CHAPTER 2: DIFFERENT ECONOMIC SYSTEMS
2.1 DIFFERENT ECONOMIC SYSTEMS
Each society has to find ways of dealing with scarce resources and deciding how those
resources will be used. Each society must therefore provide answers to three central
economic questions:
1. What goods and services will be produced and in what quantities? These are output questions.
2. How will each of the goods and services be produced? This concerns how much of the scarce
resources will be used in the production of each good.
3. For whom will the various goods and services be produced? This concerns who will receive the
goods and services, how much they will receive and where the production will occur. These are
distribution questions.
CLASSIFYING ECONOMIC SYSTEMS
No two economies necessarily provide identical solutions to the questions of what, how and
for whom. Economic systems can therefore be classified according to certain common
features.
The two basic criteria used to classify economic systems are property rights and the
coordinating mechanism.
Property Rights
Property rights refer to the right to possess, use or dispose of tangible assets (eg
houses) and intangible assets (eg patents) as well as the right to all or part of the
income generated by those assets.
Property can be owned publicly or privately. Public ownership may involve different levels of
government, workers' management or public boards, while private ownership may involve
individuals, partnerships, cooperatives and companies.
Coordinating Mechanisms
A coordinating mechanism is a means of providing and transmitting information so
as to coordinate the economic activities of the great number of participants in an
economy.
In a market economy, coordination is achieved through the market mechanism or price
system, through the movement of market prices as determined by the forces of supply and
demand.
In a centrally planned economy, coordination of decisions is achieved through a central plan
drawn up by a central planning authority.
Classification of Economic Systems
Economic systems may be classified broadly as market capitalism, planned socialism or
market socialism.
Market capitalism, or a capitalist market economy, is characterised by private ownership of the
factors of production. Decision making is decentralised and rests with the owners of the factors of
production. Their decisions are coordinated by the market mechanism. Economic activity is drive
by self-interest and limited government intervention.
A mixed market economy is an economy in which economic decisions are made partly through
the market and partly by government. The degree of the mix varies from country to country.
In a free-market economy, all decisions are made by individual households and firms with no
government intervention. A free-market economy is a theoretical construct and does not exist
in real life.
Planned socialism, or centrally planned socialism or command socialism, is characterised by
public ownership of the factors of production. Decision making is centralised and is coordinated
by a central plan containing binding directives to the system's participants.
A mixed command economy is a planned economy that makes some use of markets.
Market socialism is characterised by public ownership of the factors of production. Decision
making is decentralised and is coordinated by the market mechanism.
Communism is a political system rather than an economic system. Communist
countries function under a single, dominant communist party.
Economic System
A system is a network of parts which interlock to form an overall pattern.
An economic system is a pattern of organisation which is aimed at solving the three
central economic questions.
Economic system Ownership Decision making Coordination
Market capitalism Private Decentralised Market mechanism
Planned socialism Public Centralised Central plan
Market socialism Public Decentralised Market mechanism
2.2 THE TRADITIONAL SYSTEM
The oldest solution to the three central questions is tradition.
By this we mean that the same goods are produced and distributed in the same way
by each successive generation. In a traditional system, each participant's task and
methods of production are prescribed by custom. Men do what their fathers did.
Women do what their mothers did. People use the same techniques of production as
their parents did and production is distributed according to long-established
traditions.
A traditional economic system provides clear and easy answers to the three central questions
because established customs determine what people produce, how they produce it and how
production is distributed.
It is a rigid system that is slow to adapt to changing conditions and resists innovation.
Traditional systems tend to be subsistence economies, and economic activity is usually
secondary to religious and cultural values and the desire to maintain the existing way of life.
2.3 THE COMMAND SYSTEM
In a command system the participants are instructed what to produce and how to
produce it by a central authority which also determines how the output is
distributed.
Because the economy is governed and coordinated by a central authority, command systems
are also called centrally planned systems.
