Economic Systems
In the first few lessons of this course, we defined economics as the study of choices in the face of scarcity, and we talked about the ways people decide to use the Earth's scarce resources. Up to this point, we have made several assumptions about who gets to make those choices. We have looked at several examples of government decisions (such as allocating spending between education and defense), but most of our examples have been based on the choices made by businesses and individuals. But the ability of businesses and individuals to make economic decisions is not equal all around the world. In some nations, the government determines how all of the nation's resources will be used, while others give more power to individuals and businesses. In today's lesson, we'll look at the characteristics of these different economic systems.
Three Basic Economic Questions
Every nation has access to various natural resources, human resources, and capital resources. But how should these resources be managed? In all economies, there are three basic questions that must be answered:
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1
What goods and services will be produced?
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2
How will these goods and services be produced?
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Who will consume these goods and services?
Let's say we live in a country called Stalkland. It's a predominantly agricultural nation, and there are two primary crops that grow well in our soil: wheat and corn. Some of our citizens think we should only grow wheat, while others think we should be a nation of cornfields. How do we decide which of these goods will be produced?
There is also a lot of debate about whether Stalkland should adopt new irrigation technologies. This involves the second basic economic question: how will the corn and/or wheat be produced? Who gets to decide whether we'll use the new irrigation techniques?
Finally, who will be able to consume the wheat and/or corn that's produced, and how much will be consumed? Should it be distributed evenly among all citizens, or should there be another method of allocating our agricultural resources?
Let's take a look at how these questions are answered in different economic systems around the world.
Command Economy
In a command economy, resources are owned and controlled by the government. All three of the basic economic questions are answered by the government or central authority. The government decides what goods will be produced and how they'll be produced. It also controls who will be able to consume those goods. Some command economies control the nation's human resources just as tightly as natural or capital resources—they determine what education people receive, where they'll live, and what jobs they'll do. The communist Soviet Union is the most obvious example of a command economy, but many still exist today, such as North Korea and Cuba.
If Stalkland operated as a command economy, the Stalkland government would decide how much corn and wheat would be produced. It would force all farmers to grow the crops the government wanted them to grow. The government would also decide if the farmers should use the new irrigation technologies, and it would decide how the wheat and corn should be distributed after being harvested. It's likely that all the farmers would ship their goods to a government warehouse, and the government would then dole out a portion back to each citizen in the nation. In addition, the government would probably decide who would even be a farmer in the first place. It might decide that the nation needed more industry instead of agriculture, and then force farmers to move to cities so they could work in factories.
Traditional Economy
In a traditional economy, resources are used the way they've always been used. What goods and services will be produced? The same ones that have always been produced in the past. How will they be produced? The same way as before. Who will consume them? The same people that always have.
Traditional economies are usually found in less-developed nations that have little interaction with the global economy. Resources are almost exclusively spent on fulfilling basic needs such as food, clothing, and shelter.
In Stalkland, it's likely no one would adopt the new irrigation technologies, because that's just not the way things are done. They've always grown their crops a certain way, and they're not going to change things now. Most farmers would like to continue growing wheat or corn based on what their parents grew. They would likely have a very basic system for trading goods, perhaps relying more on barter instead of using currency.
Market Economy
Consumer
Producer
In a market economy, resources are controlled by the people, and different groups are responsible for answering our three basic economic questions. Let's look at each question individually.
What goods and services will be produced? Consumers—the people who purchase goods and services—decide what will be produced by casting "dollar votes." In other words, if consumers spend their dollars on a certain product, then more of that product will be produced. Conversely, if consumers buy less of a product, then less of it will be produced. This is because no one wants to produce a product if no consumers are buying it. The producers would lose money and go out of business! So, even though they're not doing the actual producing, it's consumers that ultimately decide what products will be produced.
How will those goods and services be produced? On the other hand, producers—the people who create goods and services—are in control of how goods and services will be produced. For the most part, consumers don't care how a product is produced, so producers are free to make their products in the most efficient way possible. By cutting down on costs, producers can make higher profits. (There are some exceptions to this. For example, consumers may avoid products from a company that damages the environment or treats its workers poorly—but as long as they act ethically, producers are generally in control of how they produce their goods and services.)
Who will consume these goods and services? Finally, goods and services are consumed by those who are willing and able to pay the market price for those products. Both consumers and producers have some control over this question. Consumers can decide how much money to offer for a particular product, while producers decide how little they're willing to accept. Thus, goods and services are allocated through the influence of prices on production and consumption decisions.
In Stalkland, this means that consumers would determine how much wheat and corn were grown based on how much of each they decided to buy. If everyone started eating more corn and buying less wheat, then corn production would rise, and wheat production would fall. Producers would decide whether or not to adopt the new irrigation techniques. Each would make this decision based on whether the improved production would be worth the cost of implementing the new technology. Lastly, the pricing of goods and exchange of money would determine who would be able to consume the wheat and corn.
Mixed Economy
A mixed economy combines elements of command and market economies. The United States, for instance, is considered a mixed economy. It is predominantly a market economy, but it also has a few elements of a command economy in its governmental policies. For example, the government sometimes encourages certain goods or services to be produced through the use of subsidies—government incentives or tax breaks designed to assist a specific industry, such as solar power or electric vehicles. Most of the world's economies today are mixed economies and exist somewhere on the spectrum between market and command. Some, like the United States, lean toward market, while others lean toward command.
Review of Key Terms
command economy: resources are owned and controlled by the government
traditional economy: resources are used the way they've always been used
market economy: resources are controlled by the people
consumers: people who purchase goods and services
producers: people who create goods and services
mixed economy: combines elements of command and market economies
subsidy: government incentive or tax break designed to assist a specific industry
The type of economic system that a nation employs heavily impacts the quality of life of its citizens. In the 1930s, for instance, the command economy employed by the Soviet Union heavily contributed to a famine that killed five to ten million people in Ukraine and Kazakhstan. The government made decisions that decreased the agricultural workforce and reduced the number of crops grown, leading to large-scale starvation. Whether the famine was intentional or simply the result of inept leaders is debated by historians; either way, this event illustrates the dangers of a command economy. The economic results of the twentieth and twenty-first centuries seem to show that market economies provide better standards of living for all levels of society. We'll learn more about the characteristics of these market economies in our next lesson.