Everything you need to know about the types of economic systems. Economic system determines the nature of state intervention in the business.
Thus, economic system is an integral part of the business environment. Economic System consists of “those institutions which a given people, a nation or a group of nations have chosen or accepted as the means through which their resources are to be utilized for the satisfaction of the human wants.”
The three types of economic systems are:- 1. Capitalism 2. Socialism 3. Mixed Economic System.
Additionally, learn about the features, merits and demerits of the types of economic systems.
3 Types of Economic Systems: Capitalism, Socialism and Mixed Economic System
Types of Economic Systems – Capitalism, Socialism and Mixed Economic System (With Features, Merits, Demerits and Comparison)
Capitalism is an economic system which can be identified from private ownership on the means of production and profit motivated production relations. In the literature, it is also named as free market economic system or a laissez-faire capitalism. In such an economic system, each economic entity whether individuals or companies, own and distribute resources or goods in a way so as to maximize their respective financial gains.
According to Macmillan Dictionary of Modern Economics, capitalism is defined as a social and economic system in which capital assets are mainly owned and controlled by private persons, labour is purchased for money wages, capital gains accrue to private owners, and the price mechanism is utilized to allocate capital goods between uses.
Features of Capitalism:
Following are the important features of capitalism:
i. Economic Freedom:
Economic freedom, as a basic feature of capitalism, has two major constituents, freedom of choice and freedom of enterprises.
a. Freedom of Choice:
It means that all economic entities, such as consumers, producers and workers, in the economy are free to make their own economic decisions, in the backdrop of resource scarcity, with regard to the resources they own. To a consumer, it means freedom to spend income on whichever goods and services he may desire.
b. Freedom of Enterprises:
A freedom of enterprises means freedom to a producer to own and operate any business. As an owner of a business organization, an individual is free to make any business decision.
Given the economic freedom, price mechanism plays an important role in the economy according to which a rational individual will exercise his rights in the best self-interest aimed at profit maximization or satisfaction maximization.
ii. Private Ownership:
In a capitalist setup, all the factors of production, as also goods and services, are privately owned. Such an ownership entitles the owners to use the resources in a manner in which they are comfortable with. Obviously, being rational owners, they will deploy the resources so as to get maximum rewards or earnings.
The right of private ownership will facilitate accumulation of wealth by all the economic entities which, in turn, will push the economic growth at aggregate.
iii. Right of Inheritance:
The inheritance means transfer from one generation to next generation. In the context of capitalism, it means transfer of assets from father to offspring. The capitalism provide right of inheritance to all individuals which act as an incentive to accumulate more wealth. It implies more economic activities and more income generation in a capitalist economy.
iv. Profit Motive:
In the capitalist economy, every activity will be governed by profit consideration. A producer will strive for maximum profit, a consumer for maximum satisfaction and a factor for maximum reward. Obviously, resources will be deployed only in those areas which are capable of providing maximum return or profit, given their scarcity.
v. Competitive Market:
All the capitalist economics are required to have competitive markets in which numerous sellers offer their goods and services to numerous buyers. This will ensure that each seller will make only a normal profit. Likewise, factor markets are also competitive which means that each factor will provide its services to a producer who offers a maximum rewards. Such competitive markets will be self-regulatory through the invisible hands of price mechanism.
This will encourage firms to always strive for better products and services for a larger market share or profit. A factor will also strive for higher productivity for better rewards as factor payments. Thus, each economic entity will attempt to improve all the time which, in turn, will push the entire economy up and up.
vi. Price Mechanism:
The price mechanism in a capitalist set up acts as a coordinating mechanism. It determines price of each and every economic activity. It works through demand and supply forces to determine equilibrium price.
vii. No Government Intervention:
The capitalist system does not involve any government interventions. Economic decisions are taken freely on the basis of price mechanism.
Merits of Capitalism:
i. Promote Economic Growth:
Many economist have argued that capitalism have great ability to promote economic growth. It leads to a faster GDP growth and better capacity utilization.
ii. High Living Standards and Hard Work:
The capitalism, while ensuring rapid economic growth, also facilitates a high living standard for all the consumers, each one of which is paid according to their respective contribution in production process. Thus, it encourages factors to strive for higher productivity and work hard so as to be rewarded better. With higher income, they will have higher living standard. The common capitalist mantra is that anyone can be rich if they work hard enough.
iii. Promote Technological Progress:
Given the intense market competition, rate of technological innovation will be high as each firm will attempt to grab market. In other words, capitalism will promote innovation and improvement in production techniques which may either contribute in lowering cost of production or improve product quality. In the quest of profit, each firm will try to offer products better than competitors. Thus, successful innovations will strengthen the competitive strength of a firm in a capitalist setup.
iv. Stimulate Rate of Capital Formation:
Two of its features, viz., private ownership and law of inheritance, encourages everyone to own more and more properties, physical as well as intellectual, and pass it on the next generation after their death. Such a tendency will stimulate the rate of capital formation in the economy.
v. Optimum Resource Utilization:
Since all the markets in a capitalist economy are competitive, it promotes efficient and optimum resource utilization at each level. Further, the interplay of market forces ensures resource to be deployed in most productive uses. In brief, thus, capitalism encourages optimum resource utilization.
vi. Emergence of Entrepreneurship:
Give the prevalence of profit prospects in the market, whosoever may have potential and capabilities will emerge as entrepreneur. Hence, there will be addition of new entrepreneurs all the time.
vii. Benefit of Automatic Functioning:
The capitalism has a unique advantage of automatic functioning of the economy. All the economic decisions are based on price mechanism. It, in other words, it means that cost of decision making at each level is nil.
viii. Sovereignty of Consumers:
Consumer in a capitalist society is accorded a status of king. It means that all the economic decisions revolve around the consumer. His decision making regarding what to consume and how much will significantly influence the firms’ survival and growth.
i. Income Inequality:
It is not true that anyone can be rich if they work hard enough. In fact, one will grow under capitalism at the cost of others only. It means that along with every rich, a large army of poor will coexist. In simple terms, there will be a growing income inequality in a capitalistic setup.
