Table of Contents
- Types of economic systems
- A capitalist economic system (capitalism)
- The concept of self-interest in capitalism
- Features of capitalism
- Advantages of capitalism
- Disadvantages of capitalism
- The socialist economic system (socialism)
- Features of socialism
- Advantages of socialism
- Disadvantages of socialism
- Mixed economic system
- The traditional economy
- A capitalist economic system (capitalism)
An economic system is a structure of decision-making. It has to do with the policies and entities that shape it. It involves production, firms, distribution of economic outputs, and input allocation. An economic system is a combination of various entities. These entities provide an economic structure that defines the social community. It is the set of principles by which economic problems are addressed. These economic problems include what to produce, how to produce, for whom to produce, and efficiency in the use of resources. Societies and governments decide how to organize and distribute available resources. These resources include goods and services across a geographical location. The economic system regulates factors of production (land, labor, capital). It encompasses institutions, agencies, decision-making processes, entities, and patterns of consumption. All these comprise the economic structure of a given jurisdiction. It includes the combination of various institutions. It is therefore an economic order.
The economic system studies the link between various institutions. It determines the way information flows between institutions. It also studies the social relations within the system, including property rights and the structure of management. The analysis is basically focused on the various categories of the economic systems. We can consider it as a part of the social systems. We also look at it as the decision-making structure of an economy. The system comprises of production and allocation of economic inputs and the distribution of economic outputs. Firms and governments provide answers to the economic problems of resource allocation. Either the government or private individuals/firms own and control the means of production. The economic structure defines the social community. The method of distributing scarce resources in a country determines the type of economic system.
The economic system controls capital, labor, and trade. We know that goods of high quality are essential to the growth and development of an economy. This includes education, the environment, and social institutions. A free and competitive market is ideal because what firms supply is exactly what the consumers demand. There are different ways in which the allocation of resources takes place. In some economies, the government takes over. Others grant citizens rights over which goods they should produce and who they should sell them to.
Types of economic systems
Broadly, there are five types of economic systems that exist within an economy. These are capitalism, socialism, mixed economy, traditional economic system, and communism. There are three major types of economic systems that exist within an economy. They are capitalism, socialism, and the mixed economy.
A capitalist economic system (capitalism)
This is a free-market economy. Here, private individuals own and control the means of production. Adam Smith, a famous economist, earlier called it “the obvious and simple system of natural liberty”. It is an economic individualism that basically pursues self-interest. And the right to own private properties. These rights are usually defensible and legitimate. In this economic system, the state exists to protect individual rights. These rights are subject to certain restrictions. Individuals are free to decide what to produce and sell, the prices to charge, and where to invest. The range of their efforts when it comes to asset sales and customers has no limits.
Individuals can decide where to operate, whether in local, regional, national, or international markets. They decide the number of customers, employees, and investors. As individuals pursue their goals to maximize their wealth and profits, so it is beneficial to the whole society. They produce goods and render services. People pay for the goods and services they need and desire. The economy as a whole prospers as these activities are beneficial. Capitalism is highly democratic in nature.
The concept of self-interest in capitalism
Because people pursue their own profits, there is a high level of competition. Businesses try to attract more customers in different ways. These strategies include improving the quality of their products and lowering prices. Such competition helps to ensure that no single entity controls the entire market. According to Adam Smith, the competition which characterizes capitalism should be left to operate on its own. There should be no government intervention and control over competition. Because of this, capitalism is usually referred to as “laissez-faire”, meaning “leave alone” in French. Capitalism consists of free enterprise and the free market. In a nutshell, capitalism is the private ownership of the means of production. The direction of competition goes toward profit. There is an absence of government interference in the competition. The government does not determine what goods and services to be produced. Demand and supply mechanisms drive them.
Capitalism depends on private individuals’ capital to produce goods and get profit in return. This however increases the capital stock of the private enterprise. Individuals can accumulate great economic power and wealth. This can create social discontent which can also lead to immoral business practices. Examples of capitalist countries are Ireland, United Kingdom, Canada, Singapore, and Switzerland.
Features of capitalism
Freedom of property ownership
Individuals are free to own and control the means of production. They own companies and factories and are free to employ others to work for them. These individuals also place these workers on wages and salaries. Producers under capitalism have the right to own almost any category of commodities. These include houses, cars, airplanes, ships, etc.
