What is Economic System ?

Concept of Economy/Economic system

It refers to the system by which people earn their livelihood (food, shelter, clothing, housing, health care, etc.) The economy is defined as a social domain that emphasizes the practices, discourses, and material expressions associated with the production, use, and management of resources.

Economics agents can be households, businesses, organizations, or government

The total of all production units of a region like factories, mines, offices, banks, schools, colleges, shops, transport systems, railways, etc. Collectively are called an economy.

The three major functions which every economy performs are production, consumption, and investment.

Production: it refers to the process of converting raw materials into finished goods to earn profit.

Consumption: it refers to the process of utilizing goods and services to satisfy human wants directly.

Investments: It implies addition to the existing capital stock of a nation which helps in future production.

Types of economic system

It is considered as one of the oldest economic systems which took its origin in England in the wake of the Industrial Revolution in the mid-eighteen century. It is that system, where means of production are owned by private individuals, profit is the main motive and there is no interference by the government in the economic activities of the economy. Hence, it is known as a free-market economy. E.g. Hong Kong, Switzerland, Singapore, the USA, etc.

NOTE: In the present scenario, it is really hard to find an example of pure capitalism because in most of the countries private and public together participate in the economic decisions.

Economic System
Economic System


The principal features of capitalism are discussed below:

  • Private Property: Capitalism thrives on the institution of private property. It means that the owner of a firm or factory or mine may use it in any manner he likes.  He may hire it to anybody, sell it, or lease it at will in accordance with the prevalent laws of the country. The state’s role is confined to the protection of the institution of private property through “laws.”
  • Profit Motive:

The main motive behind the working of the capitalist system is the profit motive. The decisions of businessmen, farmers, producers, including that of wage- earners are based on the profit motive. The profit motive is synonymous with the desire for personal gain.

  • Price Mechanism: Under capitalism, the price mechanism operates automatically without any direction and control by the central authorities. It is the profit motive which determines production. Profit being the difference between outlay and receipt, the size of profit depends upon prices. The larger the difference between prices and costs, the higher is the profit. Again, the higher the prices, the greater are the efforts of the producers to produce the varied quantities and types of products. It is the consumers’ choices which determine what to produce, how much to produce, and how to produce. Thus, capitalism is a system of mutual exchanges where the price- profit mechanism plays a crucial role
  • Role of the state: During the 19th century, the role of the state was confined to the maintenance of law and order, protection from external aggression, and provision for educational and public health facilities. This policy of laissez- faire system is now changed and the state has important tasks to fulfil these days. They have to initiate monetary and fiscal measures to maintain aggregate demand; anti- monopoly measures and nationalized monopoly corporations; and measures for the satisfaction of communal wants such as public health, public parks, education, flood control, etc.
  • Consumers’ Sovereignty: Under capitalism, ‘the consumer is the King.’ It means the consumers are free to buy any number of goods they want. Producers try to produce variety of goods to meet the tastes and preferences of consumers. This also implies freedom of production whereby producers are at liberty to produce a vast variety of commodities in order to satisfy the consumer. These twin freedoms of consumption and production are essential for the smooth functioning of the capitalist system.
  • Freedom of Enterprise: It means that there is free choice of occupation for an entrepreneur, a capitalist, and a laborer. But this freedom is subject to their ability and training, legal restrictions, and existing market conditions. Subject to these limitations, an entrepreneur is free to set up any industry, a capitalist can invest his capital in any industry or trade he likes therefore it is also called a free enterprise economy.
  • Competition: Competition is one of the most important features of a capitalist economy. It implies the existence of large number of buyers and sellers in the market who are motivated by self- interest but cannot influence market decisions by their individual actions. It is competition among buyers and sellers that determine the production, consumption and distribution of goods and services.