In fact, it is this demerit of capitalism that has been amply highlighted by the socialist thinkers including Karl Marx. It has provided a basis for the evolution of socialist form of economic system, as an alternative to capitalism.
ii. Economic Instability:
The free market mechanism of a capitalist society is a source of cyclic behaviour of the economy, commonly known as trade cycle or business cycle. Such behaviour of economy will produce recession and inflation in the economy one after other and, hence give rise to instability in growth.
Both of it will not be good for the economy. A recessionary phase will result into unemployment causing considerable hardship to the workers who will be thrown out of their jobs for none of their mistake. Likewise, an upward economic swing will strengthen inflation again adversely affecting the poor in the economy.
iii. Social Welfare is Ignored:
Another important demerit of the capitalism is that it does not bother about social welfare. For example, in the process of allocating resources across products, more allocation is made for luxury goods rather than basic necessities. It is because of the fact that the profit prospects are much better in the production of luxury items as compared to basic necessities.
iv. A Lot of Wasteful Expenditure:
In capitalism, intense market competition force companies to go for large selling cost though which aggressive sale-promotion is carried out. Such expenditure is wasteful in nature since it does not add any value to the products for the consumer. It may simply help companies to protect their respective market share from competitors. In fact, capitalism is known for a cut-throat competition implying that such wasteful expenditure is huge.
Another source of wasteful expenditure comes from unequal income distribution in a capitalist society. While the rich usually do a lot of wasteful expenditure, poor do not find enough to meet even basic necessities and hence starve.
It is not correct to say that a capitalist economy pays everyone as per their contribution to the production process. The marginal productivity theory of distribution, tells that every worker is paid a sum equals to marginal productivity of last unit of labour and not that of his own. The difference between the own marginal productivity and that of the last unit is basically the profit of the producer or exploitation of the worker.
vi. Emergence of Monopoly Market:
Under capitalist society, each firm wants to become bigger and bigger. They even adopt strategies to throw out competitors out of market to grab the market share. Obviously, competitive markets will gradually become oligopolistic or even monopolist in long run. A monopolist firm produces a lower quantity and charges a higher price than that of a competitive firm.
Further, in long run, a competitive firm will only earn a normal profit while a monopolist will always earn a super normal profit.
Again, a monopolist will not mind to sell the same product at different prices to different customers through price discrimination while a competitive firm will not be capable of doing so.
Based on all these facts, one can say that the under capitalism the monopolies will emerge and exploit the workers and consumers enormously and impoverish the majority of the population as the monopolists want to maximize their super normal profits.
vii. Undemocratic in Nature:
While it is claim that capitalism is democratic in nature, this is not true. Rich and powerful, both individuals and companies, usually have more say in government policy-making as compared to the poor.
It is not surprising therefore that the capitalism has been severely criticized by a large number of social scientists including economists and sociologist, for all the demerits inbuilt in it. So much so that the capitalism have been completely discarded by the socialist thinkers. They have propagated altogether a new form of economic system which is based on equality and social justice. It is known as socialism.
Emergence of socialism has been traced above in the criticisms of capitalism, specifically the rising income inequality under it which divides the society into have and have-nots. Further, the root cause of income inequality in capitalism is the private ownership on factors of production.
The socialist thinkers have, thus, proposed a socialist mode of product as an alternative to capitalism or as a solution to all the demerits of capitalism. To be precise, socialism proposes state ownership on means of production and maximum social benefits as profit motive in the production system. The system is looked upon as need-based rather than profit-based.
Important features of socialism can be highlighted as follows:
i. Social Ownership on Production Factors:
The basic feature of a socialist economy is that all major means of production are placed under collective social ownership rather than under the individual ownership. It thus takeover private property and transforms them into social property through nationalization. In simple words, all big industries and land are to be bought under state ownership. As a matter of fact, private ownership is considered at par with private robbery under socialism.
Practically speaking, however, only key and strategic means of production are brought under public ownership while some minor activities are left for individual ownership. Such private activities constitute an insignificant portion of the total activities in the economy.
ii. Motive of Social Welfare:
The socialism is fully dedicated to social welfare and the individual interests take a back seat. That is, individual interests are being sacrificed for social interests. The social interests are always supreme and maximizing social gains is the guiding motive of production. Basic philosophy is that entire society should be enriched rather that enriching a few.
iii. Economic Decisions and Planning:
Under socialism power to take economic decisions rest with public authorities and not with the profit-seeking private individuals and firms. The economic development is carried out through economic planning, which is an essential feature of socialism. Decisions regarding central problems (what, how and for whom to produce) are taken by a central board or planning commission. It follows need-based decision-making in place of a profit-based one.
