economics economic systems

8/3/2019 ECONOMICS Economic Systems

http://slidepdf.com/reader/full/economics-economic-systems 1/8

Economic Systems

There are three main questions any economy has to answer:

• What is to be produced?

• How will it be produced?

• Who will get what is produced?

These three fundamental questions have to be answered by any economy, whether it is a highly

developed economy, the poorest of countries, or a small group of people stranded on a desert

island.

To answer these questions, different economic systems have developed. These systems revolve

around how people in those societies allocate scarce resources to satisfy competing wants and

needs. In other words, an economic system attempts to find ways of solving the basic economic

problem.

To think about how this works, imagine you were stranded on a desert island with a group of

friends. You each know that you have to find some way of surviving. You have a meeting and

Identify the basic necessities needed to survive - food, water, clothing, shelter - and then put

your minds to working out how you are going to provide for these needs.

Stranded on a desert island - what sort of system would you set up to solve the economic

problem?

You identify each person's particular talents and interests, and split up the tasks of providing for

your needs by agreeing to exchange what you each produce. Some people in the group have an

interest in fishing and agree to spend their time catching enough fish for all. Others have skills in

design and technology and volunteer to build shelter and so on.

The common agreement to exchange is crucial to survival. There might also have to be some way

in which the rate of exchange will be managed. For example, the people going fishing pointed out

that what they were doing was so essential to survival that they ought to be allowed to keepmore of the fish they caught, whilst another group felt the fact that they collected water pointed



out that they were going to collect water and that was the most important thing, some agreed

means of exchange would be essential.

This simple example highlights the three key questions any economy has to answer.

• What is to be produced?

This refers to the food, clothing, shelter, water and so on, which the friends

identified.

• How is it going to be produced?

This is exemplified by the group discussions about their relative skills and what each

person could contribute.

• Who gets what is produced?

This is characterised by the discussions about how much each group should get in

exchange for what they bring to the island.

In any economy, these questions remain, but the system to allocate scarce resources might be

highly complex. We might not even recognise it as a 'system' but in reality, many developed

economies run like well-oiled machines even if we sometimes think they are highly inefficient.

There are, of course, problems in many economies: we see examples of shortage, glut,

starvation, famine, excess and poverty across the globe. In such cases, it might be seen that

the economic system to allocate scarce resources is not working properly for a variety of

reasons.

In essence, there are three main types of economic system that can be identified. These are:

•A command, or planned, economy

• A market or free market economy

• A mixed economy

We will look at each in turn.

The Command, or Planned, Economy

The famous GUM department store in Moscow in 1990. Lots of people and shops but not a lot

to buy!



Command, or Planned (referred to hereafter as planned) economies have been closely

associated with the so-called communist regimes in Russia and Eastern Europe that arose from

1917 onwards, finally collapsing in the late 1980s and early 1990s. We say 'so-called'

communist states because they were not the states that Marx and Engels would have

recognised; however, they did have some characteristics of that philosophy.

The main feature of this type of economic system is the way in which resources are allocated. In

a planned system, the three basic questions are answered through some form of central

planning. In the former Union of Soviet Socialist Republics (USSR), the state central planning

authority was called Gosplan. Its function was to identify what goods and services were needed

by the people, how these goods and services would be produced and how the state output

would be distributed.

It takes a considerable imagination to understand the complexity of such a task. Needless to

say, it involved huge numbers of people involved in the planning process - bureaucrats shuffling

paper and directing operations. In reality, it meant that factories, farms and so on were given

directions about what they should be producing. They were also given the resources that the

planners had worked out would be necessary for producing that output. Most factories and

farms were given output targets to reach; once produced, it might be the job of another body to

ensure that goods were distributed.

In return for the labour expended in producing this output, a wage was given. This wage,

however, bore no relation to the value of the output being produced. The wage was planned to

allow workers to be able to buy the things the planners had worked out they needed to live on.

To enable this to happen, prices were also set by the planning authorities.