  • Increase in Production: Arthur Young wrote’ “The magic of property turns sand into gold.” This observation of young holds goods in a free enterprise economy where every farmer, trader or industrialist can hold property and use it in any way he likes. He brings improvement in production and increases productivity because the property belongs to him. This leads to increase in income, saving and investment, and to progress.
  • Quality Products at low Costs: The twin freedoms of consumers and producers lead to the production of quality products and lowering of costs and prices. Thus, the society as a whole stand to gain under capitalism.
  • Progress and Prosperity: The presence of competition under capitalism leads to increase in efficiency. Encourage producers to innovate and thereby brings progress and prosperity in the country. As pointed out by Seligman,” If competition in biology leads only indirectly to progress, competition in economics is the very secret of progress.”
  • Maximizes Welfare: The automatic working of the price mechanism under capitalism brings efficiency in the production and distribution of goods and services without any central plan and promotes the maximum welfare of the community.
  • Optimum use of Resources: Under capitalism, producers undertake the production of only those goods which appear to yield maximum profits in anticipation of demand. This leads to optimum use of resources.
  • Flexible System: A capitalist economy operates automatically through the price mechanism. If there are shortage or surplus in the economy, they are corrected automatically by the forces of demand and supply. As such, capitalism is a highly flexible system which can adapt itself to changing economic. That is why it has survived many depressions, recessions and booms.


  • Leads to Monopoly: Competition which is regarded as the very basis of capitalism contains within itself the tendency to destroy competition and leads to monopoly. It is the profit motive under capitalism which leads to cut- throat competition and ultimately to the formation of trusts, cartels and combinations. This brings about a reduction in the number of firms actually engaged in production. As a result, small firms are eliminated in this process.
  • Inequalities: The institution of private property creates inequalities of income and wealth under capitalism. The price mechanism through competition brings huge profits to big producers, the landlords, the entrepreneurs and the traders who accumulate vast amount of wealth. While the rich roll in wealth and luxury, the poor live in poverty and squalor (extremely bad).
  • Consumer’s Sovereignty a Myth: Consumers have to buy only those commodities which are manufactured and supplied by the producers in the market. The majorities of consumers are not rational buyers and are often ignorant about the utility and quality of the products available at the stores or shops. They are also misled by advertisement and propaganda about the usefulness of the products. Products which are produced by monopoly concerns are often of an inferior quality and are priced high. Thus, there is no consumers’ sovereignty in a seller’s market.
  • Depression and Unemployment: Capitalism is characterized by business fluctuations and unemployment. Excessive competition and unplanned production lead to over production and glut of commodities in the market and ultimately depression and unemployment.
  • Inefficient Production:  Capitalism fails to produce goods in keeping with the society’s requirements. Frivolous luxury goods and obnoxious (extremely unpleasant) articles are produced to satisfy the wants of the few rich at the expense of the necessities needed by the poor. Thus, there is social wastage of economy’s resources.
  • Non-utilization of Resources: The price mechanism under capitalism fails to employ the country’s resources fully. Free and unfettered competition, inequalities of income distribution, over production, and consequent depression lead to wastage of productive resources.

Socialist Economy

The word ‘socialism’” means “all things to all men”. It refers to the economic system under which all the decisions related to central problems are taken by the government to increase social welfare.

In this economy, the material means of production i.e. factories, capital, mines, etc. are owned by the State.

A socialist economy is also called a “Command Economy” or a “Centrally Planned Economy”. Here, the resources are allocated according to the commands of a central planning authority and market forces have no role in the allocation of resources.

Three prominent socialist economies across the globe- Cuba, China, and North Korea.

Features of Socialist Economy

  • Collective Ownership: In socialism all means of production is controlled by the central authority i.e., Government, and private individuals are not allowed to hold property beyond certain limit.
  • Economic, Social and Political Equality: Under socialist pattern of society there is not any class difference like there is almost equality among rich and poor.
  • Centralized planning: In socialism the decisions related to allocation of resources, unemployment, inflation etc. are taken by the central authority. For e.g., Ministry of Justice of the Republic of Cuba is solely responsible for all the welfare programmes and policies adopted by the nation.
  • No Competition: Unlike capitalist economy, there is no cut throat competition. It means lack of competition because state is the sole entrepreneur.
  • Maximum Social Welfare: The only objective of socialist pattern of society is to avoid any exploitation of labour, reduce income inequalities thereby maximizing social welfare.