A need-based decision-making system is one which assured everyone a share in national income irrespective of his/her contribution in it. Given that decisions are taken through a planning process and not through market forces, such economies are also called as centrally planned economies.
iv. No Role of Price Mechanism and Lack of Market Competition:
Given the pre-dominant role of planning process, market oriented decision making through price mechanism has no role to play. As a result, there is no market competition, no rivalry between production units and, hence, no wastage of resources in the form of selling cost or sale promotion measures like advertisement. The State commands a virtual monopoly on production system.
v. Classless Society and No Exploitation:
Capitalist mode of production divides society into have and have-nots. Contrary to it, socialism attempts to create a classless society, a society of peasants and workers. Means of production being state-owned, there is no capitalist class.
Even if it existed, as under liberal socialism, it is effectively regulated and controlled by the state institutions. It has to operate within the framework provided by the State. It has to follow the regulation imposed on it. Obviously, such a system has no scope of exploitation.
In nutshell, the root cause of exploitation, the individual ownership on means of production, is being rooted out to a significant extent.
vi. Inequality in Income and Wealth Distribution:
Another important feature of the socialism is that income and wealth inequalities are within the pre-determined limits since it is a need-based rather than productivity-based system. Thus, there is no scope for social tension and no risk of disintegration.
vii. Social Security:
It provides social security to all implying that every member of the society is assured of an income, which is sufficient for satisfying his needs irrespective of the fact whether he is able to work or not. It even takes care of old age needs of the people when they are unable to make contribution in production.
There are many advantages in socialism.
They can be summarized as follow:
i. Efficient Resource Utilization:
In a socialist economy, production decisions are taken by a central body on the basis of requirements of the economy. Depending upon the availability of resources, it decides to produce the items most needed and in just quantity ruling out any duplication of production. Hence, there is neither any wastage of resources nor unemployment. On this basis, one can argue that a socialist set up ensures efficient resource utilization.
ii. Inequality of Income within Desirable Limits or Distributive Justice:
Since factors of productions are owned by the government and the factor payments are need based, there is no possibility of income inequality beyond desirable limits. Moreover, it also offered social security to everyone, at least with regard to basic needs. In nutshell, it upholds the principles of distributive justice.
iii. No Class Struggle:
As the society does not divide into have and have-nots, there is no possibility for social tension and, hence, no scope for class struggle.
iv. No Economic Instability:
Since market mechanism has no role to play, presence of business cycles are not witnessed and hence no economic instability under socialism. Each and every sector develops in a planned manner. There is no excess demand or excess supply scenario. It implies that resources are better allocated under socialist mode of production.
v. No Unemployment:
In socialist mode of economic system, production is planned as per the availability of resources and, hence, there is no scope for unemployment.
i. Efficiency and Factor Productivities are Low:
Being a need based system it ignores efficiency and factor productivity. No serious attention is given, especially at individual level, to increase productivity since factor payments are no way linked to their respective contributions in the production.
Moreover, high social security also discourages a person to work hard as he knows that even if he does work, or does not work hard, his future is secured at least for basic needs. Further, even if he works harder, he will not gain much in terms of better life style. His needs are pre-determined by the system. As such labour productivity in socialism is always low.
At the other end, the production system is managed by state officials who have no personal interest in it and hence, has no incentives to perform.
For all these reasons, the socialism witness low labour productivity which may even decline overtime. The efficiency level is also found to be low in such a system.
ii. De-Motivating Hard Work:
An important weakness of socialism was that it adversely affected the motivation to work hard as no personal gains and losses are involved. This ultimately resulted in slower economic growth and smaller income generation.
iii. Complex Administration:
Since every venture and each aspect is managed by bureaucrats, the administrative process becomes very complex and the network becomes multi-layered. The state officials used to consider production system just as an extension of government departments. Thus, often it used to take a long time to take a decision which has to be approved at various levels. This not only increases the cost but often cause considerable delay in decision-making.
iv. No Consumer Sovereignty:
A serious drawback of the socialist system is that it has no respect for the consumer sovereignty. His preferences for the goods and services to be consumed have just no place in the decision making. He has to consume whatever decided for him by the State authorities. This considerably lowers his motivation to work.
v. No Economic Freedom:
In this form of economic system, there is neither a freedom of choice nor a freedom of enterprise, as observed in case of capitalism. Hence, workers have no job satisfaction. They are asked to perform a task and one has to do it whether he likes or dis-likes.
vi. Concentration of Power:
It has also been argued that the socialist system is also not free from concentration of power. Under it, power gradually concentrates in the hands of bureaucracy and the State machinery.
Despite many merits and positive features of socialism, it has been criticized for several reasons, which are amply elaborated under its demerits. With the demise of socialism, it appears that its demerits were more powerful and its merits did not exist in reality.
A mixed economy is nothing but an attempt to incorporate advantages of both capitalism and socialism under it while keeping their respective disadvantages away.
Conceptually speaking, two forms of mixed economy can be identified:
i. Mixed capitalist economy, and
ii. Mixed socialist economy
i. Mixed Capitalist Economy:
A mixed capitalist economic system is one that rely more on capitalism while incorporating a few features of socialism into it. It is basically a market economy characterized by the presence of a small public sector to protect the welfare, especially of the weaker sections of the society. The presence of public sector is also noticeable in the areas such as, national security. The market mechanism plays a dominant role under it and government interventions in the market are limited.
As a matter of fact, almost all the capitalist economies of the world, now-a-days, are the mixed capitalist economies marked by the presence of a public sector and wide-ranging government interventions for orderly functioning of the respective economies. The policy perception provided by Keynes following the great depression of the thirties laid the emergence of such mixed capitalist economies.
ii. Mixed Socialist Economy:
On the other hand, a mixed socialist economy will look more like a socialist economy marked by:
i. Some freedom to producers to operate mostly in non-core areas of production. Even the limited freedom to private sector is subjected to considerable government interventions through various macro- economic policies. This is to ensure that it functions in accordance with national development priorities.
ii. Considerable freedom to consumer to select goods and services for consumption, and
iii. Almost a complete freedom to factors of production, labour in particular, to choose the work place. The state influence resource deployment indirectly through different policy instruments.