Most people start businesses with the sole aim of making a profit. Each individual tries to increase his profit by adopting different market strategies. The profit motive is a very common feature of capitalism.
People think of their own interests and welfare above that of the community or state. We cannot rule self-interest out of capitalism because it is a strong feature.
Minimum government interference
Government interference is minimum both in the individual lives and the business sector. The major goal of the government is to provide general justice. They ensure that individuals maintain law and order. Social services such as education, roads, electricity, water, individuals cannot provide conveniently. In this case, the government steps in. Another thing the government does here is to defend the citizens.
Individuals have the right to start any form of business of their choice. They can also dissolve it at their own pace. This happens as long as they adhere to the laws that the government laid down.
There is a high rate of competition among businesses. This usually leads to the production of high-quality goods and services. This is because a high rate of competition motivates high-quality production. This is to attract higher demand.
Freedom of choice
Capitalism provides choices for individuals. Consumers can choose whatever brand of products they want to buy. People are free to work wherever they want. Therefore there is freedom of choice for individuals.
There are usually class conflicts. These are struggles between the working class and the government. These struggles can take the form of negotiations, ultimatums, strikes, and protests.
Advantages of capitalism
Efficient resource allocation
Competition leads to the most efficient resource allocation. This is because companies utilize the factors of production. This fosters efficient production. They cut down costs to improve competitiveness and productivity. If firms become unproductive, they will go out of business.
Businesses engage in heavy research to develop their firms. The incentives for constant innovation exists for entrepreneurs. This happens because companies compete. The competition is to provide high-standard products to customers. Business firms take risks in setting up businesses. This is because of the large financial rewards that follow. If the scope for private profit is not present, then new firms will not come up. Businesses only produce the goods and services that are profitable.
Economic freedom fosters political freedom. A strong relationship exists between these variables. Any state that limits the rights of individuals will face greater political interference. These rights include setting up new businesses and choosing where to work. This economic system, therefore, fosters political freedom.
This economic system is a tool to bring people together and overcome discrimination. It encourages both domestic and international trade. This incentive also works towards breaking down barriers. It also works towards bringing people and countries together. It ignores racial differences, tribal differences, and religious differences. People who hate one another can deal with and help one another. Quoting Gary Becker, profit motive would penalize those firms and individuals who practice racial discrimination.
Raising the standards of living
It has contributed to raising the standards of living and reducing poverty. Fostering economic growth leads to a rise in the standards of living in an economy. We can trace an improved standard of living to a fall in the poverty rate.
Consumers pay whatever they want to pay for the brand of a particular product of their choice. In other words, consumers choose whatever they want to consume. Competition develops in the private sector. This is to provide the best quality of possible goods and services. It is through the availability of these choices that competition develops. This advantage boosts the level of innovation. This is because an average individual will always want to buy the best item he can afford. Affordable items with better quality always exist under this economic system.
If firms lose their efficiency, they will go out of business. This amounts to short-term problems such as unemployment. This however allows labor and capital to be more innovative and efficient.
Firms under capitalism can respond to changes in consumer preferences. They respond to new consumer trends. It has to do with efficiency in response to changes in consumer taste and preferences.
Firms have the motivation to be efficiently productive. They cut down costs to improve competitiveness and productivity. Cutting down costs while maintaining a high quality of products improves efficient production.
Minimal government control
Basically, when the government attempts to control the economy, it ends up with problems. These problems include corruption, poor information, and lack of incentives. When a corrupt government controls the economy, it will do more harm than good. It has a very high tendency of eroding the economy.
Disadvantages of capitalism
As a result of high competition, businesses will not care for the disadvantaged and less privileged. This class of people includes the aged, disabled, and orphans. This deviates focus from the benefits of society leading to higher income inequality. It widens the gap between the rich and the poor. This is because capitalism bases on self-interest rather than the interest of society. Some businesses can exploit consumers.
Capitalism does not always stay in a growth pattern
It is pleasurable to live in a capitalist society during the period of expansion. When the economy begins to contract, there will be a higher chance of a recession occurring. This recession can cause a higher rate of unemployment and declining revenue for producers. Those with higher wealth have immunity to this time. This is because they go back to fetch wealth from their reserves to maintain their quality of life. Low-income earners will not have the opportunity to enjoy that luxury.
