It is an extensive system of interrelated activities of production, consumption, and trade to divide the wealth of a community into scarce resources

Christopher Haynes

Reviewed by

Christopher Haynes

Expertise: Asset Management | Investment Banking


September 1, 2023

What Is An Economy?

It is an extensive system of interrelated activities of production, consumption, and trade to divide the wealth of a community into scarce resources. In simpler terms, it can be described as the condition of the economic life of its people.

It also refers to the framework of economic activities by all economic agents. Economic agents can be businesses, organizations and individuals.

Economic activities are all activities of trade and industry that are legal and fair. Smuggling, robbery, and other unlawful activities are not included as monetary transactions. It refers to the regulatory system involved in producing, distributing and consuming

Economy involves goods and services of an area, a community and an nation. Human wants are unlimited, while the resources available are scarce and have many uses. It means in every economic system, careful management must decide on the best possible use of resources. Resources include:

  • Labor
  • Capital
  • Land
  • Entrepreneurship

These resources interact to perform activities of production, consumption, investment. The management of all financial matters forms an economic system. Every economy results from several other factors, including:

  • Culture
  • Education
  • Technology
  • Values
  • History
  • Political system
  • Geography
  • Legal system

Key Takeaways

  • An economic system involves production, consumption, and trade to allocate resources. It includes businesses, individuals, and legal trade activities, while illegal activities are excluded.
  • Economic systems manage resources like labor, capital, land, and entrepreneurship for production, consumption, and investment.
  • Economic systems aim to meet needs and want by producing goods and services, generating income, and deciding what, how, and for whom to produce.
  • Economic structures affect the cost of living, government spending, employment rates, and citizens' quality of life.
  • Economies vary based on complexity, ownership, development levels, and administration, leading to different degrees of government intervention and ownership.

Understanding an economy

The features and purpose of an economy can be seen in the following descriptions. 

1) Features 

Every economic institution has the following fundamental features:

  1. It is artificial; hence, it is what the people make of it.
  2. It is dynamic and can be created, destroyed, replaced, or changed.
  3. The level of economic activities keeps changing over time and during business cycles.
  4. Production, consumption, and investment are necessary economic activities.
  5. Money is the general medium of exchange.
  6. Economic agents have dual roles. Producers and consumers are the same people.
  7. The extent of government intervention varies according to the type of economy. In modern economies, government intervention is undesirable. It is based on the economic concept that a competitive market exhausts all gains from trade. 
  8. No two economies are identical. Several influencing factors differ.

2) Purpose 

Every economic system's function is to meet people's needs and wants using the limited means available. It involves the production of goods and services that bring income to the people. This income is then either consumed or saved and invested. 

For the efficient use of resources, the three major economic decisions to be taken are: 

  1. What to produce -  The financial institutions monitor the production of economic bad like harmful unregulated drugs and weapons. 
  2. How to produce - The labor and capital involve intensive primary production. Labor-intensive production benefits all agents in nations with high unemployment or low wage rates.
  3. For whom to produce - distribution of goods and services created. It refers to the final consumers in an economy.

3) Importance

The way an economic institution of an area or a country is structured affects the everyday life of its agents in 4 significant aspects:

  1. Cost of living: the amount of money required to cover basic expenses depends on the "inflation rates" and other economic parameters like interest rates. More prosperous economies are generally associated with higher costs of living.
  2. Government Spendingas a country grows, agents pay more taxes allowing the government to invest more in infrastructure and welfare schemes leading to further economic development.
  3. Employment Rates : a booming industry creates more employment opportunities, whereas an industry in recession has lower employment rates. The migration of the workforce is in the direction of more prosperous economies.
  4. Quality of life: Economic growth allows resources to be used for healthcare and education and other factors like public infrastructure that improve the quality of life for its citizens.

How does an economic system work?

An economic system is formed when a group combines its skills and resources to trade. Such a trade benefits all economic agents.

