ECONOMIC SYSTEMS

MECHANISMS FOR THE ALLOCATION

OF SCARCE RESOURCES

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Lesson Objectives
• Explain the three basic questions confronting
all societies
• Explain the main features of the three
economic systems
• Discuss how each economic system answers
the three basic questions
• Examine the strengths and weaknesses of each
type of economic system

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3 Basic Questions
• What to produce – product mix (what goods
and services)

• How to produce – factor mix (technology to

use: labour intensive or capital intensive)

• For whom to produce – distribution(how

should the output be shared)

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 Economic Systems
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Meaning of Economic System
• An economic system is a set of institutional
arrangements whose function is to employ most
efficiently scarce resources to meet the ends of
society
• It is a mechanism for the allocation of scarce
resources in an economy
• The economic system represents how a given
society chooses to answer the three basic
questions of what, how and for whom to produce.
• 3 Basic Types of Economics Systems:
a. Planned/Controlled Economic System
b. Free Market /Laissez Faire/ Capitalist
Economic System
c. Mixed Economic System
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 Planned Economic System
Main Features:
• All resources are owned and controlled by the state
• Production activities do not take place because of
the pursuance of personal interest. Consumers,
workers and government are all assumed to be
selfless, co-operating together to work for the
common good.
• Resources are allocated through a planning process.
• No private ownership and control of resources
• Prices of goods and services are set by the state.

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 Resource Allocation in Planned
Economies
• A central committee of planners decide:
– What to produce - the number of cars or shirts to be
manufactured in a period. Production targets are set for
each firm in the country
– How to produce - the technology or methods of
production and which factors of production are to be
employed
– For whom to produce – this is achieved through non
price rationing. The government tries to be fair in
distributing the output of the economy.
• Government is, effectively, determining how much
each consumer can consume.
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 Disadvantages of Planned Economies
• Consumers’ choices are limited significantly
• There is no consumer sovereignty
• There are little individual incentives for enterprise and
innovation.
• Lack of competition between firms makes them
inefficient.
• As economies grow, they become more complex. Hence
it becomes more difficult to plan the allocation of
resources efficiently. They bring about bureaucracy and
red tape.
• It does not respond quickly to changes in consumer
preferences
• Planned economies frequently experience shortages of
essential goods
• Resource allocation takes place at a cost unlike in free
market systems where the market does the allocation
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 Advantages of Planned Economies
• Basic services like education and health are made
available to all irrespective of the people’s ability to pay.
This is done through the provision of heavy subsidies.
• There is less inequality in the distribution of income and
wealth
• The absence of competition eliminates wastage of
resources as a result of duplication.
• Lack of competition may make economies of scale possible
due to mass production.
• The production of harmful goods may be prevented and
external costs may be significantly limited.
• Adequate amounts of public (streetlights and national
defence) and merit goods (education and healthcare) are
made available.
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 Free Market Economic System
(Price Mechanism)
• A market economy is an economy that
allocates resources through the decentralized
decisions of many firms and households as
they interact in markets for goods and
services.
– Households decide what to buy and who to work
for.
– Firms decide who to hire and what to produce
– The free forces of demand and supply interact to
determine price and the allocation of resources.

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 Features of Market Economies
• There is private ownership of resources. Nearly all
factors of production within the economy are owned
mainly by private individuals and organisations.
• The decisions of producers and consumers are
motivated by self interest.
• There is no government involvement in the
production and consumption decisions of individuals
and firms. It only makes laws to regulate economic
activities.
• Prices of goods and services are determined by the
forces of demand and supply.
• There is a high level of competition in this market

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 Market Economy and the 3 Basic
Questions
What to produce
• Market forces (demand and supply) determine the
price of each good or service
• Producer determine whether it is profitable to
produce the good or service at that price
• Resources are allocated to the production of the
good only if it is profitable
• So long as it is profitable to do so, the good will be
produced
• Goods that are not profitable at the existing market
price will not be produced

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 How to produce
• Producers given the profit motive are motivated
to use the most efficient method of production
(technology) in order to produce the best quality
good/service at minimum cost and increase
profit.
• The choice between labour intensive or capital
intensive method of production would usually,,
depend on cost.
• Normally, the cheaper the technology used for
production, the higher profits would be.
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For Whom to Produce
• Goods and services produced are shared
(rationed) according to ability to pay.
• Those with high incomes and wealth are able to
buy large amounts of goods and services but
those with low incomes and little wealth can
only buy a few goods and services.