Nonetheless, the State keeps an effective control over the economy and different markets are regulated to varying extent for their orderly functioning.
The two forms of mixed economic systems, thus, differ considerably with each other depending upon their leaning towards capitalism or socialism.
India’s Economic System:
India is one of the countries that have experimented with a mixed socialist economic system since 1951. It instituted a physical control regime up until 1984. Towards this —
i. It established an industrial licensing regime, a rigid foreign exchange regulation regime, several price and distribution controls, and so on.
ii. It also setup several public sector undertakings and a distribution network consisting of numerous ration-shops.
iii. The state acted as a biggest employer in the economy providing employment to millions of youth.
iv. The financial sector, including the commercial banks, has functioned totally under RBI regulations and controls.
Despite all these and numerous other initiatives, the country suffered from slow growth, industrial stagnation, rising unemployment and high cost production structure.
This led policy makers to do a rethinking on policy regime and paved the way for economic liberalization since 1985 under which the country move away from the principles of socialism. Since 1991, it initiated an aggressive reform process under which role of market forces was gradually widened, areas reserved for public sector were considerably curtailed and more and more areas were opened up for private initiatives. In nutshell, India has made a gradual move from a mixed socialist economy to a mixed capitalist economy. Such a process of transformation is still continuing.
Important features of a mixed economic system, keeping Indian economy in view, are highlighted below:
1. Public and Private Sectors:
A basic feature of mixed economic system is the co-existence of both public and private sectors under it. Mostly, essential and core production activities are placed under public sector while private sector is allowed to operate in non-core areas, such as production of consumables.
In India for example, production of heavy machinery and most of the critical intermediates, like petroleum products, fertilizers, chemicals, iron & steel etc., were put under the State ownership while private entrepreneurs were allowed to take up production of items like farming, textiles, leather items, and so on.
The Industrial policy-1991 has however, introduced a radical shift in the policy perception. It curtailed the scope for public sector by way of reducing areas reserved for it from 17 to just 4. Many public sector units were gradually privatized. The industrial licensing was virtually abolished which was a very powerful instrument for regulating private initiatives in industrialization in pre-1991 era.
All these and many other measures have significantly curtailed the scope for public sector and widened the scope for private sector. Still, even today Indian economy can be characterized by the presence of both public and private sectors.
2. Economic Welfare:
Under a mixed economic system, the Government introduces several instruments to safe-guard the interests of weaker and unorganized segments of the economy. For example,
i. Regional balance may be taken into account while approving investment in different areas even though it lead to high production cost due to logistic disadvantages.
ii. Similarly, for the sake of more employment opportunities a relatively out-dated and less efficient technology may be selected in place of a modern one.
iii. In the field of distribution, essential items, like food grains, vegetable oil, sugar, salt etc. may be provided at a cheaper rate from public distribution system.
3. Economic Planning:
A mixed socialist economy considerably relies upon the planning process since the Government has to carry out almost all the critical production activities. For this purpose, in addition to a central planning board, the State and district level planning machinery is also established.
However, the role played by such a network of planning agencies is considerably less in a mixed capitalist economy. In a way, planning process will transform itself from a lead role to a supportive role in development process when an economy moves from mixed socialist to a mixed capitalist arrangement, as happened in the case of India in post-1991 era.
4. Profit Motivation:
Economic activities guided by profit motivation are limited in a mixed socialist economy but are considerable under a mixed capitalist economy. Even the role market mechanism is different under the two modes of production, more in a mixed capitalist economy and less in the other.
5. Private Ownership:
Both the forms of mixed economic system allow private ownership on means of production though in the socialist setup they may be subjected to regulations for a more equitable distribution of such ownerships. For example, in India, rich are subjected to wealth tax so that capital accumulation in a fewer hands may be restricted, to an extent.
Likewise, earlier an Estate duty was also in force which was abolished in the reform process. Further, there are land-ceiling Acts, applicable to both rural and urban areas. Such regulations in a mixed capitalist setup are fewer in number and less severe.
6. Freedom of Choice:
Similarly, the two types of mixed economic systems also provide for freedom of choice to all means of production but this may not be unlimited in case of the socialist one.
7. Income Inequality:
Given that market mechanism is in force, possibility of rising income inequality cannot be ruled out. However, under an inclination towards socialism, the government through various policy instruments attempts to keep it within a desired limit.
For example, high personal incomes are subjected to higher income tax under progressive taxation or luxury goods are imposed high excise duty. On the other hand, income of the workers may be protected through Minimum Wage Acts. Subsidies may be provided to the necessity goods.
Merits of Mixed Economic System:
Being an attempt to bring positive aspects of the capitalism and the socialism both, the mixed system is marked by several advantages. They are highlighted below as merits of mixed economic system.
1. Faster Economic Development:
Given that the mixed economic system provides a role to both public and private sectors, it ensures a faster and balanced growth.
2. Limited Income Inequality:
Further, the mixed economic system ensures income inequality to remain within a desired limit since the Governments apply various policy instruments to control it.
3. Equal Opportunities to All:
The mixed economic setup provides opportunities to grow to all. For example, in India, it has provided reservation to the backward castes in jobs for facilitating their uplifting.
