Economic System

Economic System A means by which governments organize and distribute available resources, services, and goods across a geographic region or country Written by CFI Team Updated November 24, 2022

What is an Economic System?

An economic system is a means by which societies or governments organize and distribute available resources, services, and goods across a geographic region or country. Economic systems regulate the factors of production, including land, capital, labor, and physical resources. An economic system encompasses many institutions, agencies, entities, decision-making processes, and patterns of consumption that comprise the economic structure of a given community.

Types of Economic Systems

There are many types of economies around the world. Each has its own distinguishing characteristics, although they all share some basic features. Each economy functions based on a unique set of conditions and assumptions. Economic systems can be categorized into four main types: traditional economies, command economies, mixed economies, and market economies.

1. Traditional economic system

The traditional economic system is based on goods, services, and work, all of which follow certain established trends. It relies a lot on people, and there is very little division of labor or specialization. In essence, the traditional economy is very basic and the most ancient of the four types.

Some parts of the world still function with a traditional economic system. It is commonly found in rural settings in second and third world nations, where economic activities are predominantly farming or other traditional income-generating activities.

There are usually very few resources to share in communities with traditional economic systems. Either few resources occur naturally in the region or access to them is restricted in some way. Thus, the traditional system, unlike the other three, lacks the potential to generate a surplus. Nevertheless, precisely because of its primitive nature, the traditional economic system is highly sustainable. In addition, due to its small output, there is very little wastage compared to the other three systems.

2. Command economic system

In a command system, there is a dominant centralized authority – usually the government – that controls a significant portion of the economic structure. Also known as a planned system, the command economic system is common in communist societies since production decisions are the preserve of the government.

If an economy enjoys access to many resources, chances are that it may lean towards a command economic structure. In such a case, the government comes in and exercises control over the resources. Ideally, centralized control covers valuable resources such as gold or oil. The people regulate other less important sectors of the economy, such as agriculture.

In theory, the command system works very well as long as the central authority exercises control with the general population’s best interests in mind. However, that rarely seems to be the case. Command economies are rigid compared to other systems. They react slowly to change because power is centralized. That makes them vulnerable to economic crises or emergencies, as they cannot quickly adjust to changing conditions.

3. Market economic system

Market economic systems are based on the concept of free markets. In other words, there is very little government interference. The government exercises little control over resources, and it does not interfere with important segments of the economy. Instead, regulation comes from the people and the relationship between supply and demand.

The market economic system is mostly theoretical. That is to say, a pure market system doesn’t really exist. Why? Well, all economic systems are subject to some kind of interference from a central authority. For instance, most governments enact laws that regulate fair trade and monopolies.

From a theoretical point of view, a market economy facilitates substantial growth. Arguably, growth is highest under a market economic system.

A market economy’s greatest downside is that it allows private entities to amass a lot of economic power, particularly those who own resources of great value. The distribution of resources is not equitable because those who succeed economically control most of them.

4. Mixed system

Mixed systems combine the characteristics of the market and command economic systems. For this reason, mixed systems are also known as dual systems. Sometimes the term is used to describe a market system under strict regulatory control.

Many countries in the developed western hemisphere follow a mixed system. Most industries are private, while the rest, composed primarily of public services, are under the control of the government.

Mixed systems are the norm globally. Supposedly, a mixed system combines the best features of market and command systems. However, practically speaking, mixed economies face the challenge of finding the right balance between free markets and government control. Governments tend to exert much more control than is necessary.

Final Word

Economic systems are grouped into traditional, command, market, and mixed systems. Traditional systems focus on the basics of goods, services, and work, and they are influenced by traditions and beliefs. A centralized authority influences command systems, while a market system is under the control of forces of demand and supply. Lastly, mixed economies are a combination of command and market systems.

More Resources

Thank you for reading CFI’s guide to Economic System. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

What Is Economic Activity? - Video & Lesson Transcript

Nicolaas has four years of professional work experience - having worked in hospitality, journalism, and marketing. He has a BA in Communication studies from the North-West University and has completed his TEFL qualification. He also has six years of writing experience complementing his qualified competence.

What Is Economic Activity?

The economic activity definition pertains to the production, supply, buying, or selling of goods or services. The consumption of a good or service in itself is also considered an economic activity. These activities occur in a wide variety of ways, degrees, and complexities in society. The term is normally used in theory as an element that drives economies. This ties to the purpose of economic activity as a means of gaining wealth and generating revenue. Economic activity is the driving force behind the flow of goods and services in an economy. The physical distribution of things around an economy is another form of activity.

The primary purpose of economic activity is to satisfy the needs and desires of individuals. The activity is also characterized by how it's centered on the exchange of goods, services, and money. It's fair to say that we practice economic activity to ultimately stay alive and pursue secondary needs like belonging, esteem, and self-actualization. The concept of this activity also fits into the general economic dilemma of satisfying unlimited needs with limited resources. Humans always want or need something - specifically need. An example of this is how we constantly need food to stay alive, so we have a constant need. We satisfy this need by means of a series of economic activity that includes working (delivering a service, selling goods, etc.) and using income to buy food and consume the food for sustenance.

Economic activity varies in nature according to the three economic sectors namely, the primary, secondary, and tertiary sectors. Primary sector activities revolve around raw materials, whereas the secondary sector relates to production and refinery, and the tertiary sector is founded on services.

