Poornima Weerasinghe

Economic Systems
An economic system is the institutional framework formed by people to solve the basic economic
problems.

These economic systems consist of economic institutions that operate according to a set of rules
made by man and are also called as institutional characteristics.

Elements of an economic system/ Economic Institutions/ Institutional Characteristics

 Households
 Government
 Business firms
 Labour organizations
 Non-governmental organizations
 Markets
 Incentives
 Legal structure
 Values, traditions and culture

Of these, the main parties that involve in decision making in an economic system are, households,
government, business firms, labour organizations and non-governmental organizations.

Households

The most important institutional characteristic in an economic system is the household

A group of people living under the same shelter sharing a common budget is called a household.

Households can consist of nuclear or extended families

They are the suppliers of labour and the consumers of most goods. They are also the owners of
factors of production.

Duties of a household include:

 Making decisions related to supply of factors

 Making decisions related to purchase of goods
 Making decisions related to how much is consumed and how much is saved

Government

Every country has a form of Government that has a large authority

Duties of a Government:

 Protection of economic and personal rights

 Regulation of industries and business
 Provision of goods and services
 Redistribution of income (taxation, welfare, public services, monetary policies)
 Poornima Weerasinghe

 Making rules and regulations

Business Firms

There are different types of business firms in an economy

Eg: Private organizations, cooperatives, State organizations

Duties of a business firm:

 Purchase of factors of production

 Deciding what to produce in what quantity, how to produce and for whom to produce
 Producing goods
 Selling goods at a reasonable price

Labour Organizations

Duties of labour organizations:

 Act to protect employee rights

 Influence over wages, production technology and employment

Non-Governmental Organization

Institutions that have emerged in modern economies. They have duties similar to Government. As
examples:

 Elimination of poverty
 Protection of environments
 Providing welfare for people affected by different crisis situations
 Poornima Weerasinghe

Classification of Economic Systems

Criteria

Decision
Ownership of Nature of
coordinating
resources incentives
mechanism

Free market Capitalist

Material
economy economy

Command Socialist
Moral
economy economy

Coercive

Economic
Systems

Market Planned Mixed

Economic Economic Economic
Systems Systems Systems

Market Economic Systems

An economic system where basic economic problems are solved based on the price determined by
market demand and supply.

Also called as capitalist economic systems or laissez faire.

Fundamental Concepts:

 Self interest
 Laissez faire
 Economic Freedom
 Competition
 Poornima Weerasinghe

Basic Characteristics:

 Private property ownership (capitalist)

 Freedom of choice/ free entrepreneur
 Competitive markets
 Incentives based on self interest / material incentives
o Determines the behaviour of economic agents
o Social welfare is neglected
 Operation of price mechanism
o Coordination mechanism to solve the basic economic problems
o Price performs 3 basic functions in a market economy

Price

Signaling Incentive Rationing

function function function
Foundation of price mechanism is set by:
 Competitive markets
 Self interest
 Decentralized decision making
 Higher degree of economic freedom

Question:

 Explain how price mechanism will be used to answer the basic economic questions

 Consumer sovereignty
 Limited role of the government
 Decentralized decision making
 Use of open economic policies
 Efficient production techniques

Advantages Disadvantages
Price mechanism maintains market balance Consumers get exploited in a monopoly
situation
More economic freedom for consumers and Social injustice and economic inequality leading
sellers to poverty
Wide range of products resulting in more Environmental protection and conservation will
choice be ignored
Due to high competition, efficient methods, Instability and price fluctuations
new products and innovations are introduced
Reap benefits of globalization Human welfare will be ignored
Increased standard of living resulting in Wasteful competition
economic development
Freedom to own private property Negative effects on domestic small scale
industries
Prevents government from becoming powerful Unemployment
Usage of inferior quality resources
 Poornima Weerasinghe

Can lead to;

Market
Failure

Inefficiencies Inequalities Instabilities

Inefficiencies Inequalities Instabilities

Non provision of public goods Income disparity High inflationary pressures
Under provision of semi public Provincial/ regional disparity Chronic unemployment
goods
Under provision of merit Large budget deficit
goods
Over provision of demerit BOP gaps
goods
Over exploitation of common Extreme fluctuations in
property resources economic activities
Information asymmetry
Absence of needed markets by
the people
Substantial monopoly power

To correct market failure, Government interference is needed.

 Regulatory role of the government

To operate a fair, smooth and efficient legal system
 Economic Role

Re-allocative role Re-distributive role Stabilization role

Provide public goods Imposing progressive tax Implementing monetary
system policy
Provide semi public goods Providing subsidies for the Implementing fiscal policy
poor
Provide merit goods Limiting property ownership Controlling inflation and
unemployment
Discourage demerit goods Minimum wage legislation Stabilizing interest rates and
exchange rates
Provide missing markets
Controlling monopoly
 Poornima Weerasinghe

Command Economic System

An economic system where basic economic problems are solved based on the commands provided
by a central planning authority.

Basic Characteristics:

 Public ownership of property, except for labour

 Dominant public enterprise
 Wide role of government
 Use of planning mechanism to solve basic economic problems
o Decisions related to what to produce? How to produce? And for whom to produce?
Are determined by the plans made by the central planning authority
 Acts based on social welfare
 Economic equality
 No economic freedom

Question:

 Explain how planning mechanism will be used to answer the basic economic questions

Advantages Disadvantages
Social justice and equality Bureaucracy and red tape
Social welfare Loss of economic freedom
Economic stability Lack of incentives and inefficient work
Provision of public goods and merit goods Lack of competition
Affordable prices Mis-allocation of resources
Often no shortage of jobs Poor quality products
High cost
Inflexibility of economic plans
 Poornima Weerasinghe

Mixed Economic Systems

An economy where features of more than one type of economic system are mixed together.

Types

Mixed socialist Capitalist

Mixed capitalist Socialist market Societal market
command centrally planned
market economy economic system economic system
economy economy

Characteristics

Government role

Traditional Economy

 Guided by traditions, customs, beliefs and leaders’ opinions

 Resources are coordinated by traditions and beliefs
 Moral incentives are prominent
 Organized as tribes who engage in barter system
 Highly inflexible
 Collective ownership of resources
 Eg: Eskimos, Aborigines, Red indians

Transition Economy

Economies that give up socialist command systems and move towards market economies.

Economic and social reforms are introduced:

 Privatization
 Move from welfare based incentives to self interest
 Eliminating price controls

Problems:

 Lack of awareness of market forces

 Removing import controls
 Absence of legal framework
 Hyperinflation can occur
 Increased unemployment and inequality
 Poornima Weerasinghe

Reasons to success:

 Foreign direct investment

 Privatization
 Restructuring key institutions
 Financial incentives