Likewise, it has exclusively reserved certain sectors for small scale and tiny units. The large companies are not allowed to venture in those areas. However, post-1991, areas under such reservations is curtailed considerably.
At the same time, planning process also ensure development of all the geographical pockets of the country by way of making a balance in investment allocation.
4. Scope for Private Initiatives:
The mixed economic systems being marked by the co-existence of both public and private sectors, provides ample scope for private growth initiatives. It is, however, somewhat more in case of mixed capitalist system than that in mixed socialist system.
It is very much evident from the Indian example. The post-reform era has widened the scope for private sector considerably not only by way of opening newer areas for it but also by way of reducing restrictions on its operations. For example, The MRTP Commission and FERA regulations were abolished and replaced by a Competition commission and FEMA regulations respectively. They are far less restrictive on growth of private sector.
5. Ensure Social Justice:
Governments under mixed economic systems, enact various legislations to protect the interests of backward sectors which save them from market exploitation. This ensures growth with social justice. For example, Indian government provides considerable support, financial or otherwise, to backward classes. It also runs numerous schemes for the benefits of poor or low income population.
6. Freedom of Choice and Consumer’s Sovereignty:
Despite restrictions, consumers in a mixed economy enjoy a considerable sovereignty as the consumables are mostly governed by market mechanism. At the same time, government ensures availability of essential items to all at reasonable prices. Workers are allowed freedom to choose the place of work. The system, however, imposes some restrictions on big companies in the national interests.
7. Economic Stability:
In a mixed economy, government being the biggest market player allows economy to oscillate within a desirable limit. In case of high inflation or recession, policy interventions and direct actions may be introduced by the government.
Further, even the private sector may be asked to operate within the broader policy framework to limit the economic instability. Hence, the mixed economic system ensures economic stability to a considerable extent and, at the same, leave ample scope for market forces.
Demerits of Mixed Economic System:
1. Slower Economic Growth:
Theoretically, a mixed economic system is expected to achieve a faster growth. However, India in reality has witnessed not only a slower economic growth but industrial stagnation as well under its socialist setup. In contrast, the post 1991 era, which is marked by closeness to capitalism, has witnessed a higher growth. This indicates that the mixed socialist system may not be favourable to the economic growth.
2. No Efficient Use of Resources:
In a mixed system, efficient use of resources may not be promoted all the time. The investment in public sector may suffer from economic irrationality and hence less productive. On the other hand, private sector may suffocate due to excessive regulations. In totality, such a system may lead to inefficient use of resources.
3. Too much Government Intervention:
This is a universal tendency in all the mixed economic setups that the governments continue to make rules and regulations for every problem faced by the economy. Too much government intervention will defeat the purpose for which the mixed economic system was setup.
4. Disadvantage of Capitalism and Socialism:
While the conceptualization of mixed economy is aimed at to incorporate merits of both capitalism and socialism into it, in practice it appears that in has incorporated demerits of the both the systems.
Basic differences among the three kinds of economic systems with regard to resolving the central problems have been illustrated in the following data:
1. What to produce — On the basis of consumers’ preference
2. How to produce — On the basis of profit prospects and availability of technologies
3. For whom to produce — On the basis of distribution of income in the economy
4. Instrument to resolved problems — Price mechanism
5. Basic objective — Private profits
1. What to produce — By Planning Body after evaluating economic needs of peoples
2. How to produce — By planning body after evaluating technological options and resources at its disposable
3. For whom to produce — On the basis of predetermined needs of the peoples.
4. Instrument to resolved problems — Through a planning process
5. Basic objective — welfare
1. What to produce — Partly on the basis of consumers’ preference and partly by planning body.
2. How to produce — Partly on the basis of profit prospects, and partly by planning body to ensure social justice
3. For whom to produce — Broadly on the basis of income distribution in the economy but ensuring that basic needs of all are met.
4. Instrument to resolved problems — Partly by guided price mechanism and partly by planning process.
5. Basic objective — Economic welfare along with private profits.
Types of Economic Systems – 3 Types: Capitalism, Socialism and Mixed Economy (With Features, Merits and Demerits)
Economic system determines the nature of state intervention in the business. Thus, economic system is an integral part of the business environment. Generally, there are three types of economic systems and these are capitalism, socialism and mixed economy.
Capitalism is purely an economic concept and can be combined with entirely different political, religious, family, educational and other institutions. According to Prof. Loucks, “Capitalism is a system of economic organisation featured by the private ownership and the use of the private profit of man-made and nature made capital.”
Prof. Pikersgill defined capitalism in the following words- “The capital system is one characterised by the private ownership of the means of production, individual decision making and the use of the market mechanism to carry out the decision of individual participants and the flow of goods and services in markets.”
According to Webbs, “capitalism, capitalistic system or capitalist civilization means the particular stage in the development of industry and legal institutions in which the bulk of the workers find themselves divorced from the ownership of the instruments of the production in such a way as to pass into the position of the wage earners whose subsistence, security and personal freedom seem dependent on the wall of a relatively small proportion of the nation, namely those who own and through their legal ownership, control the organisation of the land, the machinery and the labour forces of the community and do so with the object of making for themselves individual and private gains.”
Thus, in simple words, “Capitalism is an economic system wherein property rights are vested with individuals or their associations, legally recognised as persons, individuals. These persons are not only free to own capital and consumer’s goods but also to use and dispose them off as and when they like.”
(i) Right of Private Property:
Private property refers to the right vested in an owner and protected by the society. The owner exercises control over the uses of the properties owned by him. Everybody has a right to acquire private property, to keep it and after his death to pass it on to his heirs as per the system of inheritance.