Central Planning
Central planning requires decisions about how, where and for what purpose natural
resources, labour and capital goods should be used. Planners must determine what consumer
goods should be produced, how they should be produced, how they should be distributed,
how resources should be divided between capital goods and consumer goods, and what types
of capital goods should be produced.
Central planning is an extremely difficult task, particularly in a changing environment,
because mistakes are inevitable and the planners must coordinate large amounts of
information.
Command Systems, Socialism and Communism
Central planning refers to the way in which economic activity is coordinated, while socialism
and communism refer to the ownership of the factors of production.
In a pure socialist system, all the factors of production, except labour, are owned by the
state. In a pure communist system, all resources are, in principle, owned by everybody and
are regarded as common property.
In practice, command systems are characterised by both central planning and state
ownership of goods, services and factors of production, except labour.
2.4 THE MARKET SYSTEM
What is a Market?
A market is any contact or communication between potential buyers and potential
sellers of a good or service.
A market does not require a specific physical location. Contact between buyers and sellers
can take place through different forms of communication. Markets can be local, regional,
national or international, and some markets have no specific location.
Conditions for a Market to Exist
There must be at least one potential buyer and one potential seller of the good or service.
The seller must have something to sell.
The buyer must have the means with which to purchase it.
An exchange ratio, or market price, must be determined.
The agreement must be guaranteed by law or by tradition.
The Market System
A market system is one in which individual decisions and preferences are
communicated and coordinated through the market mechanism.
The most important elements of the market mechanism are market prices. Market prices are
signals of scarcity that indicate to consumers what they have to sacrifice to obtain goods and
services. They also indicate to owners of factors of production how those factors can best be
employed.
The types of goods and services produced also depend on the distribution of income because
consumers with greater purchasing power have a larger impact on demand, market prices
and the structure of production.
Market Capitalism
A market system is not necessarily a capitalist system because the market mechanism can
also be used in socialist systems, resulting in market socialism.
Market capitalism is characterised by individualism, private freedom, private property,
property rights, decentralised decision making and limited government intervention.
Most means of production are privately owned, and individuals make decisions based on their
self-interest. Property rights are protected by law, provided that individuals do not infringe on
the legal property rights of others.
Self-Interest and the Invisible Hand
In market capitalism, economic activity is driven by self-interest. Consumers seek to
maximise their satisfaction, business people seek to maximise their profits and workers seek
the highest possible income for a given amount of work.
When profits are high in a particular industry, more firms are attracted to that industry, while
occupations offering higher remuneration tend to attract more workers.
Adam Smith argued that the market mechanism works like an invisible hand, which
coordinates the selfless actions of individuals to ensure that everyone is better off.
The Three Central Questions in a Market System
What will be produced?
Goods and services will be produced when consumers are willing to spend their income on
them and producers can supply them profitably. Goods that consumers do not want will
generally not continue to be produced because producers will incur losses.
How will it be produced?
Producers are forced to combine resources in the cheapest possible way for a particular
standard or quality. Their decisions about the combination of factors of production are
governed by the prices and productivity of those factors.
For whom will goods and services be produced?
Goods and services go to those who have the means to purchase them. This is linked to the
production process because production generates income, and in a pure market system the
income earned is linked to the value of the resources contributed to production.
Competition in Market Capitalism
Competition is an important feature of market capitalism. It occurs among suppliers and
among buyers and should not be confused with negotiation, which occurs between buyers
and sellers.
Competition among sellers protects consumers against exploitation and promotes efficiency
and growth. Successful producers are rewarded with profit, while unsuccessful producers
make losses and are eventually eliminated.
The pure market system also has defects, including a tendency towards inequality and
instability, which may require government intervention.
THE FUNCTIONS OF PRICES IN A MARKET ECONOMY
Prices serve two important functions in a market economy: a rationing function and an
allocative function.
Rationing Function
Prices serve to ration the scarce supplies of goods and services to those who place
the highest value on them (and can afford to pay for them).
Because goods and resources are scarce, prices help determine who receives the available
goods and services.
Allocative Function
Prices serve as signals that direct the factors of production between different uses in the
economy.