The households provide factors of production (land, labor, and capital) to producers in exchange for income on these factors. The producers using these factors give the households goods and services to generate revenue.

The government acts as an external agent. It provides welfare and infrastructure investments to families and producers.

Studying an economic system

The study of an economic system and all its factors is called economics. Economics is a social science dealing with people as its primary focus. Based on perspective, economics is classified into two broad categories.

  • Microeconomics studies financial decisions by individual economic units like individuals, firms, and households. These financial decisions affect the production and consumption activities in a country.   Microeconomics studies these decisions and the interaction of individuals to determine their impact on supply and demand. It is more specific and specialized.
  • Macroeconomics also referred to as the 'big picture economics,' studies the nation as a whole, dealing with aggregate demand and supply. 

It helps in forming fiscal and monetary policies to create large-scale decisions. It studies significant nationwide problems like:

  • Unemployment
  • GDP
  • Inflation

It requires a broader focus. Both Microeconomics and macroeconomics are vast areas of study and have different applications. While studying an economic problem, knowing which perspective is to be used is essential.

For example,  microeconomics studies price effects, whereas macroeconomics studies income effects on the economy.

Types of economies

No two economies are identical. However, specific characteristics can help us classify the type of system that is prevailing.

Many bases for such classification include:

  • Size
  • Complexity
  • Control over resources
  • Administrative structure

Each country varies in its culture, social norms, and level of education. Thus, the ruling body must decide the focus of welfare policies and how it shall regulate the market.

An example of no government intervention is a free capitalist nation where all economic decisions result from interactions between consumers and producers.

On the other hand, socialism is an example of complete government intervention where all economic decisions are taken for the welfare of the general public. No one financial system is considered the most suitable for a country as there is always a payoff between equity and efficiency.

A free-market country with booming production may have higher income disparities than a country with a relatively lower level of economic activity.

 An economic system may favor the government's policies at the producers' cost. It is usually seen in communist economies. In such a case, producers do not have the incentive to work at an efficient level of production. Knowing the nature of an economy is essential while studying its characteristics.

Classification based on complexity

Also known as levels of economy, it refers to classification based on resources and the level of economic activities.

  1. Local Economy: It refers to interconnected markets and networks of a particular community. It deals with a specific community's economic units, consumers, and resources. Such a system was standard and usually restricted to a geographical area. With time, as trade became easy and accessible, local markets expanded.
  2. National Economies: It refers to a particular nation's industry and trade activities. Every country has different policies best suited to its structure. It helps us differentiate between nations, like China and the US, for example. As the availability and distribution of resources vary across countries, so do the economic policies.
  3. Global Economies: As resources and people move beyond national borders, they become a part of the world market. It refers to the economic activities of all units worldwide and economic interaction between nations. This level is primarily affected by international trade and globalization.

Classification based on ownership of resources

The type of administration in an area determines the features of its economic system.

  1. FeudalismThis type of economic system was common in the historical ages. The defining feature of feudalism was that the 'king' or 'ruler' would own all the resources. The ruler and the land-owning nobles made financial decisions for regular workers.
  2. Capitalism: In a capitalist system, all production and property factors are owned by private individuals. Prices are set according to market conditions, and individual behavior differs.   Examples include the US, UK, and Australia. 
  3. Socialist: In a socialist structure, everything is owned by the public or the state. The goods and services produced are according to the needs of society. Examples include North Korea and Sri Lanka. 
  4. Communist: This system allows economic agents to contribute and consume according to their needs. The community owns the production factors. This type of structure often takes freedom from individual economic agents. Examples include China and Cuba.

Based on ownership and control over means of production

The type of markets in an economic unit determines the production decisions.