Economic Activities vs. Non-Economic Activities

Non-economic activity is the opposing component of economic activity. It is defined by the provision of goods and/or services without the exchange of something in return. This makes the main difference between the two, money. Economic activity normally involves the transfer of money and non-economic activity only involves the one-way transfer of a good or service. An example of non-economic activity is volunteering to tutor local children in English for no cost. Other examples are painting, singing, religious worship, and donating. Usually, non-economic activities are motivated by self-satisfaction or social obligation. In essence, we participate in economic activities to ultimately spend more time doing non-economic activities. It can generally be assumed that middle-to-lower class individuals' routines are comprised of majority economic activities, whereas upper-class individuals have more freedom to engage in non-economic activities. This is due to how middle-to-lower class individuals have to do economic activities more frequently in order to meet their needs.

Religion is a non-economic activity that is widely practiced.

Real-Life Examples of Opportunity Cost

What do economists think about strawberry smoothies? That depends on how good the kiwi flavor is instead—plus a range of other choices. Which stirs up the idea of opportunity cost.

How is opportunity cost defined in everyday life?

“Opportunity cost is the value of the next-best alternative when a decision is made; it's what is given up,” explains Andrea Caceres-Santamaria, senior economic education specialist at the St. Louis Fed, in a recent Page One Economics: Money and Missed Opportunities.

The Scoop on Scarcity

We can’t have everything we want in life. This is where scarcity factors in. Our unlimited wants are confronted by a limited supply of goods, services, time, money and opportunities. This concept is what drives choices—and, by extension, costs and trade-offs, Caceres-Santamaria says.

She uses the example of deciding to buy a $7 smoothie at the mall. She notes that many people would view the choice as a single one based on whether you want the drink.

Instead, she suggests wearing “a unique pair of ‘economist glasses’” to see the decision differently, asking:

How much do I value this? What am I giving up now to have this? What am I giving up in the future to have this now?

Costs That Are Seen and Unseen

Our inclination is to focus on immediate financial trade-offs, but trade-offs can involve other areas of personal or professional well-being as well—in the short and long run.

That’s why Caceres-Santamaria challenges us to consider not only explicit alternatives—the choices and costs present at the time of decision-making—but also implicit alternatives, which are “unseen” opportunity costs.

“It's about thinking beyond the present and assessing alternative uses for the money—that is, not being shortsighted,” she writes.

What are some other examples of opportunity cost?

A student spends three hours and $20 at the movies the night before an exam. The opportunity cost is time spent studying and that money to spend on something else.

A farmer chooses to plant wheat; the opportunity cost is planting a different crop, or an alternate use of the resources (land and farm equipment).

A commuter takes the train to work instead of driving. It takes 70 minutes on the train, while driving takes 40 minutes. The opportunity cost is an hour spent elsewhere each day.

Is Opportunity Cost a Big Deal?

We might not consider lost studying time or $7 spent on a smoothie costly decisions, but what about bigger choices—like the decision to stretch and buy a more expensive home versus a starter home, or to spend $1,500 more on an upgraded trim package for your next car?

Caceres-Santamaria describes how opportunity costs are neglected even more when making higher priced purchases. Using the car-buying example, a consumer might default to thinking of the relative value of the $1,500 upgrade to the base price of the car, say, $18,500.

Rather than comparing the fancier configuration to the vehicle itself, it might be more helpful to ask what else that $1,500 could buy outright.

Why the Rush?

“Most of our decisionmaking that involves money is based on immediate or sooner-than-later consumption,” Caceres-Santamaria notes. “The excitement of consuming today is valued significantly more than the thought of consuming in the future.”

It’s human nature: We grow impatient, tugged by the immediacy of a promised benefit versus a payoff that’s possibly years down the road.

If seeing is believing, it’s worth looking at the future value of money—a concept many of us have read about in retirement plan literature or heard from financial advisors.

The Future Value of Money

Example 1: The one-time windfall

Let’s say you got a surprise $4,000 windfall and want to use it for a getaway trip. Why not? It’s found money, so there’s no loss to you—unless you think about the opportunity cost.

If you nixed the trip and plunked your money into an income-producing product that earned an average annual interest rate of 3%, compounded monthly, you could find yourself with a cool $5,397 in 10 years.

Notes: Chart is for illustrative purposes only. Created with Compound Interest Calculator on Investor.gov

Wait another five years, and your funds could grow to $6,270. (Neither example factors in the effects of inflation and taxes owed.)

That’s the added benefit in money terms. You’ll also want to consider the experiences that an extra $1,400 or more—the future earnings on your $4,000—could make possible.

Example 2: Small, regular savings over time

That’s an example of investing a single lump sum over time. What about the opportunity cost associated with daily purchases, such as the $4.49 caffè mocha you pick up three times a week? How much money could you find yourself with if investing that $54 each month rather than spending it?

If you dropped the coffee (careful!), invested $54 per month and earned the same 3%, compounded monthly, you’d have $7,619 to dunk your doughnut into in 10 years.

Notes: Chart is for illustrative purposes only. Created with Compound Interest Calculator on Investor.gov

Too long to forego that regular mocha? Cutting the time frame in half to five years would still give you $3,554 in savings. (Again, these sums don’t include the impact of inflation and taxes.)

These examples are striking, especially when considering that a $4.49 caffè mocha habit over time can dwarf the seemingly larger decision to splurge on a $4,000 getaway trip.

Want to test some of your own opportunity cost what-ifs? Caceres-Santamaria encourages consumers to avoid “autopilot” mode when it comes to financial decisions. Start small—even with a pack of gum—and brainstorm as many alternative uses for your money as you can.

Additional Resources