Low-skilled people will have fewer advantages
Real capitalism expects people to remain competitive. Competition is needed to remain active in the economy. If you lack the skills in demand, there may be no place for you to exist. Social safety and empowerment programs are not part of the theory. It is either you contribute or you do not. If you do not contribute, then your experience will become life-threatening. Capitalism does not account for age, health, wisdom, or experience. Every individual always looks out for themselves above every other person. This implies that there will be less emphasis on education, social amenities, transportation, and healthcare needs.
Requirements for successful consumption
Capitalism is more effective only when consumers spend their money. If consumers decide to save, then there will be struggles to survive as profit is the sole aim and objective. In essence, capitalism requires consumption to be successful to survive.
Ignorance of ongoing opportunities
The capitalist does not define “fairness” the same way as other market systems will. Even though everyone has an equal opportunity to pursue success, some factors can limit this possibility. Those with more money have more chances than those with less money.
Socialism is an economic system in which the government owns and controls the means of production. In this system, the main aim is not self-centered. Earning personal profits is not the sole aim. Socialism considers basically the needs of society. Asa result of this, there is no competition for profit among individuals. They work for the good of everyone. Under socialism, the government has full control over the economy. It is a centrally planned or a command economic system. In a pictorial view, the outcome is classless though not fulfilled.
Under socialism, individuals may possess little property. They do not have the right to own large means of production such as factories or companies. This implies that they cannot employ people to work for them. The attributes of a socialist economy are directly the opposite of capitalism. The central planning committee (government) gives answers to the basic economic problems. That is what to produce, how to produce, for whom to produce, and efficiency in the use of resources. They also decide the price to charge for the goods and services.
The focus of government on the good of society usually leads to more efficiency in the use of resources. The government decides the amount to pay workers. The government provides necessities such as healthcare schemes and education for free. The state determines what people need in the economy. Examples of socialist countries are the Soviet Union, Cuba, China, and Venezuela.
The governments are the central planners. They decide what to produce, the quantity to produce and how to produce them. Because of this, the working price is minimal-at the affordability of the citizens.
The concentration of power
Only one existing political party has all the economic and political power in its hands. This makes the government very powerful.
Lack of profit motive
Workers tend to lose their personal drive due to the absence of a profit motive. This drive on a normal case is what businessmen have when working for themselves.
Collective ownership is the most important attribute of socialism. The government owns all the means of production. All factories, big machines, commercial transportation, and big commercial undertaking belong to the government.
Absence of exploitation
The government employs all the citizens. No one has the right to own a firm or employ workers. No one can exploit another as a result of this. The exploitation of consumers which is sometimes present under capitalism is absent under socialism.
No work, no food
Everyone who is not disabled has to work. Anyone who does not work will not receive payment. Although this rule does not apply to the disabled/physically challenged, the aged, or the less privileged.
Absence of exploitation
The government ensures that no one experiences exploitation. Each person receives and contributes according to their potentials. Also, each person has guaranteed access to basic goods/necessities. This also includes those who are unable to contribute.
The system helps to minimize poverty as there exists equality among the people. Each person has the same right to necessities of life (healthcare, education, infrastructure).
Rejection of discrimination
Socialism does not approve of discrimination because equality is the basic norm. Every individual does what he is good at and enjoys best. The government protects natural resources for posterity. They provide higher remuneration for jobs that should be done but no one to perform them.
Socialism focuses more on the needs of society. Because of this, it encourages selflessness rather than selfishness. This amounts to more efficient use of resources.
Hidden taxes are those taxes on consumer goods. The taxes are transferred to consumers without the knowledge of consumers. A proper socialist economic system does not have taxes. The government takes everything and pays allowances to the people.
Depending on corporate pooling to get things done is a great disadvantage of socialism. Competition becomes an odd norm to the system. Society expects everyone to cooperate without competing with one another. Competitive individuals seem to find ways to cause social catastrophe for their personal interests. This is the view socialism has towards competitors.
It kills innovation
As a result of the absence of competition, the system discourages innovation. Socialism does not reward business ventures and competition. The economic system does not encourage innovation as capitalism does.
Unlike capitalism, socialism does not provide choices to the people. Consumers cannot pay for a product of their choice, it has to be that brand which the government firm produces. It is a form of coercion on people to pay a particular price for a particular product because of its monopolistic nature.
Lack of incentives
A high progressive taxation rate can cause disincentives to work and set up businesses. Entrepreneurs may have the feeling that the government is taking a high percentage of their profits. They prefer to avoid that risk or work abroad.
