Every society needs to develop an economic system—an articular set of institutional arrangements and a coordinating mechanism—to respond to the economic problem. Economic systems differ as to (1) who owns the factors of production and (2) the method used to coordinate and direct economic activity. There are two general types of economic systems: the market system and the command system.
The Market System
The private ownership of resources and the use of markets and prices to coordinate and direct economic activity characterize the market system, or capitalism. In that system each participant acts in his or her own self-interest; each individual or business seeks to maximize its satisfaction or profit through its own decisions regarding consumption or production. The system allows for the private ownership of capital, communicates through prices, and coordinates economic activity through markets—places where buyers and sellers come together. Goods and services are produced and resources are supplied by whoever is willing and able to do so. The result is competition among independently acting buyers and sellers of each product and resource. Thus, economic decision making is widely dispersed.
In pure capitalism—or laissez-faire capitalism—government’s role is limited to protection private property and establishing an environment appropriate to the operation of the market system. The term laissez-faire means “let it be,” that is, keep government from interfering with the economy. The idea is that such interference will disturb the efficient working of the market system.
But in the capitalism practiced in most other countries, government plays a substantial role in the economy. It not only provides the rules for economic activity but also promotes economic stability and growth, provides certain goods and services that would otherwise be underproduced or not produced at all, and modifies the distribution of income. The government, however, is not the dominant player in deciding what to produce, how to produce it, and who will get it. These decisions are determined by market forces.
The Command System
The alternative to the market system is the command system, also known as socialism or communism. In that system, government owns most property resources and economic decision making occurs through a central economic plan. A government central planning board determines nearly all the major decisions concerning the use of resources, the composition and distribution of output, and the organization of production. The government owns most of the business firms, which produce according to government directives. A central planning board determines production goals for each enterprise and specifies the amount of resources to be allocated to each enterprise so that it can reach its production goals. The division of output among the population is centrally decided, and capital goods are allocated among industries on the basis of the central planning board’s long-term priorities.
A pure command economy would rely exclusively on a central plan to allocate the government-owned property resources. But, in reality, even the pre-eminent command economy—the Soviet Union—tolerated some private ownership and incorporated some markets before its demise in 1991. Recent reforms in Russia and most of the eastern European nations have to one degree or another transformed their command economies to market-oriented systems. China’s reforms have not gone as far, but have reduced the reliance on central planning. Although there is still extensive government ownership of resources and capital in China, it has increasingly relied on free markets to organize and coordinate its economy. North Korea and Cuba are the last remaining examples of largely centrally planned economies.