In theory, everyone had enough to live on. Wage differentials were minimal - whether you were

a highly qualified university professor or a street cleaner, wages only varied by a small amount.

In the late 1980s to early 1990s, it was estimated that the average income in a city like Moscowwas between £18 and £38 per month. As such, the income distribution could be seen as being

very narrow, with few 'rich' and few 'poor'. Most people had a job if they wanted one, regardless

of the type of job; unemployment was therefore zero. Inflation did not exist as we know it

because of the system of price fixing and there were very few homeless people - the state

provided housing.

Housing estate outside Moscow, 1990. Homeless people were rare in Soviet Russia but the

quality of housing and of housing accommodation was not necessarily of the highest quality! To

understand this type of system, it is important to try to appreciate the political assumptions

underpinning it. There was an expectation that each person was not working for their own



benefit but for the good of the state. If everyone worked hard and excelled, the state would also

excel and the collective pride that resulted was the reward for all this hard work. The power of

the state was everything and in many cases, would dictate how resources were allocated. This

helps to explain the investment in sport, military and space technology that occurred in the

USSR. A nation that could go to the Olympic Games and compete successfully with the

Americans was seen as being an important political statement: communism could outdo the

corrupt and selfish capitalist philosophy. Equally, the status bestowed on space pioneers such as

Yuri Gagarin, the first man in space, was extraordinary. He personified what a planned economy

could achieve.

These assumptions, however, did not always manifest themselves in reality. People did not

always work as hard for the common good as might be expected. Factories found that if they

met their targets or even excelled them, they were given higher targets next year but not

necessarily the resources to do so, nor any extra wages - so what was the point? Targets soon

appeared to become subject to what has been called 'Goodhart's Law' , where targets used to

manage something become corrupted to the extent that they cease to be able to be used to

measure what you want them to measure!

The communication between the different sectors of the economy was not always good. It was

estimated that something of the order of 40% of all agricultural produce rotted before it could

be processed or reach its intended markets. Price fixing meant that the pressure of supply and

demand was contained, shortages and surpluses developed and were not eliminated. Product

quality fell, negative externalities like pollution increased and inefficiency was endemic.

The planned system in the USSR was founded on egalitarian principles; the reality tended to be

inefficient and wasteful..

Some examples of how this inefficiency crept in can be highlighted as follows.

• At one stage, there was a massive surplus of rubber. At the same time, planners were

alerted to a shortage of shoes and boots. The obvious answer was to divert resources and

use the rubber to produce shoes. Millions of pairs of rubber shoes were produced but were

so uncomfortable and unhygienic that they were left piled high in warehouses across the

USSR.



• Many roads in the USSR and even in the capital, Moscow, suffered from potholes.

Gangs of workers would be tasked to go and repair these potholes; indeed, that is what

they did. They would arrive with a lorry full of tarmac, shovel some into the offending hole

and flatten it out with the back of their shovel. Job done and off they went. The next car

that came along very quickly dislodged the tarmac and Muscovites were back to square

one.

• Workers were told to go and decorate hotel rooms in a Moscow hotel. The woodwork,

including the windows, needed painting. That is what the workers did - they painted the

windows. There was no preparation of the woodwork, no masking of the windows, just

paint applied to the wood and most of the window as well! Still, the job had been

completed as requested.

• Four women all have jobs - their job is to sweep leaves and litter in a local park. They

are each given their allocated section to clean. They do this by sweeping the leaves and

litter from their section onto another section. It does not take much imagination to work

out the futility of this process, but it does mean that everyone has a job!

Some of these examples come from personal observation - as ridiculous as they might sound.

At the other extreme were examples of amazing achievements - the space programme for one,

but also the move from a backward, agrarian-based economy to one of the most powerful

nations on earth, all in the space of just 40 years. Additionally, the metro and public transport

systems in Moscow were to be envied - and at ridiculously low prices. Despite this, the

pressures of the inefficiencies in the system did mean that something had to change and with

the accession of Mikhail Gorbachev to the presidency in 1985, things changed very rapidly

indeed.

