Types of Economic Systems
The economy is the set of inter-related production and consumption activities that lead to determining how society’s scarce resources are allocated to satisfy its unlimited wants. The economy includes all activities related to production, consumption and trade of goods and services. The economy includes everyone from individuals to entities such as firms and governments. The economic system is the means by which economic decisions are made in a country. The economic system determines how a country answers its fundamental economic questions of what to produce, how the output is to be produced and for whom to produce. There are three main types of economic systems (also referred to as allocative mechanisms) plus the traditional or subsistence system each with its own merits and demerits. These systems are: the market economy or free market enterprise, the planned or command economy and the mixed economy.
Market Economy or Free Markey System
In a market economy, the government plays a minor role. Instead, consumers and their buying decisions drive the economy. Market decisions are mainly dominated by supply and demand. The role of the government in a market economy is simply to ensure that the market is stable. Resources are privately owned and consumers and firms make decisions based on self-interest. There is freedom of choice and the forces of demand and supply determine price and optimum quantity. There is consumer sovereignty since consumers possess the means by which decisions are made. The following graph shows the working of the free market price system. In terms of product prices, suppliers and producers supply goods and services to the market and consumers demand these goods and services. In terms of factor prices, suppliers demand factors or resources while consumers supply these factors and resources.
The following are the advantages and disadvantages of the market economy.
- Market economies respond quickly to people’s needs,
- Only those factors of production which are profitable will be employed,
- There is a wide variety of goods and services in the market,
- Modern methods of production are encouraged thus leading to lower cost of goods and services and prices.
- Public goods such as education, health care, safety and social welfare may not be provided for meaning that the government will have to intervene to provide these types of goods,
- Market economies may encourage consumption of harmful goods such as tobacco and alcohol,
- Social cost may not be considered while producing goods and services..
A planned economy is sometimes called a command economy. The most important aspect of this type of economy is that all major decisions related to the production, distribution, commodity and prices are made by the government. This type of economy lacks the kind of flexibility that is present in a market economy. There is no private sector involvement in decision-making and there is also no consumer sovereignty. All decisions are made by a central authority appointed by the government and price and quantity of output are determined by this same authority and not by the forces of demand and supply. There is no freedom of choice and profits earned belong to all citizens.
The following are the advantages and disadvantages of the planned economy.
- There is no competition between firms which results in less wastage,
- Government ensures that everybody is employed,
- Less gap between poor and rich,
- Public goods such as health care, education, safety and security are provided for to address the issue that the less fortunate in society may not be able to afford such public goods.
- No incentives for businesses to produce,
- Production of goods is decided by government thus there is no consumer sovereignty,
- Businesses usually are less efficient because of lack of profit motive,
- Methods of production may be obsolete.
The mixed economy combines elements of both the market and planned economies. This system prevails in many countries where neither the government nor the business entities control the economic activities of that country – both sectors play an important role in the economic decision-making of the country. In a mixed economy, there is flexibility in some areas and government control in others.
Advantages of Mixed Economies
- State provides the essential services;
- Private sector encouragement for profits;
- Competition keeps prices low;
- Consumer choice.
Disadvantages of Mixed Economies
- Less efficient than the private sector;
- Excessive control over business activity can add costs and discourage enterprise.
Traditional or Subsistent Economy
A traditional economy is defined as one that is based on agriculture, fishing and hunting and is guided by traditions and use barter instead of money. It is sometimes called the subsistence sector. Most people who live in this type of economy are poor. This is a closed economy where people strive to be self-sufficient. Due to the fact that the economy is closed, there is very little innovation due to the lack of contact with the outside world. Decisions as to what to produce, how to produce and for whom to produce are based on culture and habits. Private persons usually own the factors of production and this is mainly based on what is passed on from generation to generation.
Advantages of traditional economies are:
- Less bureaucracy in that the means of trading is through bartering;
- People are less dependent on the outside world.
Disadvantages of traditional economies are:
- Poverty is associated with this type of economy;
- Population growth is limited;
Types of Sectors
There are five main sectors in the economy depending on the types of resources that are being used plus levels of authority. These sectors are the primary, secondary, the tertiary, the quaternary and the quinary sectors.
The Primary Sector
The primary sector comprises of factors of the land and the sea. Agriculture is a primary sector industry as well as fishing. The former produces things of the land and the latter produces things from the sea and rivers. In addition, forestry is also another primary sector industry. Inclusive in the primary sector is also mining such as for asphalt, petroleum and bauxite.
The Secondary Sector
In the secondary sector, countries take the raw materials from the primary sector and convert them into semi-finished products. This sector can be seen as the construction, manufacturing and even the industrial sectors. The following are some of the other industries that fit into the secondary sector: automotive, electrical, chemical, energy, food, glass, textile and the consumer goods industry.
The Tertiary Sector
The tertiary sector is very different from both the primary and secondary sectors in that, in this sector, services are provided. The service sector is comprised of firms offering intangible goods. The following are some of the services that constitute the tertiary sector: retail industry, hotels and tourism services, restaurants and cafes, transportation, communication, banking services, insurance services, medical services, dental services and postal services.
The quaternary sector can be seen as an improved version of the tertiary sector. This is so because it involves services related to the knowledge sector, which includes the demand for the information-based services. The quaternary sector consists of intellectual activities. The services include intellectual activities, research and development (R&D), media, culture and information technology.
The quinary sector is the branch of a country's economy where high-level decisions are made by top-level executives in the government and nonprofit organizations. The quinary sector is the top economic sector. It involves highly paid professionals, research scientists and government officials. The people in this sector are designated with high positions and powers who make important decisions that can be far-reaching in the world around them.