With the result, inequalities of wealth distribution are perpetuated. The rich people become richer and the poor people become poor. Besides, factors of production are owned by private individuals. They are also the owners of the firm and factories.
(ii) Freedom of Enterprise:
It has three dimensions, viz., freedom of enterprise, freedom of contracts and freedom to use one’s property. In the system, everybody is free to opt for any occupation, or start any business or to enter into contracts in a manner most profitable to him. Every citizen has the freedom to form any firm or company or business anywhere he likes provided he has the requisite capital, skill and risk taking capacity.
(iii) Consumers Sovereignty:
Every consumer enjoys a freedom to have the commodities and the services that he wishes to consume. Consumer is treated as the king. Thus, it means the production decisions are governed by the consumers desires which are reflected in their demand pattern. However, the consumer’s sovereignty is limited by the consumer’s income and the availability of goods in the market.
(iv) Profit Motive:
Profit motive induces the people to undertake any productive activity. Entrepreneurial activity is governed by the profit motive and not by the social service. He is not in the business for social service. He is in the business to earn profit and out of that profit he fulfills his social obligations.
It means profit motive of individual governs the formulation of business enterprise. Commodities and services produced by the entrepreneurs are expected to yield maximum profit. Actually, it is the profit motive which induces entrepreneurs to ensure the optimum use of factors of production.
(v) Absence of Central Economic Plan:
Freedom of enterprise and property rights rule out the possibility of central direction or central authority. Resource allocation and investment decisions are guided by the market forces. The state has no role to play in the economic planning of the country. Entrepreneurial decision generally decides the nature of product and level of production.
It is also influenced by the number of individual consumers who make their decisions without consulting one another. It is the consumer’s preferences which finally decide what should be produced and what should not be produced.
(vi) Class Conflict:
Capitalistic structure leads to inequal distribution of income and wealth. It further envisages inequality in economic and political power. The society has been divided in two categories- the haves and haves not, which have conflicting interest to each other. Moreover, class conflict is inherent in capitalism.
(vii) Role Assigned to Entrepreneurs:
An entrepreneur plays a vital role under this economic order. He directs all productive machinery of the country. It is he who hires the other factors of production and compensates them. He represents the community in the matter of production.
The first important function of competition in a capitalist society is pricing of goods and factor services. Prices are determined by free play of market forces. Secondly, competition creates and preserves efficiency in the production process. Capitalism is essentially a free market economy.
(ix) Control with Risk:
Golden rule of capitalism is to control and control the business which goes with risk. Investors or entrepreneurs who have invested or taken initiatives with regard to investment of capital and risks have every right to control the business under their command.
(x) Rate of Price System:
Price mechanism facilitates the working of capitalism. Price equate the demand and supply of commodities and factors of production. Price guides the producers as to what to produce and what not to produce. Similarly, price also sends signals to the consumers as to what to consume and what not to consume. Thus, capitalism is governed by the price mechanism.
(i) Optimum Utilisation of Resources:
Entrepreneurial activity is guided by the profit motive. Practically, every entrepreneur tries to use the productive resources at his disposal in the most efficient manner with an objective to maximize his profit. There is a keen competition among producers to produce at lowest cost and control wastes to their lowest level. Thus, capitalism ensures the most efficient use of national resources.
(ii) Automatic Working:
Price mechanism is the basis of automatic working of capitalism. Price rectifies the distortions available in the economy, if any. Price mechanism also rules out any expenditure to be incurred on the operating system of capitalism.
(iii) Higher Level of Productivity:
Under capitalism, control of business rests with the entrepreneur and so he is induced to work hard and work efficiently to earn higher level of profits. Similarly, workers can also earn higher income by improving their efficiency and doing more work. Thus, under this system, entrepreneurs and workers both are induced to improve their efficiency and put hard work.
(iv) Economic Prosperity:
Capitalism encourages potential investors to invest more and more to earn the profit. Larger the investment level larger the level of production and services. Higher investment also ensures higher level of employment opportunities. Society is the most beneficiary of huge availability of goods and services in the market.
(v) Improvement in Risk Taking Capacity:
Profit motive also induces entrepreneurs to innovate and assume more risks. Higher the risk, greater is the profit innovations and it leads to improvement in production technique and lowering the costs of production.
(i) Class Conflict:
Capitalism divides the society into two categories, viz., have and have not or capital and labour. Thus, they have conflicting interest and look out for an opportunity to fight. The workers want higher wages and less working hours which is against the philosophy of capitalists. Class conflicts ultimately leads to strikes and lock outs which are not in the interest of the society as well as economy.
(ii) Exploitations of Consumers:
Economic decisions of entrepreneurs are governed by their self-interest and not by social welfare. Entrepreneurs involve themselves in gentlemen’s agreements which lead to monopoly in place of competition. Lack of effective competition, manipulative practices of entrepreneurs and the ignorant and the helpless behaviour of individual consumers turn the consumer-king into an abject slave—a victim of exploitation. Thus, consumers are exploited by the unscrupulous entrepreneurs.
(iii) Wasteful Competition:
Competition encourages wasteful expenditures like advertisement and selling costs. Actually, consumers are unable to gain from cut throat competition launched by the producers. Competition also leads to the production of too many varieties lead to but these too many varieties lead to wasteful use of economic resources.
(iv) Economic Instability:
Excess competition and high saving rates encourage recurrence of trade cycles in the system. Trade cycles are again responsible for over production. Thus, combined effect of these variables leads to economic instability in the economy.
