An economic system is the way an economy produces and allocates resources. There are three economic systems: A free market economy, a mixed economy and a command economy.
Free Market A free market economy is an economic system which resolves the basic economic problem through the price mechanism. Basically market demand and supply determine prices and then whoever can afford goods at the market prices can buy them. A rise in the demand for a good means its price increases and firms switch more resources into producing that good. The government’s role is limited to providing the legal framework (property rights) and providing public goods (police).
A free market economy has the following characteristics:
1) Main Agents.
The main agents include consumers, producers, owners of private property and the government.
2) Private Ownership.
Most of the factors of production (land and capital) are owned by private agents. The government must enforce property rights to protect private agents’ property.
Motivation in a free market system is pure self-interest. Consumers maximize their own welfare, firms maximize their profits, private individuals maximize their own returns (wages, rents, interest and profit) and the government maximize social welfare.
4) Free Enterprise.
Firms can sell basically anything they want to sell, consumers can buy nearly anything they wish to buy and people can work for whoever they choose to.
Basically all markets are competitive because there are many buyers and sellers. Buyers compete with each other to buy goods and firms compete with each other to sell goods.
6) Decentralized Decision Making.
Agents are free to choose what they want to do, so decision making is decentralized, that is, the government do not allocate resources.
Mixed Economy A mixed economy is an economic system which allocates resources partly by the price mechanism and partly by the government. The government provide public goods, subsidizes merit goods, regulates monopolies, sets minimum wages and provides social safety nets.
Command Economy In a command economy the government directs resource allocation. Central planning is used, that is, the government decides where every input and output is allocated. Jobs are allocated by the government and goods like food and housing are rationed. Basically the government decides what, how and who to produce for.