To inject the element of efficiency into the system, a whole culture change was necessary. The

acceptance of some form of profit motive as a means to improve the allocation of resources andimprove quality and efficiency, along with the abandonment of price fixing, was a key part of

the programme. When price fixing was removed, it was invariably followed by rapid inflation as

the pent-up demand and shortage of supply began to feed through into the system. For many

ordinary Russians, the move to a capitalist economy meant hardship, uncertainty and economic

collapse. Gone were the certainties of the old planned system.

Cuba - still ruled by Fidel Castro as a planned economy. Inefficiencies in the system, as well as

sanctions by the US, have not helped the country to develop as its potential might suggest.

Planned economies still exist in some parts of the world, most notably in Cuba and some states

in Africa. In most cases, these economies are high on political rhetoric about equality but low on

economic benefits to the population. It must be remembered that there are elements of a

planned system that have some benefit, notably in the provision of public goods. However, as

an economic system in answering the basic questions of the economic problem, it has been

found wanting.

The Market Economy

Pure market economies rarely exist but in theory, a market economy answers the three

questions that form the economic problem through a market system. The market system is

based on the demand and supply of products. Demand and supply determine prices and prices

act as signals to both producers (suppliers) and consumers (who create demand).

The market system relies on a number of factors to ensure that it works efficiently.



• The profit motive - the incentive for a reward for enterprise

• Good levels of information being available to both producers and consumers

• Price accurately reflecting the costs and benefits of consumption and production

• The ease with which resources can move to different uses

At the heart of the market system is the profit motive. Entrepreneurs (those who organise

resources into production) are stimulated to take risks and produce goods and services by the

prospect of seeing some return on their efforts. The extent to which they achieve this success is

dependent on identifying the level of demand for the good or service, as well as their ability to

manage production efficiently. If the costs of providing the good or service is less than the

revenue that they receive from selling those goods and services, they will make a profit. If they

can maximise revenue whilst reducing costs to a minimum, the level of profit they make will be

higher.

To maximise revenue and reduce costs, producers rely on high quality information to enable

them to access supplies at minimum cost, find ways of organising production in the most

efficient way and finding resources at minimum cost. Equally, consumers rely on information to

give them the guidance about what is available and what they are getting for their money.

To enable this to happen, price has a central role. It acts as a signal to both consumers and

producers. For consumers, it tells them whether what they are being asked to give up in terms

of money reflects the value or the level of satisfaction that will be gained from consumption. If I

buy a CD priced at £12.99 but do not like the music on it, I might decide that I was not getting

£12.99 worth of value - I could have used that £12.99 to better effect by buying something else

that would have given me more satisfaction.

For consumers, price tells them something about the relationship between the cost of production and the level of profit they are making. If prices are falling then this suggests

demand is also falling. As a result, the revenue being received from sales set against the cost of

supplying the good will narrow. There will come a point where that difference is so small that

the producer might decide that they would be better placed moving onto some other line of

production.

Price will only act as an accurate signal to consumers and producers if it properly reflects the

costs and benefits of production and consumption. This implies that prices will include all the

positive and negative externalities that are associated with production and consumption - in

many cases, this does not occur. When this happens, we get what is called market failure - an

inefficient allocation of resources.

If we assume that prices accurately reflect costs and benefits, decisions made by both producers

and consumers will lead to an efficient allocation of resources. This can only happen if resources

are able to move from one use to another. The ease with which resources can transfer from one

use to another is therefore important. How does this work?

Imagine a company that used to produce typewriters before computers and word processors

came along. Demand was high and prices, as a result, enabled the firm to make healthy profits.

As PCs and word processing software became more accessible, demand for typewriters starts to

fall. As demand falls, prices will also start to fall. The profit margins - the difference between

price and cost of production - start to narrow. The firm can continue but things are getting more

difficult. This process will continue and eventually it will be not worth the firm's while to

continue to produce typewriters. They start to look instead at moving into production of PCs



where there is clearly demand and profits to be made. If they are able to transfer their

resources relatively easily, then they can switch production and move into a new area.