(v) Defective Allocation of Resources:
Capitalism has its own priorities. It encourages investment in those areas where expected profit is at higher level. In this sense, goods and services required for basic needs of the society is not the goal of the production under capitalism. Capitalism makes available productive resources for the production of luxuries which is meant for rich people. Productive resources are not utilised in producing sufficient quantity of goods for human consumption as poor people has no capacity to compensate with profit to the entrepreneurs.
Under socialism the instruments of production are owned and controlled by the state. Resources mobilisation and allocation are also governed and regulated by the government. In a theoretical framework, all resources are under the control of public ownership. However, management of these resources are also undertaken as per the wishes of society at large.
Dickenson defined “Socialism as an organisation of society in which the material means of production are owned by the whole community and operated by organisation’s representative of and responsible to, the community. According to a general plan, all members of the community being entitled to benefits from the result of such socialised planned production on the basis of equity rights.”
According to Webbs, “Socialised industry is one in which the national instruments of production are owned by public authority or voluntary association and operated not with a view to profiting by sale to other people, but for the direct service of those whom the authority or association represents.”
According to Loucks, “Socialism refers to that movement which aims at vesting in society as a whole, rather than in individual’s ownership and management of all nature made and man-made producers’ goods used in large scale production to the end that an increased national income may be more equally distributed without materially destroying the individual’s economic motivation or his freedom of occupational and consumption choices.”
(i) Social Ownership and Control:
Socialism assumes that ownership and control of means of production are to be vested in the state so that the state may provide work for everybody. Besides, stat e has a control over means of production and profit of all enterprises go to the state exchequer. The government uses these profits for the benefits of society at a large.
(ii) Central Authority:
Socialism assumes the existence of a central authority which directs the allocation of productive resources of the community. Similarly, state is responsible for the production and distribution of goods and services. Since means of production are owned and controlled by the state it has authority to direct the production of commodities and the utilisation of resources in the desired channels.
Central authority is entrusted with price mechanism which lays down the objective of planning and to settle the targets and priorities of planning.
(iii) State Enterprises:
Under socialism, state is expected to play its participative role in business. Production is generally initiated and conducted by the state-owned enterprises as there is no role for private enterprises. These state enterprises are responsible for the payment of wages and other costs and keep profit for themselves. These enterprises generally work as a model employer. A state is required to work as a capitalist in terms of landlord and entrepreneurs.
(iv) Equality of Opportunity:
Socialism tries to provide equality of opportunity to all. Equitable distribution of income is ensured. Every individual has an equal opportunity to rise in life. Every person has an opportunity to receive educational facility and he can enter a profession of his choice. Every step is taken to provide full opportunity to each and everybody to achieve his goal, mission or objective. Every individual enjoys equality of opportunity regardless of caste, creed, family and religions.
(v) Classless Society:
Socialism believes in classless society. There is no distinction between the have and haves not. The main objective of socialist state is to remove the distinction between two classes of labour and capitalists. Severe regulatory measures are generally adopted to check the growth of private wealth. Every individual gets a reward according to his work and ability.
(vi) Social Development:
Socialism provides the consideration to social welfare which guides productive resources in the country. Commodities and services of such type and in such quantities are produced which are essential for promoting social welfare. Central authority ensures effective actions for social development of society at large. The state takes necessary steps to ameliorate the lot of the common man by providing adequate medical aid fully and free educational and recreational facilities.
(i) Effective Resource Allocation:
Socialism ensures effective allocation of productive resources to different sectors of the economy. Central planning authority just like Indian Planning Commission determines the allocation of resources more economically and optimally among the various productive uses.
Central planning authority is also in a better position to assess the basic needs of the people and the intensity of their desires and to entrust the resources to satisfy these desires in the best possible manner.
(ii) Improvement in Productive Efficiency:
Under Socialism, production activities are undertaken to increase the social welfare. Central planning authority also ensures availability of improved techniques of production and scientific research to all organisations to improve their productive efficiency. State control reduces the possibility of wasteful expenditure on competitive selling campaigns.
(iii) Economic Stability:
Trade cycles are the special feature of capitalism and they create hardships to the producers and consumers. Socialism eliminates trade cycles as means of production are owned and controlled by the state. Central planning authority effectively determines the level of investment and the level of aggregate demand.
The state has full authority to prevent the imbalance between aggregate demand and aggregate supply by ensuring effective implementation of regulatory measures.
(iv) Accelerating Economic Development:
Under Socialism, state is expected to adopt economic planning as a means of promoting accelerated economic development. Economic planning ensures effective and fruitful utilization of potential productive resources. A planned socialist economy functions effectively according to the development programme and in a systematic manner. Economic planning raises the rates of saving and investment as these are essential to accelerate economic progress.
(v) Social Justice:
Socialism develops social justice. The socialist principle provides for a fair and equitable distribution of income for all. There is no provision or role for exploitation of man by man. Inequalities of income are minimized to ensure equal distribution of national income. Socialism also ensures protection against uncertainties relating to income, work and living conditions.
(i) Development of State Capitalism:
Socialism is responsible for state capitalism in place of private capitalism. In the system, state is not merely political authority but it also exercises unlimited authority in the economic area. All powers are generally concentrated in the state and the individuals have no role in the economic decision-making.
(ii) Essence of Personal Liberty:
Under Socialism, private individuals have no initiatives as their whole activities are governed by the dictates of the state. With the result, there is no incentive to hard work and stimulus to self-improvement; inventive ability, enterprising spirit and the go ahead attitude are some of the causalities of state capitalization.
