Theoretical Economic Systems
Basically, there are only three systems. At one extreme we have the free market economy where there is a very limited role for the government. At the other end we have the command economy, where the government takes virtually total control. As with market structures (with perfect competition and monopoly), these two extremes are highly unrealistic. Just about every economy in the world is a mix of the two, and is, therefore, called a mixed economy. The question is, what is the degree of mix? Let's see how these different systems answer the three basic economic questions (see above).
A free market economy
Before we look at how the three questions are answered, we must quickly look at some of the characteristics of a free market economy.
Characteristics of this system
Ownership: Nearly all of the country's factors of production are owned privately. Although it might make sense to argue that firms own some of the resources, it is private individuals, or groups of individuals, who own the resources. They then rent them out to the firms so that they can produce the goods and services. Richard Branson is in charge of Virgin, but first and foremost he is a private individual who owns the majority of the shares. He could get someone else to run the company. This brings into play one of the government's limited roles. Through the legal system, the government must uphold the property rights of these private individuals. Objectives: Everyone in this system is motivated by pure self-interest. Consumers maximise welfare, firms maximise profits and the private individuals, who own the factors of production, aim to maximise rents (on land), wages (on labour), interest and profit (on capital). Free enterprise: Basically, firms can sell anything they want. They effectively respond to the consumers, who are allowed to buy anything that is sold by the producers. Workers can take on any job they want (this may seem obvious, but wait and see what happens in the command economy). The level of competition: Very high. Basically, it is assumed that nearly every market is a perfectly competitive one, with numerous buyers and sellers and no barriers to entry or exit. Firms are competing desperately for customers and the consumers are competing with each other for the goods on offer. The pricing system: Nearly all markets are perfectly competitive. You may remember that in these circumstances, the price mechanism allocates the economy's resources. The reason why it is called the price' mechanism is because the price acts as a signal and an incentive for producers to act in the required way so as to maximise their gain, which, in turn, optimises the allocation of resources in the whole economy. What, how and for whom?
We now need to see how these three important questions are answered in a free market economy.
What will be produced?
You might think that the firms decide what is finally produced. Actually, in a free market economy, it is the consumers who have all the power. Consumer sovereignty exists. In a free market, a firm will only produce a good if the consumer is prepared to buy it. Through their purchases (or money 'votes') consumers effectively dictate to the firms what should be produced. If consumers, on mass, stop buying bitter (perhaps they prefer drinking lager in pubs) then the producers (the brewers) would stop making it. So the answer to the question is, "whatever the consumers want." How will it be produced?
The simple answer is, "the firms." But there is more to this question than that. "How" also means "how well." Due to the highly competitive environment that exists, there will be pressure on firms to produce the goods as efficiently as possible and keep their prices as low as possible. As we said earlier, most industries will be perfectly competitive, so in the long run firms should be both productively efficient and alloctively efficient.