make products that the population no longer wanted. The planned system offered little by way of incentives for both firms and their workers. In a planned system, firms did not have to make profits to survive so there was no incentive for people to work hard. Managers concentrated on fulfilling production quotas, so the quality of what was produced was often of secondary importance to the quantity. The failings of this type of system not only led to its demise but also to the privatization revolution that took place in the mixed economies.
Free market economists who believed that the weaknesses of the planned system were also present in the state-run nationalized industries such as the telephone service. To return these industries to profit they needed to be opened up to market forces. New companies were allowed to compete alongside the privatized Telecom. Management and staff were forced to become more efficient and more market orientated. The change in ownership also helped to stimulate change. Shareholders were proving to be far more demanding in terms of pushing for improvements in performance.
In the former Communist countries, the vast changes required in political, economic and social structure are progressing unevenly. Conversion from a planned to a free market economy ideally requires a formidable combination of:
Political stability and social order, including the absence of corruption;
The transfer to private ownership of the factors of production;
The development of competition and flexible labour markets;
The development of a complex financial system to acquire and channel investment;
Prospects and Problems for the World Economy
It is generally agreed that the Communist planned economy ‘failed to deliver’, but debate continues on the appropriate public/private balance for the mixed economy of the twenty-first century. ‘Free marketers’ propose further reduction of the public sector, reduced regulation and the introduction of a simplified taxation system, including a low, flat rate of income tax, common for all tax payers. The ‘laws’ of demand and supply should be almost the sole means of allocating limited resources. Consider, for example, the recent oil crisis and the environment. In eighteenth-century, where horse-drawn carriages dominated the transport system, many predicted the end of city life, as every street would soon be covered by several feet of dung, and the population would either be suffocated beneath the dung or poisoned by the methane emitted! Instead, we soon had steam power, electricity and the internal combustion engine. Then the ‘experts’ predicted that oil reserves would be exhausted sometime in the next decade or two, but there were new discovery areas like the new technology for searching and recovery and more economical usage of energy.
During this century, the argument is that the laws of demand and supply will ensure further progress on these fronts and on the problems of pollution and the disposal of nuclear waste, greenhouse gases etc. Rises in oil prices to record levels, which make most of the world’s semi-submersible oil rigs, to experience their biggest surge in orders which followed the last huge rise in oil prices, and there may soon be a means of disposing of greenhouse gases underground. Moreover, new sources of energy like further developments in nuclear power, oil shale and a variety of renewable resources like ‘biomass’ and solar and wind power will first supplement and then replace petroleum oil. Battery or vegetable-oil-driven cars will travel across the world to replace horse-drawn carriages and their successors. The new battery-driven Lotus sports car perhaps points the way and during 2009 we expect the launch of the Mitsubishi l MiEV. ‘Free marketers’ demand minimal interference from Government in the economic process and would, therefore, be very critical of such measures as the current actions to boost the economy that would involve massive Government spending and borrowing and sooner or later the inevitable tax increases to pay for them. They might even object to the measures to help the financial system. The same applies to the rest of the economy which needs rebalancing. Let the markets decide the exchange rate and the level of economic activity and employment. Government rescue famous banks, motor or retail firms, may make headlines and even win local elections but they need to be considered in relation to the concept of ‘opportunity cost’. If over the last 30 years scarce capital resources had gone to prop up companies that deserved to fail, there would be no ‘opportunity’ to create ‘Microsoft’, ‘Apple’, ‘Vodafone’, ‘Google’ etc. “Markets are not interested in headlines but in returns and consequently should be able to allocate capital reasonably efficiently”( ‘The Independent’ 8 December 2008). The idea that capitalism is fine when things are going well but a dose of socialism needs to be administered when things go badly is not the answer.
Others have less confidence in the free market models. They predict a collapsing scenario, based on a number of criteria:
Despite disease, hunger and natural disasters, the world’s population will quadruple over a period of 30 years. Predictions concerning the general population growth have been raised recently, but China’s and India’s growth, in particular, will cause an imbalance between demand and supply in relation to food, raw materials and energy. Demand simply grows too fast for supply to respond adequately. The result will be scarcity and rising prices. Political and military conflicts continue between and within nations, so maintaining global instability.
Economic and societal imbalances within and between nations and groups of nations are widening: international trade deficits (imports compared to exports), now at their highest all over the world since records began; fiscal deficits (tax revenue compared to Government expenditure); the widening gap between rich and poor; and rising national and personal debt levels. This left many families vulnerable to rising mortgage rates, council and other taxes and energy bills, a situation which overall has deteriorated even further since.
Many of the above criteria are said by the critics of free market economics to reflect the character of capitalism. Apart from its inherent instability, capitalism they say must sustain economic growth in order to maintain capital accumulation, and it is this insistence on constant growth that is threatening the planet’s ecosystem without necessarily enhancing social justice.
Perhaps there is need for a new model to succeed the market-orientated improved model, one which focuses on the need for recycling, conservation, renewable energy and social justice, and one which embraces more international co-operation and a more effective functioning of bodies like the United Nations, World Bank and World Trade Organization.
Meanwhile, at final time of writing, January 2009, the word which best summarizes the immediate future is ‘uncertainty’, a word with which the insurance industry is familiar!
During 2007 most of the world’ stock exchanges were booming. We had enjoyed for some sixteen years what became known as the ‘nice’ (non-inflationary, consistently expansionary) era, but it soon became apparent that there were increasing inflationary pressures. The price of crude oil eventually went to $150 per barrel and UK pump prices above l00p per liter. All raw material prices were rising to feed the demand for industrial growth and agricultural prices rose partly as a result of floods or droughts in various countries, and diseases affecting pigs and sheep, but also because of soaring demand for food and shortages caused by farmers switching from food production to more profitable bio fuels. Then came the summer financial crisis and ‘credit crunch’ which threatened not just the financial system but many parts of the world economy.
Meanwhile, with new economic models come new economic theories. Monetary theory which became the key to economic reform, perhaps to be replaced by a new ‘Theory of Credit’ so that we can better understand, and perhaps in future, avoid the current brand of financial and economic shock.
However, it is advised to monitor global developments, since, as indicated above, a key feature of the global economy is ‘uncertainty’. Two well-known judgments of the reliability of economists come to mind, it is said that if you were to place all the world’s economists end to end in a straight line, a) they would still tend to point in different directions and b) they would still fail to come to a conclusion. On the first Tuesday of most months some of the most eminent economists meet for lunch. During the last meeting they naturally discussed the current crisis and at end they agreed on just one point; that there was absolutely no consensus about what had happened or what to do.
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