(iii) Essence of Consumer Sovereignty:
Socialism encourages only those consumption and production which increase the level of social welfare. Consumption will have to adjust itself against available production from state agencies. Consumer does not have its own choice. His consumption behaviour is directed and governed by the state philosophy of consumption and production.
(iv) Red Tapism and Bureaucratic Management:
Under socialism bureaucracy runs state affairs. But, bureaucrats are not fully trained in running economic machinery. Actually, bureaucracy is considered to be inefficient in running a business. Bureaucracy does not believe in quick decision-making and encourage red tapism and corruption in the system. The Government can and does attract able men but conditions in government services are not conducive to hardworking and effective people.
(v) Defective Resource Allocation:
Socialism lacks automatic indicator for the efficient allocation of economic resources. Some commodities are produced in excess and floated while there is shortage of other commodities, resulting in unsatisfied demand. Central economic authority fails to ensure effective production system, viable allocation of resources and efficient working environment.
Besides, Government also lacks sufficient resources which are necessary for the efficient running and expanding of industrial units.
Mixed economy may be defined as a form of economic system, which possesses the elements of both, i.e., market or capitalistic economy and command economy. Thus, it integrates good features of both capitalism and socialism. It relies primarily on the price system for their economic organisation but use a variety of government intervention such as taxes, spending and regulation to handle macro-economic stability and market failure.
Under this form of economic system, the means of production are partly owned by the private sector and partly owned by the state. The centralized economy (public sector) and the market economy (private sector) co-exist under this system. Thus, system of mixed economy integrates the good features of capitalism as well as socialism to provide a practical platform for the economic development.
Economic development of mixed economy depends upon the joint cooperation of the government and the private sector. In other words, in a mixed economy, the means of production and productive capital is owned by private entrepreneurs. But, the government also directly regulates, promotes and participates in the working of economy through its statues, policies, programmes and initiatives.
Features of Mixed Economy:
(i) Co-Existence of Public and Private Sector:
In a mixed economy, the public sector and the private sector participate jointly for the development of the country. The resources of the country are owned and used both by the government and the private industrialists. There is neither exclusive public ownership of the means of production nor the private ownership.
The state is the owner of many sources of economic activities. Besides, private sector also manages and some other economic activities. The two sectors are expected to work on a cooperative basis. But, often they become competitive.
(ii) Existence of Economic Planning:
Mixed economy implies that both the sectors should function in a properly coordinated manner. Economic planning lays down the broad framework within which the economy as a whole is expected to function to realise specific goals. However, social welfare is the major objective of whole planning process.
Government also adopts necessary measures to regulate and influence the private sector so that it may function in the interest of nation. Exclusiveness of private entrepreneurs is regulated by the state or by independent regulatory authorities.
(iii) Price Mechanism:
Mixed economy is governed by price mechanism and government directives. In other words, market mechanism and administrative pricing structure are the important components of mixed economic system. Products of the private sector are priced by the market forces of demand and supply.
On the other hand, prices of goods and services produced by the public sector are determined by the state. Thus, dual pricing is an important work of a mixed economy.
(iv) Protection of Consumer Sovereignty:
Under mixed economy, consumers are free to buy commodities and services of their choice. Private entrepreneurs are free to produce commodities according to consumer preferences but under the broad policy framework formulated by the government. The aim of price control is to protect the consumers from the exploitation of private entrepreneurs.
(v) Dual Objectives:
Private sector operates with profit maximization motive and public sector is guided by social welfare considerations. Private entrepreneurs are attracted to remain in the business only for profit. Public sector enterprises also earn profit but they transfer this profit to the government for providing social welfare. Public sector judges its success by social profitability. Thus, mixed economy fulfills dual objectives- private profit and social profitability.
(vi) Protection of Labour:
Under mixed economic system, the government protects the weaker sections of society including labour. With the help of economic and legislative measures, government tries to protect labour from the exploitation of private entrepreneurs. The government also takes necessary steps to prevent industrial disputes.
(vii) Reduction of Economic Inequalities:
In mixed economy, government initiates necessary steps for the reduction of inequalities of income and wealth. The government motivates promotion of backward area development and if need arises participate in the business by establishing enterprises in the backward areas.
Merits of Mixed Economy:
(i) Benefits of Both Sector- Mixed economy secures the merits of both capitalism and socialism while avoiding the evils of both.
(ii) Protect of Freedom- Mixed economy protects individual freedom. Under the system, individuals have the freedom of consumption, choice of occupation, freedom of enterprise and freedom of expression.
(iii) Supremacy of Price Mechanism- Price mechanism is allowed to operate under mixed economy.
(iv) Reduction in Inequality- Reducing the inequalities of wealth and class struggle is one of the aims of mixed economy.
(v) Control on Economic Fluctuations- Economic fluctuations can be avoided due to centrally planned economy.
Demerits of Mixed Economy:
(i) Operational Difficulty- Mixed economy is difficult to operate. Balancing and adjusting the public and private sector is often difficult.
(ii) Possibility of Excessive Control- Excessive controls and heavy taxes are likely to prevail under mixed economy. These will discourage production in the private sector.
(iii) Bureaucratic System- Problems of red-tapism, nepotism, favouritism, officialdom, etc. are also found in this type of economic system.
(iv) Existence of Exploitation- Mixed economy is described by Schumpeter as “Capitalism is the oxygen tent.” According to him, it is only a trick of the capitalists to cheat the working class by offering them some temporary advantages like social security and uplift of the depressed classes, etc.