Ideally, the government will succeed in regulating firms, labor markets, and run public industries. Government intervention is prone to government failure and inefficient resource allocation. For instance, the regulation of the labor market such as minimizing g or maximizing the working period can lead to unemployment. Lack of flexibility can surface as well. Firms need to deal with sudden shoot up in demand. High regulation of firms which is an extra cost can discourage investment and lower economic growth.
It is difficult to remove subsidies/government benefits.
Rationing of healthcare
Doctors face a higher rate of financial constraints. They ration non-urgent operations and there are usually waiting lists than in capitalism.
Mixed economic system
A mixed economy is a case in which both capitalism and socialism coexist. Both the government and private individuals own and control the means of production. They both decide what to produce, how to produce, and how much they want to charge. A mixed economy allows a certain level of economic freedom in the use of capital. It also allows the government to interfere in economic activities to achieve social aims.
Mixed economic systems allow and maintain private ownership and control of properties. This private control is subject to government regulations. They select industries that are fit to produce public goods. The system does not block the private sector from pursuing profit but yet regulates businesses. They may nationalize some industries that produce public goods. Although the public sector and the private sector work together, they may compete for the same limited resources. The government’s role depends on the priorities of the citizens. They create a central plan that guides the economy. Most countries have mixed economies. Examples of countries operating under this system are Russia, Nigeria, Iceland, the United States of America, and France.
Features of mixed economic systems
Control of the pricing system
It is not usual in a mixed economy for the government to frequently take action to improve the working of the pricing system. The government influences consumption and production through price regulation. For example, the government can levy high taxes on alcohol to reduce its consumption.
Private and public sectors
Two sectors coexist in the economy, the public, and the private sectors. The government owns some of the business enterprises while private individuals own the rest. The two separate bodies make economic decisions. They determine what to produce, how to produce, and for whom to produce. They both determine how efficiently they should allocate resources.
Advantages of mixed economic system
Because a mixed economy combines the capitalist and the socialist economy, it combines both the advantages and the disadvantages of the two systems. Some of the advantages are as follows;
Efficiency in distribution
The distribution of goods and services takes place where people need them the most. It allows the price to measure supply and demand.
It rewards the most efficient producers with higher profits.
It encourages business innovation. This is to meet the needs of customers more creatively, cheaply, and efficiently.
A major disadvantage of a mixed economy is that it tends to press towards government control. Government control seems to overshadow individual freedoms. Sometimes, the requirements of government control may cost a company. This high cost resulting from it may be so much, this may put some companies out of business. Unsuccessful regulations can keep features of production paralyzed and because of government involvement, efficiency hardly occurs. This system places more emphasis on profit than the welfare of the citizens. This imbalance is usually at the expense of social welfare. A high level of corruption exists both on part of the government and individuals. There exists an inequality.
Differences between the three types of economic systems
Under capitalism, private individuals provide those goods and services which the society needs. In socialism, it is the government that provides those goods and services. In a mixed economy, the private sector produces the goods and services it can produce. The government will provide those essential goods and services which the private sector fails to provide.
The traditional economy
Traditional economies depend on beliefs, customs (cultural values), and history. Tradition guides economic decisions mostly in terms of production and distribution in terms of production and allocation of resources. such economies usually depend on farming, hunting, fishing, gathering, or some of their combinations. They often use the barter system for trading instead of money exchange. People in traditional economies mostly live in families, tribes, and clans. Other types of economies that use a large volume of natural resources can affect the traditional economy negatively. They most times produce only what they need. Most of these economies operate in developing countries. A lot of traditional economies have evolved into a mixed type that possesses the features of capitalism, socialism, and communism. The current examples of traditional economies are Bhutan and Haiti.
The history of the three major economic systems can be traced from the inefficiencies of communism and the traditional economic system.
Under communism, the state owns and controls all means of production and distribution as well as properties. Everyone produces according to his ability and resource allocation is according to their needs. Like socialism, communism is a classless economic system where everyone is regarded as equal. The entire community owns and controls all means of production and properties. Communist economies include North Korea, China, and Cuba.
Communism is similar to socialism in some ways such as the classless society, collective ownership, and central planning.
Chyou is a published author who focuses on the field of international business. After an established career facilitating mergers and acquisitions for medium to large corporations, Chyou turned to writing to help students better understand international business concepts.