Economy: an area where people and firms produce, trade and consume goods and services. This can vary in size- from your local town to your country, or the globe itself.
Resource allocation: the way in which economies decide what goods and services to provide, how to produce them and for who to produce them for. These questions- what to produce, how to produce, and for whom to produce for- are termed ‘the basic economic questions’. In short, resource allocation is the way in which economies solve the three basic economics questions.
*(Public sector refers to everything in govt. ownership and control, while private sector refers to everything owned and controlled by private individuals).
Economic Systems:
There are three main types of economic systems- three ways in which resources are allocated.
The Market* Economic System: (a.k.a free market economic system). Here, all decisions are made by private individuals; that is, there is no government intervention or involvement in resource allocation. (There are virtually no economies in the world who follow this-there is a government control everywhere, though USA does come close).
Features:
1. All resources are owned and allocated by private individuals. No govt. control exists.
2. Thus, profit is the main-motive
3.The demand and supply (covered in the next section) fixes the price of products. This is called price mechanism.
4.What to produce is solved by producing the most-demanded goods for which people spend a lot, as their only motive is to generate a high profit.
5. How to produce is solved by using the cheapest yet efficient combination of resources– capital or labour- in order to maximise profits.
6. For whom to produce is solved by producing to people who are willing and able to pay for goods at a high price.
Advantages:
1. A wide variety of quality goods and services will be produced as different firms will compete to satisfy consumer wants and make profits. Quality is ensured to make sure that consumers buy from them. There is consumer sovereignty.
2. Firms will respond quickly to consumer changes in demand. When there is a change in demand, they will quickly allocate resources to satisfying that demand, so as to maintain profits.
3. High efficiency will exist. Since producers want to maximise profits, they will use resources very efficiently (producing more with less resources).
4. Since there is no govt. control, there are no taxes on goods and servicesand income. So consumers have more income to consume, and producers can cheaply produce.
Disadvantages:
1. Only profitable goods and services are produced. Public goods* and some merit goods* for which there is no demand may not be produced, which is a drawback and affects the economic development.
2. Firms will only produce for consumers who can pay for them. Poor people who cannot spend much won’t be produced for, as it would be non-profitable.
3. Only profitable resources will be employed. Some resources will be left unused. In a market economy, capital-intensive* production is favoured over labour- intensive* production*(because it’s more cost-efficient). This can lead to unemployment.
4. Harmful (demerit) goods may be produced if it is profitable to do so.
5. Negative impacts on society (externalities) may be ignored by producers, as their sole motive is to keep consumers satisfied and generate a high profit.
6. A firm that are able to dominate or control the market supply of a product is called a monopoly. They may use their power to restrict supply from other producers, and even charge consumers a high price since they are the only producer of the product and consumers have no choice but to buy from them.
7. Due to high competition between firms, duplication of products may take place, which is a waste of resources.
- Planned Economic System: Here, all decisions are made by the government. They decide what to produce, how to produce and for whom to produce. Example: North Korea.
Features:
1. All resources are owned and allocated by the govt. They also fix the prices.
2. Profit is not the main motive- social welfare is.
3. They produce goods that will be most beneficial to the social welfare of the economy.
4. Efficiency may not be the highest priority as profit isn’t a motive. Thus they could use inefficient production methods to produce the goods.
5. Goods will be produced for all people- mainly those with poor incomes. Rich people may demand for luxury goods, which the govt. might not be interested in producing.
Advantages:
1. As it’s a welfare-motive economy, it will produce necessities(food/water/clothes), public goods and merit goods.
2. Negative externalities will be controlled and reduced.
3. Prices are kept low, so it’s affordable for everyone.
4. Low unemployment can exist as the govt. aims at full employment.
5. Since there is no competition, duplication of products is eliminated.Disadvantages:
1. Consumer sovereignty is low as the govt. decides what to produce.
2. Lack of profit motive may lead to firms being inefficient.
- Mixed Economic System: Here, both the market and planned economy co-exist.Examples include almost all countries in the world (India, UK, Brazil etc). This is because it overrides all the disadvantages of both the market and planned economies.
Features:
1. Both the public and the private sector exists.
2. Planning and final decisions are made by the govt. while the market system can determine allocation of resources along with the public organizations.
Advantages:
1. The govt. can provide public goods, necessities and merit goods. The private businesses can provide most-demanded goods (luxury goods, superior goods). Thus, everyone is provided for.
2. The govt. will keep externalities, monopolies, harmful goods etc. in control.
3. The govt. can provide jobs in the public sector (so there is better job security).
4. The govt. can also provide financial help to collapsing private organizations, so jobs are kept secure.Disadvantages:
1. Govt. taxes will be imposed, which will raise prices and also reduce work incentive.
2. Govt. laws and regulations can increase production costs and reduce production.
3. Public sector organizations will still be inefficient and will produce low quality goods and services.
Sectors in an economy
Production in an economy can be divided into three types:
Primary sector: this involves the use/extraction of natural resources. Examples include agricultural activities, mining, fishing, wood-cutting, oil drilling etc.
Secondary sector: this involves the manufacture of goods using the resources from the primary sector. Examples include auto-mobile manufacturing, steel industries, cloth production etc.
Tertiary sector: this consist of all the services provided in an economy. This includes hotels, travel agencies, hair salons, banks etc.
*Market: any set of arrangement that brings together all the producers and consumers of a good or service, so they may engage in exchange. Example: a market for soft drinks.
*Public goods: goods that can be used by the general public, from which they will benefit. Their consumption can’t be measured, and thus cannot be charged a price for (this is why a market economy doesn’t produce them). Examples are street lights and roads.
*Merit goods: goods which create a positive effect on the community. Examples are schools, hospitals, food. The opposite is called demerit goods.
*Capital- intensive production: where more capital (machinery/equipments) is made use of rather than labour. An example is a modern car manufacturing plant
*Labour-intensive production: where more labour is made use of rather than capital. An example is agricultural activity.
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