When there is excess demand, prices increase. Higher prices create increased profit
opportunities and attract factors of production towards the activities concerned.
When there is excess supply, prices fall and losses occur, which drives factors of production
away from those activities.
THE ROLE OF MONEY IN A MARKET SYSTEM
In a market system, money is used primarily as a medium of exchange. It is accepted in
exchange for goods and services and makes exchange and specialisation possible.
Barter
A barter system is a system in which goods and services are directly exchanged for
other goods and services.
Barter requires a double coincidence of wants, meaning that each person must have
something the other person wants.
Money eliminates the need for barter and the double coincidence of wants. It allows people to
specialise in particular economic activities and use their money income to purchase what
they require and can afford.
2.5 THE MIXED ECONOMY
In the real world no economic system is based purely on tradition, command or the
market.
All economic systems contain a mixture of traditional behaviour, central control and market
determination, although one of these mechanisms usually dominates.
The appropriate mixture between the market mechanism and government intervention, or
between the private sector and public sector, is an important issue. The mix depends on the
problems and needs of the society and can change over time.
2.6 SOUTH AFRICA'S MIXED ECONOMY
The South African economy is a mixed economy in which private property, private initiative,
self-interest and the market mechanism all play an important role. It is also characterised by
a substantial degree of government intervention.
State Ownership, Privatisation and Nationalisation
In pure market capitalism all factors of production are privately owned. In South Africa, some
enterprises or significant shares in enterprises are owned directly or indirectly by the state.
Privatisation refers to the process of transferring state-owned assets or enterprises
to the private sector. Also referred to as the restructuring of state assets
Nationalisation is the acquisition of privately owned assets by the state.
Government Intervention
Government participates in the economy as a buyer and seller of goods and services, as an
employer and as a regulator. Some of these actions restrict the freedom of private consumers
and producers.
One area of government intervention is price control. In a pure market system, prices are
established through the market mechanism, but certain prices in South Africa are fixed or
regulated by government.
Perfect and Imperfect Competition
The distinguishing feature of perfect competition is that no buyer or seller can
influence the price of the good or service in question (ie they are price takers).
In practice, individual buyers or sellers, or groups of buyers and sellers, may have the power
to influence prices. When this happens, there is imperfect competition and participants are
price makers.
Why South Africa is a Mixed Economy
South Africa does not have a pure market system. It is a mixed system in which both the
market mechanism and central direction, in the form of government intervention, play a
significant part. The balance between the market and central organisation, and between the
private and public sectors, changes over time.
2.7 THE MEN BEHIND THE SYSTEMS: SMITH, MARX
AND KEYNES
Adam Smith (1723–1790)
Smith argued that the purpose of economic activity is to satisfy human wants. He therefore
viewed the wealth of a nation in terms of its annual production of goods that can satisfy
human wants, with emphasis on total output or national product.
Division of Labour
Smith regarded the division of labour and the specialisation it created as important
determinants of economic growth. However, the scope for division of labour is limited by the
size of the market.
Larger markets allow greater division of labour and increased economic growth. Smith
therefore supported the expansion of markets and free trade.
Self-Interest and the Market
Smith believed in decentralised decision making. Individuals should be allowed to pursue
their own self-interest, while the market mechanism acts as an invisible hand that
coordinates their decisions and promotes the national interest.
Role of Government
Smith did not argue that government should have no role. He believed that its role should be
limited.
John Maynard Keynes (1883–1946)
Keynes and Aggregate Demand
His main message was that the aggregate level of economic activity is determined
by the aggregate demand for goods and services.
Keynes explained that aggregate demand could be insufficient to sustain desired levels of
production and employment. When this occurred, government had to stimulate total demand
through appropriate policy measures.
These measures included raising government spending or decreasing taxes. Keynes therefore
provided intellectual justification for government intervention to stimulate economic activity
and reduce unemployment.
Keynesian Economics
Keynes focused on large economic aggregates such as total output, total employment and
the general price level. By focusing on aggregates, he laid the foundation for modern
macroeconomics, usually called Keynesian economics.