What is an Economy and how it functions?
Economy is a system where all the individuals collectively
pursue to use different resources at their end to fulfill their needs and
wants. Now as the needs and wants are unlimited and the resources that are used to
fulfil the needs and wants are limited and scarce, question of prioritizing
comes into picture. Individuals (which also includes firms and business units
over and above people) need to allocate the resources in such a manner that the
most important and required needs and wants are fulfilled, as resources are
scarce and limited and not sufficient to fulfill all their needs and wants. So
these individuals collectively make the society. So to say, even at the
societal level, the wants and needs of the society are unlimited but the
resources that can be used to fulfil those are limited and scarce and hence the
society or the whole economy also needs to prioritize the needs and wants to be
fulfilled first and hence allocate the scarce resources accordingly to produce
the most needed and demanded goods and services.
What are the Economic Problems in an Economy or Society?
So from the above discussion, what we can summarize is that
there are two very important economic decisions or economic problem that an
economy or society faces, that is how to allocate the scarce resources towards
making of goods and services which are most demanded or needed and secondly how
to distribute those goods and services produced from the scarce resources in
the society among the individuals (which also includes firms and business units
over and above people).
Solutions to the Economic Problems | Different types of
Economies
As we discussed the two basic economic problems in an
economy is regards to the allocation of scarce resources and distribution of
the final mix of goods and services produced from the resources among the
individuals in the society.
These economic problems or so called economic activities of allocation
of scarce resources and distribution of final goods and services produced from
those resources can be solved through implementing different form of
organizational structure in an economy or society or country. Let us discuss
about the same.
Centrally Planned Economy
In an economy, where the government or the central authority
which runs the country, if decides totally on to how the scarce resources will
be allocated among production of different goods and services and how the
produced goods and services will be distributed among the individuals (which
also includes firms and business units other than people), such an economy is
known as Centrally Planned Economy. Every decision regarding the production,
distribution and consumption of goods and services in the economy will be
completely decided by the government or the central authority in such a manner
which is utmost beneficial for the society. In centrally planned economies, if
the government founds that there is improper allocation of resources such that
the goods and services of basic necessity are not produced in a sufficient
proportion, then the authority will shift more resources towards the production
of the same, like building more schools and hospitals, etc. to ensure
sufficient supply of the same, solving the problem of allocation of scarce
resources in the optimum way possible. And at the same time, if the government
or the central authority finds unequal distribution taking place of essential
goods and services which are basic necessity and is resulting into people’s
suffering, then the authority will take the onus of itself and will ensure
equitable distribution of final goods and services produced in the economy
among the individuals, thus solving the second problem of distribution of final
goods and services.
Market Economy
In an economy where the individuals freely interact with
each other to undertake the economic activities using their available resources
for acquiring goods and services to satisfy their needs and wants and
accordingly through the natural synchronization of the same the resources get
allocated for production and distribution takes place between the individuals,
such an economy is known as Market Economy. In a market economy, all the
economic activities take place in the market and through the market. In economics,
the word market is used in broader sense which means an institutionalized system
where the economic participants that is the individuals undertaking economic
activities can freely interact and exchange the resources as well as goods and
services. And here the word market denotes not only a physical place where the exchange
takes place, it can be any system where the exchange of goods and services can
take place including but not limited to platforms such as telephone, internet,
etc.
One of the astounding feature of the market economy is that
all the exchange of goods and services takes place at collectively decided
prices between the buyers and sellers. As we know the individuals collectively
make up the society, so to say, the goods and services are valued at prices
which are an average of the individual perception of demand and supply taken
collectively and hence becomes the society’s mutually accepted price.
But now one may get surprise to see, how the perception of
millions and millions of individuals get synchronized in a coordinated manner
which results in efficient allocation and distribution of resources and goods
and services respectively. There comes the invisible communication taking place
between the economic participants in the market.
Now as the prices are average of mutual and collective perception
of individuals, they generally work as the signals to the other market
participants. If the buyers increase their demand for a certain good, the price
of the same will increase in the market. This will act as a signal to the
producers that the particular good’s demand is higher than its supply and hence
the producers of that good will increase the production of the same. This is
how the communication takes place between different economic participants
through price signals.
Thus in the market economy the solution to the economic
problems of allocation of scarce resources and distribution of goods and
services are coordinated in a synchronized manner through the price signals
generated with the confluence of demand and supply.
Mixed Economy
In an economy, where both the Central authority or
government as well as the market forces of demand and supply both exist and
coordinate in the allocation of scarce resources and in the distribution of
goods and services to certain extent depending upon their roles in those economic
activities, such an economy is known as Mixed Economy.
In the real world scenario, there is a spectrum with Mixed
Economy at the center and the Centrally Planned Economy and Market Economy at
the extreme ends. And most of the economies fall in between the spectrum near
to the Mixed Economy, with different economies showing different level of roles
being played by Central Authorities and Market Forces. For example, the
allocation and distribution related to basic necessities and essentials is
controlled by the central authority or government to confirm equitable access
to all in the society whereas the allocation and distribution of rest of the
things would be left to be decided by the market forces of demand and supply by
generation of price signals.
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