MODULE NO.

: _2__ Teacher: Cristiano

Subject: ECONOMICS DATE: Feb 6 –Feb 9, 2024

International School Parent’s Signature:_________

TOPIC: ECONOMIC SYSTEMS

LEARNING OBJECTIVES: Students should be able to:

- Define economic systems

- Explain the advantages and disadvantages of economics systems
- Explain the role of price in the capitalism/market economy
- Explain the role of government in allocation of resources

RESOURCES: Cambridge AS and A level Economics by Colin Bamford & Susan

Grant

LESSN 1
What are economic systems?
The fundamental problem of scarcity requires choices to be made. The problem is
common to all economies: low-income, middle-income and high-income. The
choices that are made and how they are made is determined by the economic
system of a particular country. A country‟s economic system identifies the means by
which households, firms and the government make decisions relating to the three
resource allocation questions:
• What goods and services are to be produced?
• How are the goods and services to be produced?
• Who should receive the goods and services?

Traditionally, economists have recognised three main types of economic system: the
market economy, the planned economy and the mixed economy. In market
economies, resource allocation decisions are largely driven by the market

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mechanism, whereby individuals and firms take these decisions without government
intervention.

Market Economic system

In a market economy resource allocation is carried out by private individuals only. All
factors of production are privately owned and managed. There is no government
intervention and everyone is free to operate according to his will and desire. The
main characteristics of such a system are:

1. Price/ market mechanism which manipulates the allocation of resources or tries to

resolve the three fundamental questions of what, how and for whom to produce. In
other words, resources are allocated through changes in relative prices. Adam Smith
referred to it as the “invisible hands” of the market.

2. Consumer‟s sovereignty exists, that is, consumer is a king because it directs the
allocation of resources to a large extent while satisfying its own needs. His basic aim
is to maximise satisfaction. The consumer‟s decision can dictate economic actions
as what and how to produce.

3. Producers aim at profit maximisation and rely on higher prices as a “green signal”
to higher production. The foundation is the profit motive. Evidently, the production of
those commodities will be more profitable which are demanded more by consumers.

4. Fierce competition among firms exists and basically it is this competition which
encourages technological change, innovation and higher investment.

5. Easy mobilization of capital due to profit maximisation and regular innovations.

Obviously, these do encourage industrialization and economic development.

ADVANTAGES OF MARKET ECONOMY:

1. There is consumer sovereignty. This means that consumers can influence what
goods are produced directly by their purchase. In fact, they are free to buy whatever
goods and services from which they can derive maximum satisfaction. Similarly, the

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greater use of price mechanism will provide an automatic and quick way to signal to
producers what consumers want.

2. The market provides a wide variety of goods and services to meet consumer‟s
wants. Indeed, the consumers may have a greater choice of a number of private-
sector producers. This increased competition may increase the quality of products
since rival producers will seek to attract new customers by improving the standard of
their goods.

3. The market system provides incentives to producers in the form of profits and
workers in the form of higher wages. This should encourage entrepreneurs to
produce high quality products and to innovate, and workers to work hard.

4. There is greater efficiency. The aim of firms in a market economy is to make

maximum profit. Hence, the market system encourages technological change, that
is, the use of new and better methods and machines to produce goods and services
at low cost. Those firms, which do not produce what people want at low cost and low
prices, may go out of business.

Disadvantages
In theory the price mechanism can go a long way in efficiently and automatically
solving the basic economic problems. However, in practice it fails in many respects.
There are many market failures such that the price system cannot ensure the best
use of scarce resources:

1. No provision for public goods or public utilities:

Public goods are goods produced on a non-profit maximisation basis because they
(streetlighting, defence, roads) aim at maximising socio-economic welfare. Thus,
they cannot be produced through the market. There is no possibility of fixing a price
for the product in question and hence no possibility of making a profit.

2. Divergence between social cost and private cost:

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Private cost refers to the cost which is incurred in the production of a certain
commodity, for example, labour cost or cost of raw materials. However, when
production process takes place, there are smokes which come from factory
chimneys, and garbage or wastes thrown in rivers, thereby, creating pollution.
Economists evaluate these costs and name them as external costs or negative
externalities. These external costs are never considered by a private producer in a
market economy. This means that nothing much is done to reduce pollution and any
other destruction caused to nature.

