6 Types of economy

Question 1

Economic system

Answer 1

An economic system is a network of organisations used to resolve the problem of what, how much, how and for whom to produce.

Question 2

Capitalist economy (free market economy)

Answer 2

An economic system organised along capitalist lines uses market-determined prices to guide our choices about the production and distribution of goods. One key role for the state is to maintain the rule of law and protect private property.

Market allocates scarce resources through the price mechanism.

Question 3

Command economy

Answer 3

An economic system where most factor resources are allocated by the government, with few officially sanctioned private markets (e.g. ex-Soviet bloc countries prior to their transition into market economies, modern-day North Korea and Venezuela).

Question 4

Mixed economy

Answer 4

Where resources are partly allocated by the market and partly by the government.

Question 5

Planned economy

Answer 5

In a planned economy, decisions about what to produce, how much to produce and for whom are decided by central planners working for the government rather than allocated using the price mechanism.

Question 6

Free market

Answer 6

System of buying and selling that is not under the control of the government, and where people can buy and sell freely, or an economy where free markets exist, and most companies and property are not owned by the state.

Question 7

Key aspects of a free-market economic system?

Answer 7

1. Light touch regulation of labour, product and financial markets
2. Legal system focuses on protecting property rights
3. Freedom to trade internationally and promote free movement of capital and labour
4. Limited market intervention (e.g. indirect taxes, subsidies, maximum and minimum prices) 5. Small size of government (including a small size/scope of welfare benefits)
5. Low tax environment / focus on “ease of doing business”
6. Consumer preferences determine allocation of resources

Question 8

Advantages of free-market competition

Answer 8

1. An efficient allocation of scarce resources – factor resources tend to go where the expected profit is highest.
2. Competitive prices for consumers as suppliers look to increase and then protect their market share.
3. Innovative dynamism provides major benefits to consumers by bringing them new goods and new processes.
4. The profit motive stimulates investment which encourages economies of scale arising from big-scale production and ultimately lower prices for consumers.
5. Competition through trade helps to reduce monopoly power and increases choice whilst lowering prices.

Question 9

Disadvantages of a free-market economic system

Answer 9

1. Free market activity can lead to a rise in income and wealth inequality as shown by rise in the Gini coefficient
2. Businesses can develop monopoly power which leads to higher prices and damage to consumer welfare
3. Under or non-provision of pure public goods (e.g. defence – goods which are non-rival and non-excludable)
4. Under-provision of merit goods such as health and education – which many cannot afford – leading to lower social welfare
5. Free markets may fail to address negative externalities from production and consumption leading to unsustainable economic growth
6. Deregulated financial markets often prone to bouts of instability – the fallout from which affects millions not directly involved

Question 10

Problems associated with central planning

Answer 10

1. Bureaucratic costs of central planning of resources – petty officialdom can lead to wasteful inefficiencies and
   therefore higher costs.
2. Problems in fixing prices of goods and services – government planners are unlikely to be as accurate as the
   market in determining suitable prices leading to numerous shortages and surpluses.
3. Absence of incentives for both workers and businesses can damage productivity and lead to large levels of
   over-employment / hidden unemployment and, ultimately, lower living standards.
4. Low productivity and weak incentives can lead to rising losses for many state-owned enterprises. The
   incentive to innovate is limited leading to a less dynamic economy.
5. Changing consumer needs and wants are not expressed as preferences in markets – the state is often slow to react to these.
6. The state can suffer from information failures and endemic corruption with elites drawing most of the wealth.
7. State-run economies are at higher risk of mal investment driven by political motivations. Projects might be
   driven by vanity rather than objective cost-benefit analysis.