What Is an Economic System?
Any economic system is essentially a network of relationships (among households, businesses, and government), organizations, and the framework for producing, distributing, and consuming the goods and services produced in an economy while protecting the rights of future generations to the earth and the environment that all must share. An economic system includes how the output of the economy is produced and divided among members of society, how incentives and decision making are formulated, the extent of government intervention and its provision of goods and services, the role of markets and their regulation and supervision, and, in the legal system of property rights, ownership of factors of production and contracts and their enforcement. Although there are a number of ways to classify the range of economic systems, one classification could divide them into these five traditional economies, market economies, mixed market economies, mixed socialist economies, and command (planned) economies. In 2014, the most prominent economic system is the mixed market economic system, which is still evolving, followed by the mixed socialist economic system, the communist (command) system, and the recent rebirth of the Islamic economic system.
The most critical characteristic that distinguishes economic systems is the relative importance of markets and governments in determining what goods and services are produced, how they are produced, and who gets the output. A secondary distinguishing attribute has increasingly become the role of morality and justice in the economic system.
Traditional Economic Systems
Today, traditional economic systems are those that prevail largely in the tribal regions of a number of developing countries. They are predominantly agricultural with little or no labor specialization. Government services, where governments exist, are severely limited. These economies invariably rely on tradition, customs, and religion to decide what and how goods are produced and distributed, what occupations are chosen, and what form of governance is followed. Paper money is rarely used. Commodities, animals, and land provide a store of wealth, and barter is quite common.
Pure Market (Capitalist) Economic System
The father of modern capitalist market system was Adam Smith, the author of two books that have shaped the capitalist market economic systems around the world. His most widely cited text is The Wealth of Nations (more precisely, An Inquiry into the Nature and Causes of the Wealth of Nations), published in 1776. It was preceded by what we consider his masterpiece, the much less quoted The Theory of Moral Sentiments, published in 1759. For many mainstream economists, the year 1776 marks the birth of modern economics. In The Wealth of Nations, Smith took the bold stance that markets, left alone, were self-regulating and required no government rules, intervention, and regulation, and that government intervention would, in practice, do more harm than good. At the foundation of a market economy is the belief that the best outcome for all involved – namely the maximum output of goods that people want at the lowest price – results from individual sellers and buyers, acting individually and independently through the language of price (as the signaling device). Consumers vote what they want with their purchases; producers respond by producing what is demanded by consumers. If demand goes up, prices increase to balance supply and demand, and the higher price is a signal to producers to increase output. Producers, in pursuit of profits, produce the goods demanded most efficiently depending on the relative price of factors of production (land, labor, and capital) by increasing their inputs into the production process. People acquire goods and services on the basis of their voting power (ownership of factors of production and accumulated wealth).
For Smith, markets worked best if largely left alone. He saw markets as being self-regulating and having the special feature that they afforded the needed incentive to market participants. Profit incentives drive producers to produce the goods and services demanded in the most efficient way. Consumers are given a wide range of choice by registering their demand (what they buy) through the markets and can increase their income through education and savings. Smith coined the now-famous term “invisible hand” that would lead consumers and producers to pursue their self-interest and, unknowingly, in the process support the economic interests of all. Smith went even further and also argued that well-intentioned government rules and regulations were not needed and might in fact be detrimental to the growth of economic prosperity. He thus advocated a laissez-faire economic philosophy. This was the foundation of the capitalist economic system that fueled the Industrial Revolution in England and later in the rest of Europe and the United States.
Smith saw markets at the center of the economic system. Markets are not limited to those for final goods and services. Markets for factors of production, labor, and capital work in the same way as those for goods and are just as crucial for a smooth functioning economic system. Without factors of production, goods and services cannot be produced. In fact, one can imagine a market for almost everything in life.
Although Smith preached laissez-faire market economics, he was also a man of God. Smith believed in the deity and that “the Author of Nature” had prescribed the rules of human behavior in all things, including for economic behavior. It was left to humans to operationalize these rules and develop laws to provide the required institutional scaffolding for the ideal and efficient economy, an economy in which the government plays a minimal role but where rules (institutions) and especially the rule of law (and rule enforcement) guide the economy along its ideal path. Smith saw effective institutions as the scaffolding of the economic system. He was anything but the cold-hearted promoter of market economics that has become his mantra in most justifications of laissez-faire market economics. The Smith of Moral Sentiments envisaged the market system functioning if market participants complied with rules, including the rules of human behavior that had been prescribed by the Author of Nature. In Moral Sentiments, he advocated the importance of morality; he believed that for market participants, the love of self would result in sympathy for others as they entered market (more on this in the following paragraph). Without morality and government rule/legal intervention, the pure market system could lead to a veritable jungle – possibly maximum output but with the rise of harmful monopolies and price gauging; extreme income inequalities (poverty alongside great wealth); inhumane working conditions; discrimination by race, religion, age, and sex; unsafe foods and medicines; harmful spillovers or externalities (such as environmental degradation that is not cleaned up by those responsible); information that is not shared (asymmetric) with all market participants; and broken social systems. In others words, there could indeed be market failure in a number of areas with adverse social consequences. Adam Smith, the champion of free enterprise and limited government intervention, still acknowledged as fact that businessmen left to themselves could not be trusted and that they might take advantage of consumers through collusion or natural monopolies.
Because our description of the “real” Adam Smith may not be familiar to most, it may be helpful to give an extensive quote from his other book —The Theory of Moral Sentiment. Smith expresses his remarkable insight regarding rules of conduct, which he believed were:
the ultimate foundations of what is just and unjust in human conduct…Those general rules of conduct, when they have been fixed in our mind