3. Harmful products may be produced and consumed:

The absence of a government sector implies the absence of taxes and the free
operation of the market mechanism. Left to the price system, there will be
overproduction of certain harmful products such as drugs, alcoholic drinks and
cigarettes. Their high prices initiate higher production and greater infiltration of these
harmful goods which greatly affect the peaceful life.

4. Luxuries in place of necessities:

Since allocation of resources depends greatly on those goods whose prices are high
or are rising, obviously, the private producers will produce more of these goods and
less of other goods may be essential products. Thus, a rise in the demand of cars
may encourage producers to produce more cars and less food which is but an
irrational allocation of resources. The system broadly indicates that only the rich
people have the greater say through their expenditure patterns and the poor, on the
hand, remain poor.

5. Unequal wealth distribution / inequalities of income:

Indeed, the laissez-faire capitalism makes the rich richer and the poor poorer.
Systematic exploitation by the capitalists of the poor working class is obvious
because they have to maximize returns and minimise costs, essentially labour costs.
The labour cost has to operate at low rates and be very productive in the production
process. In this case, the wealth distribution under this system can never be
reduced.

6. Persuasive advertising:

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Owing to the fierce competition which exists among firms in a pure market system,
huge expenses are made annually on advertising. The advertising which is adopted
is meant for product differentiation. Such expenses are usually against customers‟
interests because they are not only misleading, but also wasteful. Resources used in
advertising could have been used somewhere else for more productive purposes.

7. Cyclical fluctuations:
Cyclical fluctuations are caused by the ever-changing demand and supply
conditions. Sometimes, when producers anticipate a rise in demand for certain
goods, they raise investment to produce more. But if demand actually does not rise,
a general glut will occur, that is, stock accumulation. Consequently, the affected
producers will have to reduce investment, dismiss workers to reduce costs. Both of
these have an adverse effect in the economy as a whole. Less investment means
lower production while lower employment means less consumption, lower prices and
profits. These cumulative effects lead to a lower national income.
It can be deduced that price mechanism determines allocation of resources as per
what consumers want more which initially sounds right. However, this system cannot
be left to itself because of its various imperfections which undoubtedly necessitate
government intervention.

LESSON 2

How the price mechanism works

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This shows how the market may operate with no government interference. The
starting point is that there is excess supply in the market – too much is being
produced compared to demand. Excess supply results in goods being stockpiled in
shops and warehouses. To encourage individuals to buy and so clear the excess
stocks, firms reduce the price. This may clear the excess supply, but it is likely to
mean that some firms which previously produced the good will now no longer be
willing to do so. With less supply in the market, the price rises. In time, assuming no
change in demand, firms may choose to reenter the market. The increase in supply
will lead to a fall in price and the whole process will continue. Therefore, prices and
the self-interest of individuals and businesses act as a guide to the decisions that
have to be made.

Role of the government in a market economy

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In principle, the government should have no direct role in the workings of the market
economy and should not interfere in the operation of the price mechanism. As long
as the price mechanism is working efficiently, the government‟s role is to watch what
is happening and only intervene when the price mechanism does not provide the
best allocation of resources

LESSON 3
PLANNED ECONOMY:
A planned economy is the direct opposite of the market economy. Here all the
resources are owned by the government or the public sector which is the central
body deciding upon the allocation of resources. This allocation is however exerted
on the following grounds:

Maximising socio-economic welfare through creation of public utilities.

Non-profit maximising strategy.
Parliamentary decisions.

Advantages

1. Greater economic efficiency: the government ensures that resources are

allocated to those sectors where they can be used most productuvely. Therefore,
production efficiency is greater than under capitalism.

2. Absence of Wasterful Competition: Duplication of goods and services or use of

resources on extensive advertisement campaign is avoided.

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3. Less Inequality of Income: Every member of the society is taken care of within
the limits of their relative capabilities and the overall resources of the state.

4. Exploitation of Private Monopoly if avoided: State monopoly exists only to

promote overall welfare of the people.

However, in real world, command economies seldom exist. Central planners may set
the prices of essential consumer goods, and allow factory managers to set prices of
less essential goods. However, such an economic system has got several demerits
which can be discussed as follows:

Disadvantages
1. Decisions are based on a parliamentary level:
Since decisions are based on parliamentary level, they are not readily implemented
and in this way, several important decisions concerning socio-economic activities
may be delayed.

