Several different types of economic systems exist. All the models and theories that I will be covering will assume that we are in a market system, otherwise known as capitalism. There are also several different forms of capitalism, but I’ll go over that another time. For now, let’s cover six basic defining characteristics of a market system.
In the market system, the majority of things are owned by individuals and firms, not the public or the government. Rights to private property is something that’s ingrained into western social norms and so we tend to take it for granted, but if we lose this element, much of our economy would fall apart. Having the rights to property helps drive economic growth because it encourages people to maintain and invest in their assets, allows them to trade their belongings with others, and it spurs innovation. You have an incentive to take care of your assets, make good use of them, and also improve them because you are the direct benefactor of the gains that come from your property.
For example, pretend you’re a giant pharmaceutical company like Johnson & Johnson or Pfizer. These companies take many years and spend billions of dollars researching various ailments and diseases to find a cure that they can sell. Suppose after spending $10 billion and doing research for twenty years, you finally develop a drug that cures boredom. (A legal drug anyway; I know there a bunch of things that “cure” boredom, but all of them are illegal.) Right before you announce your cure and put your drug on the market, I break into your lab and steal your recipe, releasing the drug before you do. So I end up stealing all of the credit and the money you would have made by releasing the drug first. If there were no rights to private property and there wasn’t any consequence for theft, you probably wouldn’t have spent all that time and money trying to develop this drug. There wouldn’t be very much incentive for you to own belongings, develop your ideas, and create things. That’s why we have things like trademarks, copyrights, and patents. Rights to private property also frees up your time and allows you to pursue productive activities because you don’t have to sit at home with a shotgun all day guarding your belongings.
Another characteristic of the market economy is self interest. Self interest is the motivating factor behind all of our actions; all of us try to do the things that we believe will benefit us the most. Businesses try to maximize the amount of profit they bring in, employees try to maximize the amount of money they make for their time, and consumers try to get the most satisfaction out of every dollar spent.
Keep in mind the economizing problem that we have: scarcity. There are an unlimited amount of wants, but only a limited amount of resources. Acting out of self interest, each person will attempt to maximize his or her benefit while minimizing their cost which leads to resources being used as efficiently as possible because we are trying to waste as little as possible.
Note: self interest doesn’t necessarily mean being selfish. Often times when you are meeting your own interests, you are fulfilling someone else’s as well. For instance, if you are extended a job offer at a company you want to work for, the employer wants to hire you and you want to work for that employer; both of you are acting out of self interest. If you help pay for your children’s college education because you want to see them succeed, you are acting out of self interest, but not being selfish. If you donate to a charity or a cause that you support because that brings you a certain sense of satisfaction, you are again acting out of self interest, but not being selfish.
Freedom of Choice and Freedom of Enterprise
Freedom of choice is exactly as it sounds; you do what you want (within legal limits of course). You can choose what kind of job you want to take, who you work for, and how you spend your money. No one is going to force you to do things you don’t want to do.
Freedom of enterprise means that entrepreneurs have the ability to acquire resources (land, labor, and capital) and use them as they see fit. They can choose what to produce; how much of it they want to produce; and when, where, and how much to sell it for.
Markets and Prices
So now we’ve got all these entrepreneurs coming up with revolutionary ideas and products that they think will change the world (intellectual private property). They’re renting buildings, hiring workers, and getting factories and warehouses ready to produce their great idea (freedom of choice and enterprise) and they’re doing it in such a manner to maximize profits (self interest). What next? Do they just sit on all the things they made? Of course not; they’re going to sell it on the market.
In economics, a market is any place that brings together people who want to buy things and puts them with people who want to sell things. In the olden days, a market used to mean meeting a in a physical location, but with the advent of technology, buyers and sellers can interact with one another by mail, phone, or internet.
Entrepreneurs don’t just produce things willy-nilly, put them on the market, and hope for the best; they’re going to produce the goods and services that consumers want to buy. We convey what we’re interested in with our “dollar votes” or our money. In other words, we use prices to signal to businesses what we want to see more of and what we want to see less of. Prices are the regulating force of the market; the ones that react to a change in prices in the correct way are the ones who will benefit the most.
Another important characteristic of the market system is competition. In the broadest sense of the definition, competition is defined as a market where there are two or more buyers and two or more sellers, all acting independently of each other buying/selling the same thing. There are no barriers to entry or exit, so anyone can come and go out of this market whenever they please.
So why is competition important? Let’s take a look at an example. Suppose you and I are rival corn farmers and right now we’re the same in every way. We produce the same kind of corn, at the same cost, and we sell them for the same price so we make the same amount of profit. If I manage to get my production costs lower than yours, then there are two things that I can do: I can sell my corn for the same price that you sell it at and have increased profits or I can sell my corn at a price lower than yours and take customers away from you, increasing my sales. I have a huge incentive to be more efficient so I can lower my total cost and up my total benefit. At the same time, you also have an incentive to be more efficient because you want to be able to experience increased profits yourself or be able to keep up with any price cuts that I make.
So competition is a driver of innovation and efficiency because in order to keep up with your rivals, you have to keep on finding better means of production otherwise you risk earning less profits or being taken out of business all together. It also helps limit the power that suppliers have on prices; they can’t arbitrarily raise their prices because they’ll lose sales to other producers who are selling the same thing at a lower price.
Active, but Limited Government
The final piece of the puzzle is an active, but limited government. In a pure market economy, the only reason government would exist is to enforce private property rights; the other characteristics of the market outlined above would take care of everything else. On the other extreme, you have a command economy, where the government has full control of everything. In many of the countries that exist today, the government has a role that lies in between the two. Because of that, they’re considered to be mixed economies, rather than pure market economies. Although the market system is an efficient system, it isn’t a perfect one. There are goods and services that would provide huge social benefits to the public that private individuals acting out of self interest have no incentive to supply. That’s where many of the modern governments step in, fixing the market failures and providing these public goods and services, making the economy more efficient.
And there you have it, the basic characteristics that define capitalism. Of course, it goes into much more detail than that, but that’s for another time.
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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