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Economic systems refer to the means by which government of an economy distributes resources amongst the people of an economy. Economic system helps to gain control over various factors of production. 

Three Basic Questions of an Economic System

The characteristics of an economic system can be determined basis three questions and how the system answers these questions:

  1. What will be produced: The first basic question or problem is related to identification of goods and services that must be produced in an economy. Since resources or factors of production available to an economy are limited and scarce in nature, the economy needs to set the priority regarding what needs to be produced. For example, basis the requirements, an economy will decide whether to produce defence equipment, schools, infrastructure, household items etc.
  2. How will it be produced: This problem pertains to allocation of factors of production. For example an economy that has decided to produce clothes now needs to decide whether it will be produced using machinery or by hand. Or, in order to produce water pipelines, which metal or material should be utilized. And so on.
  3. For whom will it be produced: Once an economy has decided what needs to be produced and the way in which it needs to be produced, it needs to determine how to distribute these goods. That is who will be the consumer. For example, goods may be available on first come first serve basis or, they may be reserved for strata of people basis a particular characteristic (say average income, gender, height, weight, location etc.)

Types of Economic System

Some of the most common economic systems across the world are as follows:

  1. Traditional Economy: The decisions are taken based on historical precedent and customs or tradition. It is one of the oldest types of economic system. It was also used in ancient times when typically the elders of the group became head with authority, irrespective of skill set or capabilities. Some parts of the world still function on basis of a traditional economic system, mostly, in rural areas or third world countries. A typical characteristic is that such economies are closely linked to activities such as, fishing, hunting and farming. Such economies have limited resources and they will be able to survive but never achieve very high standards of living or economic growth and development because they tend to grow very slowly. It is also characterized by resistance to change and new technologies. However, they provide economic security and ensure almost equal distribution of goods and services.
  2. Command (or planned) Economy: This type of economic system is characterized by dominance of the central government which determines what to produce, how to produce and for whom to produce. The central government imposes the decisions on individuals in form of quotas and regulations. Hence, the government and its employees command the economy and perform the role of the market. Such economies do not provide any incentive to individuals to work hard and produce goods and services required by others. It limits the economic freedom of people. The economy is also characterised by economic inefficiency; if the central government errs in decision making and planning process, entire economy has to pay the price. However, command economies can provide economic security and can also adapt to the changing environment rapidly.
  3. Market Economy: As is obvious by the name, this kind of economic system is dominated by the people or market. Hence, the three questions of what to produce, how to produce and for whom to produce are answered by the individuals in free market. There are buyers and sellers of various goods in the market and exchange of goods and services takes place as per their wishes. According to Adam Smith, the economic activity is co-ordinated by an invisible hand. In such an economy, government has minimal role as market dominates the decision making activities. Due to this, property and ownership rights gain importance in this structure. 

This structure tends to be more efficient compared to other structures as individuals have a strong financial incentive to perform well and produce goods and services demanded by other individuals in the market. For this reason, free market economy exhibits some of the fastest economic growth rates when compared to other economic structures. On the flipside, such structure do not provide any economic security and resources may be exploited such that there is a lot of wastage. Also, the distribution of goods and services will not be equitable and weaker sections my stand at a disadvantage.

  1. Mixed (or hybrid) Economy: As the name suggests, mixed or hybrid economy is a mix of different types of economic systems. It is characterised by both the central government and individuals playing important roles in deciding what to produce, how to produce and for whom to produce. The extent of role of either party (government or individuals) will vary from economy to economy. Sometimes, the government will have a more pivotal role while in other cases, individuals may be more dominant as compared to the government. For example, in one economy, the central government may only be providing rules and regulations to ensure smooth trade and exchange of goods and services. Whereas, in another economy, the government may be doing this and much more, such as public distribution system, subsidies for weaker section, day care, old age homes etc. A major advantage of such an economy is that it ensures much fairer distribution of goods and services as compared to a free market economy. Further, it is more sustainable and provides better level of economic security as compared to free market economy. At the same time, it provides incentives to individuals so that they produce goods and services required by others. Hence, there is good scope for entrepreneurship. At the same time, the government intervention implies that wrong decisions by the government will impact the economy – such as, too many subsidies or bad debts in state run enterprises etc.

Hence, various economic systems are categorized basis.

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