Merits of Socialist Economy

  • No Labour Exploitation: There is only one class in a socialistic economy hence there is no question of exploitation.
  • Proper Utilization of Resources: Since there is no exploitation of resources the resources are utilized in most efficient manner.
  • Proper Planning: In order to solve various problems, which arise from time to time, there is proper economic plan in this type of economy.
  • Social Welfare: This system provides equal opportunities of employment to all individuals according to their abilities and hence increase social welfare.

Demerits of Socialist Economy

  • Loss of Consumer Sovereignty: A consumer has no choice of his own, he acts as mere slave under this system. Government produces goods and services keeping in view the needs of the people.
  • Less Democratic: Socialist economy is always less democratic as it possesses no element of freedom. It is also like government dictatorship.
  • No Automatic Functioning: Under this system, no automatic function in system exits at all. It is the Central Authority, i.e., government, that governs the country according to its own interest.
  • Rigid Economy: Socialist economy is very rigid and not susceptible (liable to influence) to change according to requirements. Hence people work like a machine and never get any incentive to work.
  • Burden on Government: All the economic activities are performed by the Central Authority on behalf of the government. Hence, it is overburdened with daily activities and, therefore, it gets very less time to think and plan for economic prosperity of the economy.

Mixed Economic System

It is a mixture of capitalism and socialism. It is that economic system in which there is full freedom of all kinds of economic activities and government interferences for social welfare. In other words, it is a blend of both economies.

Most of the developing nations are nowadays adopting this system. Even the developed countries like the UK, the USA, etc. have also adopted Mixed Capitalism System.

Features of Mixed Economy

  • Co-existence of Private and Public Sector: Under this system there is co-existence of public and private sectors. In public sector, industries like defence, power, energy, basic industries etc., are set up. On the other hand, in private sector all the consumer goods industries, agriculture, small-scale industries are developed.
  • Personal Freedom: Under mixed economy, there is full freedom of choice of occupation, although consumer does not get complete liberty but at the same time government can regulate prices in public interest through public distribution system.
  • Price Mechanism and Controlled Price: In a mixed economy, price mechanism and regulated price operate simultaneously. In consumer goods industries price mechanism is generally followed. However, at the time of big shortages or during national emergencies prices are controlled and public distribution system has to be made effective.
  • Profit Motive and Social Welfare: In mixed economy system, there are both profit motive like capitalism and social welfare as in socialist economy.

Merits of Mixed Economy

  • Encouragement to Private Sector: The most important advantage of mixed economy is that it provides encouragement to private sector and it gets proper opportunity to grow.
  • Freedom: In a mixed economy, there is both economic and occupational freedom as found in capitalist system. Every individual has a liberty to choose any occupation of his choice. Similarly, every producer can take decisions regarding production and consumption.
  • Optimum use of resources: Under this system, both private and public sectors work for the efficient use of resources. Public sector works for social benefits while private sector makes the optimum use to these resources to maximize profits.
  • Lesser Economic Inequalities: Capitalism enhances economic inequalities but under mixed economy, inequalities can easily be controlled by the efforts of government.

Demerits of Mixed Economy

  • Unhealthy competition: There is unhealthy competition between private and public sectors in a mixed economy.
  • No Freedom to Private Sector: There is no freedom to private sector in mixed economy. This is because Government regulates private industries through its various regulations and licensing.
  • Inefficient Public Sector: Inefficiency of public sector is another demerit of mixed economy. They may suffer heavy losses. People will have to bear these losses. The objective and targets of economic planning also may not be achieved in a mixed economy.
  • Threat of Nationalization: There is always a threat of nationalization in the mixed economic system because of which the private sector does not work properly.

Despite the defects in the mixed economy, it has become popular in some countries. India is one of the important countries, which adopted a mixed economy.

Economic System

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