2. Inefficiency:
A common feature against the public sector is inefficiency and lack of competence.
The sector is generally over-staffed and inefficient. The services are of “Red-Tape”
type because of high level of bureaucracy. In addition, the attitude of a secured job in
the government sector makes workers idle and careless about the quality of services
to be provided to the members of the public.

3. Waste of resources:
Very often there is wastage of resources especially when public sector expenditure
is analysed. There is a great abuse on the part of the workers concerning the use of
public sector resources and materials.

4. The absence of competition:

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The absence of competition in this economic system does not ensure innovation and
constant improvements in the quality and quantity of products. Owing to the principle
of “No profit- No loss”, huge losses have to be borne at times by the public sector.
Therefore, it is difficult to find out additional resources for innovations.

5. Restriction on consumers’ sovereignty:

Since there is central allocation of resources, consumers may demand what they
wish but to a restricted extent. The production of luxuries is given as the ultimate
priority by the government because of the concept of the welfare state. Priority must
be given only to the production of the most essential products in the society.

LESSON 4
Mixed Economy
Mixed Economy It is an economic system which combines features of both
market/capitalist and planned. In a mixed economy therefore, there exist private and
public ownership of productive resources. In those areas where the private
individuals and firms are dominat, allocation and distribution of resources is done by
price – mechanism. But in those activities reserved for the government, central
planning and administrative fiat decisions are used to solve fundamental questions
on allocation and distribution of resources, goods and services. The state
intervention, however, is considered necessary to remedy the defects of the market
economy earlier identified. In the real – world, all economics are mixed, but the
extent to which one mixed economy differs from another depends largely on how the
government interprets its role in the economy.

Advantages
1. Best allocation of resources. A mixed economy combines the good features of
both capitalism/marke and command/planned. Therefore, the resources of the
economic are utilized in a way that ensures the adequacy of all types of goods and
services and production efficiency increases,

2. General Balance. The competition and cooperation between the public sector
and the private sector favours the realization of a high rate of capital accumulation
and economic growth.

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3. Welfare State. In a mixed economy, there is no exploitation either by the
capitalists or by the state. Government agencies are established to protect
consumers‟ interest, while legislative measures are adopted to reduce poverty and
inequalities of income and wealth.

Disadvantages
1. Non-cooperation between the private and the public sector. In real – life,
public – private sector partnership to promote economic progress is hardly found.
Most often, the private sector is subjected to heavy taxes and restrictions that impact
negatively on its performance, while the public sector is given subsidies and
preferences.

2. Inefficient public sector. The public sector of a mixed economy works

inefficiently due to bureaucratic control, over-staffing of the personnel, corruption and
nepotism. As a result, resources are misutilised and the level of production is low.

3. Economic fluctuations. Periods of economic prosperity and hardship alternating

which are characteristic features of a capitalist economy are equally experienced in a
mixed economy. This is a result of the improper mixture of the features of capitalism
and socialism.

EXAM QUESTIONS

1 Which of these terms describes a country where government planning, regulations

and directives are responsible for the allocation of resources?
A capitalist economy
B mixed economy
C market economy
D planned economy

2 A criticism of a planned economy is that it puts more emphasis on producing

capital goods than producing consumer goods. This is because:
A the system of decision-making is too centralised.
B there are shortages of many consumer goods.
C the government‟s focus is on growth and not current

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consumption.
D consumers cannot afford to buy any more consumer goods.
3 A planned economy has recently become a mixed economy. This process has
involved a change in the composition of what it produces. What is the most likely
consequence of this change?
A an increase in food prices
B an increase in imports
C an increase in structural unemployment
D an increase in the growth rate of the economy

4 A mixed economy can best be described as one in which:

A production is determined by the central government and the market mechanism.
B agricultural and manufactured goods are produced.
C production is determined by entrepreneurs.
D consumer goods and capital goods are produced.

5 Which of these is the most likely outcome when a mixed economy privatises its rail
services?
A Peak train fares will increase.
B Off-peak train fares will decrease.
C Fewer rail services will be provided.
D Train fares will now be determined by supply and demand.

6 After a planned economy changed to a more market economy, there was a

reduction in the proportion of household income that was being saved. How might
this be explained?
A Households were more concerned about the economy‟s
future economic prospects.
B More „big ticket‟ goods had become available.
C New charges were introduced for secondary education.
D Household incomes fell.

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