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How Economic Systems Work

Have you ever heard the phrase, “you can buy almost anything online!”? It stands as a simple reminder that everything, in some capacity, will be owned. An economic system is the way society determines who will own things and how that ownership will be decided.

All societies must answer three questions. The answers they select determine what type of economy, or economic system, the society primarily has a command or market economy. The three questions are:

  1. What should we produce?
  2. How should we produce?
  3. For whom should we produce?

A free market system answers the questions in the following way:

  1. BUYERS decide what will be produced.
  2. SELLERS decide how to produce.
  3. MONEY determines who gets the goods and services.

As buyers purchase goods and services, they signal to the producers what ought to be made.  If people want to wear pants with farm animal designs, they buy them. Producers have to be observant to anticipate demand. As they see that the stock of cow pants is flying off the shelves, they will create many more of them. Buyers and sellers are able to communicate effectively using just money. No one has to send emails to the company to ask for more pants with sheep designs; the fact that the pants sell quickly sends the message quickly. Likewise, when people move away from barnyard fashions and don’t buy them anymore, producers know to slow or stop production based merely on sales. Again, no one calls the company to request fewer pairs of chicken pants.  Money talks, as they say, so buyers decide what will be produced. The producer of the good or service selects the best, most profitable way to produce. They use the factors of production—land, labor, capital, and entrepreneurship—to maximize goals of the company.  Finally, to establish distribution of the good or service, price is used. In market economies, when consumers want anything from food to dental services to a new hat, they need only go to the correct place and give enough money to fulfill the price requirement.

A purely free market economy has several important characteristics. The first requirement is great freedom to buy and sell goods and services to satisfy one’s own desires. Individuals are responsible for making their own decisions regarding if, where, and how hard to work.

The father of economics, Adam Smith, wrote in The Wealth of Nations, “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest” (Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776).

By producing items of value to others, people will in turn help themselves.

A purely free market is not devoid of government. Rather, the government has a limited, small, and important role to play in the economy: protection of private property might require a lot from government in certain conditions. The ownership of factors of production as well as finished goods and services relies on clearly-defined and well-enforced property rights. We have paperwork like receipts, ownership titles, and deeds to prove that we own things. We are able to enjoy all the privileges that go along with ownership, including the right to sell the objects.

If property rights are threatened, the police and court system get involved to solve problems.

That role for government, while critical, is small. There are no public goods such as roads, streetlights, or public parks provided under a purely free market. There also exists no governmental safety net. People who are permanently or temporarily unemployed or disabled receive no government assistance. In this scenario, private individuals, civil organizations, or businesses must provide these goods and services.

On the opposite side of the spectrum is a command, or socialist, economy (Cuba, India, and North Korea). In these countries, central planners make decisions about what, how, and for whom to produce. Using complex computer models, government workers make output and supply decisions and businesses fulfill orders.

In a command economy, the government owns the factors of production; all decisions about land, labor, and capital are made by the state. Bureaucrats analyze enormous sets of data about current stock levels, predicted demand, and availability of resources. They determine output plans which are checked and sometimes adjusted at lower levels by regional directors and company managers. Orders are set, supplies ordered, and then the workers need only fulfill the job. Since the government planners also get to determine what individuals’ occupations are, they can effectively command the entire economy. Once the good or service is created, the price is also set by the government planners. The overall goal is equity. By having fair prices and wages that are set by the government, all of society will have needs met, and there will not be a division between rich and poor people.

The logic of a command system has been described in this way: “experts would plan, zealots would compete in zeal, technology would tame nature, labor would make free, the benefits would accrue to all.  From each according to his ability; to each according to his deserts; and eventually, to each according to his needs” (David Landes, The Wealth and Poverty of Nations: Why Some Are So Rich and Some Are So Poor, 1998).

There are many problems with a command system. Perhaps the most stifling problem is the lack of freedom resulting from the coercion needed to make a command economy function. In a command economy, the state is the coercive force that determines many facets of individuals’ lives, including what job to work, where to live, and what and how many goods and services are available. The command system is also encumbered by the vast amount of information needed to properly make production decisions for an entire country. It is invariably beyond the scope of planners to comprehend. In terms of the nation’s productivity, the incentives to work hard or invent new products do not exist. This coercive system results in major inefficiencies. Without rewards for hard work, people naturally complete just the bare minimum required. For example, China transitioned its agricultural sector from pure command to more of a market-based system between 1978 and 1984. Over that time, total agricultural production increased by 42 percent as farmers were able to keep, use, and sell any crops above the government’s quota (Justin Yifu Lin, “Rural Reforms and Agricultural Growth in China,” American Economic Review, 1992). The market-based transition gave famers incentives to work hard and improve what they do to utilize fertilizers and other machinery helpful in producing crops. The reality of a command system is that production decreases and with it, overall happiness decreases.

This loss of freedom and happiness is the opportunity cost of coercion.

In reality, there is no such thing as an economy that is only market or only command. Rather, all systems are mixed models and fit along a spectrum. The United States is primarily market-based, but the government plays a role, too. The government provides a social safety net. In 2011, the United States spent over $2 trillion (13.5 percent of the overall GDP) on Social Security, Medicaid, Medicare, and other social services like unemployment compensation. There is also the extensive regulation of the economy with policies about the environment, working conditions, taxes, and subsidies.

Likewise, there is no economy that is purely command.  Features of a market system exist, sometimes legally and sometimes illegally.  In North Korea, one of the most centrally-planned economies in the world, the government allowed for some market reforms in agriculture, creating the possibility of farmers’ markets to emerge.  In Cuba, the underground economy is said to be so vast that 95 percent of the population buys and sells goods illegally (Paul Haven Paul, “Cuba’s Shadow Economy Sees Some Daylight”, The Washington Times, 2011).

Examining the type of economic system gives great insight to how governments of countries function.  Market-based systems allow for more individual freedom and thus, less government control. Governments in command-based systems must be more heavy-handed, affecting the day-to-day lives of citizens in a much greater capacity.

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