  1. Command markets: This market system involves control over resources and economic decisions by the state. What to produce is based on government preferences. For whom to pay is based on government preferences. Examples include Vietnam and China.
  2. Free markets: Under this market system, producers and consumers take all economic decisions. Money is the decision-making factor. What to produce is determined by consumer preferences. How to make producers decide to maximize profits. For whom to pay is determined by purchasing power. Completely free-market countries often overlook the welfare of citizens and are rare in the modern world.
  3. Mixed Markets: In this, higher authorities also interfere in decisions as well as the boundaries where the market has the opportunity to move freely. What to produce is based on consumer preferences with partial intervention by the government, how to make producers decide it, and partly by the government. For whom to pay is determined by purchasing power and government intervention. Examples include the US, India, UK.

Based on development

Due to different levels of economic activities and accumulated earnings, some countries grow faster than others.

  1. Developed or Rich Economies: It refers to economies with high growth rates and lower poverty. The technology and infrastructure in such countries are enough to support increased production levels. Examples include the US, Japan, and Germany.
  2. Underdeveloped or poor economies: It refers to countries with:
  • A high poverty level 
  • High unemployment rates
  • Lack of capital
  • Poor infrastructure
  • Lack of social welfare

These economies also have lower per capita income and standard of living. Examples include Niger, South Sudan, and Mozambique. 

The classification of countries as developed or undeveloped is done using economic measures. These indicators determine the level of the performance of a nation.

Some basic economic measures used are as follows:

  • GDP (Gross Domestic Product) - the aggregate monetary value of all the goods and services produced in a country. It is related to a specific period. The level of GDP tells us about the status of economic activities in the country. More affluent countries are usually associated with a higher GDP.
  • CPI (Consumer Price Index) - refers to the change in consumer prices over time in a country. While comparing CPI across countries, a basket of goods is considered, for example, food, transportation, and clothing. It ensures similarity in the interests measured.
  • Unemployment Rates- refers to the proportion of people in the labor force actively seeking jobs but unable to find any. High unemployment reflects reduced income and lower-than-efficient levels of production. A country unable to produce enough jobs for its citizens is called a depressed economy. 

Other types of structures in the modern world

Based on the practices followed by economic factors, there have been many upcoming economic structures in the current complex world.

  • Green economyThe economic structure aims to reduce the ecological scarcity of resources. The focus is sustainable development with improved well-being for its citizens. It puts a greater emphasis on social equity than the efficiency of resources.

  • Digital Economy: It refers to the industry and commerce activities done on the internet. The market of people and devices with the help of the internet. Cryptocurrency, stock trading, and digital assets are a significant part of this market.

  • The Gig economy: Refers to the labor market of a more comprehensive structure comprising freelancers. Short-term contracts or ventures replace the concept of permanent jobs and employment. It provides the flexibility of human capital to both employers and employees. The wage rates in this structure fluctuate.
  • Open Economies: Refer to countries available for trade and investment with other countries.
  • Closed Economies: Refer to countries that do not indulge in internal trade. Export and import of goods and services are restricted through trade barriers and laws.

Comparative economics

Comparative economics is the study of real-world economies and how they differ. It involves studying and comparing economic systems across countries on specific measures. Initially, it related to the comparative study of feudalism and various forms of socialism. The modern world mainly deals with the shift of nations from socialism to capitalism. 

It also refers to analyzing the modern world's similarities and differences and economic problems. Dealing in studying institutional structures includes the legal sphere (laws and acts) and the political sphere (different forms of government).

The aim is to check their impact on society, markets, norms, and the culture of a nation. Using comparative economics, we can understand how the institutional structure of a country affects financial results.

A simple example would be the difference in government policies in the US and Australia despite being free-market economies. 

It raises a critical question: What economic institutions are integral to the successful growth of a nation?

These economic institutions include:

  • Courts
  • Government
  • Regulatory bodies
  • Professional organizations

Economists can find the most efficient way of production by comparing countries. In developing countries, it implies learning from past experiences of similar countries and how they resolve economic problems. 

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Researched and authored by Manya Bhardwaj | LinkedIn 

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