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 Advantages of the Market Economy
• Consumers are sovereign because they choose what
to buy and consume. They also determine what type
of good should be produced with society’s scarce
resources through their purchasing decisions.
• They have a wide array of goods to choose from since
a particular good may have many manufacturers.
• The existence of competition among producers
creates an incentive for innovation and high product
quality.
• Fierce competition among producers helps to keep
prices as low as possible.

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• The market mechanism ensures efficiency in
the allocation and reallocation of scarce
resources. Resources are used to produce only
those goods and services which society
actually wants.
• People are encouraged to work hard because
opportunities exist for individuals to
accumulate high levels of wealth.
• Resource allocation is undertaken at no cost
to the society
• It offers relative better prospects for sustained
growth and development
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 Disadvantages of Market Economy
• The pursuit of the selfish interest of producers,
profits, makes them ignore external costs. External
costs are costs borne by society as a whole as a result
of the negative consequences of a firm’s activities.
• Since access to goods and services is determined by
one’s ability to pay, those who cannot afford to pay
may not consume essential goods and services
• The free market system allocates little or no
resources towards the production of public goods
and merit goods. These goods and services are
usually not profitable so private individuals would
not allocate resources towards their production.

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• It brings about huge inequalities in the
distribution of income and wealth.
• It allocates resources towards the production
of harmful goods like cigarettes and hard
drugs
• Competition may result in fragmented
markets with little economies of scale and
wasteful duplication of resources.

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 Transition Economies
• A transition economy is one that is changing
from central planning to free markets.
• Since the collapse of communism in the
late 1990s, countries of the former Soviet Union,
and its satellite states, including Poland, Hungary,
and Bulgaria, sought to embrace market
capitalism and abandon central planning.
• However, most of these transition economies
have faced severe short-term difficulties, and
longer-term constraints on development.

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 Problems of Transition Economies
• Rising unemployment – arising from the privatisation of state owned
businesses.
• Rising inflation – due to the withdrawal of government subsidies
• Lack of entrepreneurship and skills -
• Corruption -
• Lack of infrastructure -
• Lack of a sophisticated legal system
• Rising Inequalities
• Shares – this a unit of ownership interest in a company
• Securities –these are financial assets like shares, bonds and treasury bills.

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 Mixed Economic System
• This combines aspect of planned and free
market economies
• It has a private sector and public sector.
– In the private sector, profit motive reigns supreme
and prices are determined through the price
mechanism. Market forces determine the
allocation of resources
– The public sector is the part of the economy
where government determines the allocation of
resources.

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Features of Mixed Economies
• It has a private sector and a public sector. In the
private sector, consumers, producers and factor
owners are assumed to be motivated by pure self
interest. The public sector, however, is motivated
by considerations of the communal interest
• Factors of production or resources are partly
owned by private individuals and organisations,
but the state also owns a significant proportion.
• There is competition in the private sector of the
economy. Hence the market mechanism allocates
resources. In the state sector, however, resources
will be allocated through the planning
mechanism.
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 Merits of Mixed Economies
• Consumers are offered choice of goods and services within the
private sector and they are sovereign in the sector in that they
determine the allocation of resources through their consumption
decisions.
• The existence of competition in the private sector stimulates
innovation and firms make a determined effort to improve the
quality of their products and survive the fierce competition and
these benefits consumers.
• The existence of the public sector ensures that adequate public
goods and merit goods are supplied. The poor would have access
to merit goods such as education and health.
• There is enough incentive for individuals to work hard because
there are enough opportunities for them to accumulate high
amounts of wealth.
• Government is able to control the incidence of negative
externalities
• As compared to Market economy, a mixed economy may have
less income inequality due to the role played by the government

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 Demerits of Mixed Economies
• Excessive bureaucracy may result in an inefficient
public sector which may retard the growth of the
private sector.
• The existence of public sector monopolies may
result in the exploitation of consumers.
• The imposition to taxes may cause inefficiency in
the allocation or resources
• Inappropriate government policies may have a
negative effect on businesses.
• Uncontrolled government interference in the
activities of the private sector may hinder growth
and expansion on firms
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 Summary of differences
Basis Free market Planned economy Mixed economy
economy
Resource Market forces (price Government through central Public sector : government
allocation mechanism) committee of planners planning
decisions Private sector : market forces

Ownership and Private individuals and Government ownership and Government through public
control of firms control sector and private individuals
resources through price mechanism

Main objectives Maximisation of profit Maximisation of social welfare Private sector : profit
of firms and for entrepreneurs and maximisation and public
consumers maximisation of utility sector: maximisation of social
for consumers welfare

How are prices Market forces Government through price Public sector: government
determined? controls price controls
Private sector: market forces

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 Structured Questions

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