In economics, an economy refers to the system through which a country or society organises the production, distribution, and consumption of goods and services. Every economy must answer three basic questions: what to produce, how to produce, and for whom to produce. The way these questions are answered depends on the type of economic system followed by a country. Broadly, economies are classified into Market Economy and Command Economy.
Market Economy
A market economy is an economic system where decisions regarding production, investment, and distribution are taken mainly by individuals, households, and private firms. These decisions are guided by market forces, that is, demand and supply. In this system, the government has a limited role, and economic activities are largely driven by profit motive and consumer choice.
In a market economy, producers decide what goods and services to produce based on consumer demand. If consumers demand more of a product, prices tend to rise, encouraging producers to increase supply. Similarly, if demand falls, prices decline, and producers reduce output. Thus, price acts as a signal and incentive in the economy. The “price mechanism” plays a central role in coordinating economic activities without central direction.
Ownership of resources such as land, labour, and capital is mostly in private hands. Individuals and firms are free to own property, start businesses, and choose occupations. Competition among firms is another key feature of a market economy. Competition encourages efficiency, innovation, better quality products, and reasonable prices for consumers.
From a banking and financial perspective, market economies support the development of financial markets, private banking, and capital markets. Banks play a crucial role in mobilising savings and allocating credit based on risk and return considerations.
However, a market economy also has limitations. It may lead to unequal distribution of income and wealth, as income depends on ownership of resources and market power. Essential goods and services like healthcare and education may be underprovided if they are not profitable. Economic instability, such as inflation and unemployment, can also occur due to fluctuations in demand and supply.
Examples of countries that largely follow a market economy include the United States, the United Kingdom, and other developed capitalist economies, though in practice no economy is purely market-based.
Command Economy
A command economy, also known as a planned or centrally planned economy, is an economic system where all major economic decisions are taken by the government or a central authority. In this system, the government decides what goods and services will be produced, how much will be produced, how resources will be allocated, and how output will be distributed among the population.
In a command economy, factors of production such as land, factories, and natural resources are owned and controlled by the state. The central planning authority prepares detailed plans, often for several years, specifying production targets for various sectors. Prices are not determined by market forces but are fixed or regulated by the government.
The main objective of a command economy is social welfare rather than profit. The system aims to reduce income inequality, ensure equitable distribution of resources, and provide basic necessities to all citizens. Since the government controls production and distribution, essential goods like food, housing, healthcare, and education are often supplied at subsidised rates.
From an exam perspective, it is important to note that command economies can help in rapid industrialisation, especially in underdeveloped economies, by directing resources towards priority sectors. They can also avoid wastage of resources due to competition and reduce extreme inequalities.
However, command economies also face serious challenges. Lack of competition may result in inefficiency, poor quality of goods, and technological stagnation. Since prices do not reflect actual demand and supply, shortages and surpluses are common. The absence of profit incentives can reduce motivation among workers and enterprises. Decision-making becomes rigid and slow due to excessive centralisation.
Historically, the former Soviet Union, China (before economic reforms), and other socialist countries followed the command economy model. Many of these countries later introduced market-oriented reforms to overcome inefficiencies.
Comparison and Relevance for India
For JAIIB and CAIIB exams, it is important to understand that most modern economies do not follow a pure market or pure command system. Instead, they adopt a mixed approach, combining elements of both systems. India, for example, followed a more planned and controlled economic system after independence, with a strong role of the public sector and government planning. After the economic reforms of 1991, India gradually moved towards a market-oriented economy while retaining government intervention in key sectors for social welfare.
In summary, a market economy relies on demand and supply, private ownership, and price mechanism, while a command economy depends on government planning, public ownership, and administered prices.