Types of Economies
Written by Togzhan Batyrbekova
The purpose of an economy is to solve the basic economic problem, the problem of scarcity, as efficiently as possible through the allocation of resources. This can be done by asking the 3 economic questions:
-what to produce
-how to produce
-for whom to produce
There are many different economic systems that solve this in different ways, but the 3 main systems are mixed economies, planned economies and free market economies.
Planned economy
In a planned economy, the resources are allocated by the government only, which means that all the companies and production belongs, and is controlled by, the government. Examples of countries with planned economies include North Korea and Cuba.
The main advantages of this system are the higher level of equality, and the lack of demerit goods (goods that are harmful, and therefore undesirable, e.g drugs).
There are also disadvantages to a planned economy. The first, and perhaps the main one, is the lower rate of economic growth. This happens because of 2 reasons. Firstly, the lack of individual firms that would compete with each other by increasing their efficiency and lowering prices in order to make a profit, and thus increasing the country's output. Secondly, because of a lack of motivation in people, which is caused by the fact that hard work won’t necessarily be rewarded- what’s the point of working more and better if it wont pay-off? This lack of motivation results in less innovation and a lower rate of economic growth.
Another disadvantage is the possibility of exploitation of labour which happens because when the whole economy is controlled by a single entity, this entity can set any wage rate they like because there is no competition and no one to impose regulations on them.
Free market economy
In a free market economy, resources are allocated through the price mechanism, which is a system where price and quantity of a product are determined by the forces of supply and demand, as opposed to the government. This system works because producers seek to maximize profit while consumers seek to maximize utility, which means a middle ground is found where the most people are satisfied and therefore the resources are allocated in the most efficient way. In a pure free market system, everything is owned by the private sector, i.e individuals, and there is no government intervention.
Advantages of a free market economy include:
Higher competition, which results in higher efficiency and higher national output
More consumer choice, which is caused by firms looking to make a profit by providing more variety
Innovation is encouraged by the fact that it is rewarded, which results in more and faster development
More economic growth
Disadvantages of a free market include:
Inequality in wealth
No regulations in the market which can cause exploitation of workers, exploitation of the environment, exploitation of consumers
The high provision of demerit goods which happens because there are no regulations
Very little public goods. Public goods are goods like street lights. They are non-excludable, which means you can't prevent someone from using them, non-rival, which means one person's consumption of the good doesn’t affect another’s, and non-rejectable, which means the consumer cannot avoid using them. Because of this, while the goods may be desirable to consumers, it is hard to make a profit from them and therefore they are under-supplied in a free market economy.
Mixed economy
In a mixed economy, the resources are allocated both by the government and the price mechanism. While enterprise is encouraged, and the price mechanism will play a big role in the resource allocation, the government will be responsible for regulating it and trying to minimize some of the disadvantages that go with a free market system. Roles of the government in a mixed economic system:
Reduce negative externalities, which are goods that have a negative impact on a third party (e.g smoking), and market failures, which are situations where the resource allocation is not efficient (and therefore a failure of the market to achieve its goal- efficient resource allocation)
Provide public goods like defense and infrastructure
Discourage demerit goods, which can be done through taxation and other regulations
Encourage merit goods, which are goods that are socially desirable, through subsidies and other support
Control macroeconomic variables like inflation, interest rates, and unemployment
Create regulations and limitations