Equally, we can see similar things happen when a business hits upon a new winning idea for a

product. As the only producer, they command all the market share. Demand is high and sales

revenue strong and as a result, profits are very healthy. Other businesses start to notice that

there is a demand for this product and profits to be made. They will look at moving resources to

producing a competing product and as more firms move into the industry lured by the prospect

of profit, supply will increase. Consumers will now have more choice and firms in the industry

have to adjust prices to compete. Prices start to fall and as a result, profit levels start to shrink.

The process will continue until the market becomes saturated. Some firms will barely survive in

this competitive environment and may leave the industry. Equally, it is likely that other firms

and businesses will be looking to develop new and better products and services that will make

this product obsolete, and so the whole process starts again.

Consumer decisions about what to buy and crucially, about what not to buy are vitally important

to the market system. A decision to choose a can of Coke rather than a can of Pepsi is a small

signal to the two companies about the relative value placed on the consumption of the drinks in

relation to the price being charged. If enough people choose Coke rather than Pepsi, Pepsi have

to do something about their product or their price, or possibly both. This is how competition and

the profit motive provides the mechanism through which the market system operates and which

is absent in the planned market system.

From the description above, it should be clear that the whole market system is extremely

dynamic - it is constantly changing and evolving as products and services come and go and new

ideas and innovations take over. The pace of change can be bewildering at times and, if there is

a lack of information, lead to market failures occurring. The constant lure of the chance to strike

it rich is what drives individuals and makes the system so dynamic and relatively efficient in

allocating scarce resources.

The efficiency of the market system is not always matched in reality. There are significant

weaknesses in the market system that we can identify - weaknesses that are collectively

referred to as market failure.

The market system can fail in a number of ways:

1. The provision of public goods - public goods are goods that could not be provided under

a market system because it is not possible to charge a price for them. This is because it is

not possible to exclude those who do not pay from getting the benefits. For example, how

could the provision of a defence system that by definition protects all citizens be charged

for individually? If just one person pays then it would not be possible to exclude all others

from the protection - what reason do they have to pay if they are all being protected

anyway?

2. The provision of merit goods - merit goods are goods and services that could be

provided by a market system but if they were, there is a possibility that some people who

need these services would either not be able to afford to pay for them or would not

believe that they need them. There is a danger, therefore, that such goods and services

would be under-consumed. Examples of merit goods are health and education.

3. Income inequalities - market systems tend to throw up individuals who become very

very rich whilst there are others that struggle to survive. Such wide income inequalities

may lead to a range of social and economic problems and tensions.



4. Existence of shortages and surpluses - imperfect information tends to lead to shortages

and surpluses not being erased. A classic example is unemployment. In theory,

unemployment should not occur because wages would adjust to get rid of the surplus

labour; in reality, wages may not adjust in this way. In addition, there may be a number

of factors preventing labour resources moving from one type of job to another.

5. The existence of externalities - externalities are the effects of decision making on third

parties - individual and groups who are not involved in the initial decision.

The Mixed Economy

The vast majority of countries around the world have some form of mixed economy where some

resources are allocated through the price or market mechanism and others are allocated by the

state. In theory, such a system is able to combine the best elements of both a planned economy

and a market economy. In reality, the proportion of planned and market varies, with some

countries placing more emphasis on market solutions to resource allocations and others

favouring a greater role for state planning.

Whatever the proportions, there is never a 'best' combination; it will depend to a large extent

on the aims and objectives of the government concerned. Even with the existence of both a

planned and a market element to an economy, there can still be problems and there will be

aspects of market failure and government failure. The latter is where the government attempts

to intervene in the market, to try to solve problems that might be caused by the market

mechanism. In so doing, this creates other problems that do not ensure an efficient allocation of

resources.

The UK is a typical example of a mixed economy. We have a private sector where goods and

services are allocated on the basis of the market mechanism and a public sector where the

government provide goods and services funded through tax revenue (for the most part) for the

general public as a whole.

economics economic systems

Documents