Economic System Definition

Economic System Definition

What is an Economic System

An economic system is a network that forms the economic relationships between individuals in society. In other words, how the people of a nation come together to create a complex whole and conduct economic transactions with each other.

Economic systems are complex in the fact that they rely on millions of people coming together in the market, driving supply and demand. If millions of people rush to the Apple store for the latest iPhone, it sets off a chain reaction. Apple needs to order more batteries, glass, electronic chips, and other components. In turn, that sets off demand in those industries.

Key Points
  1. An economic system refers to the framework by which individuals conduct business and trade with each other.
  2. There are four types of economic systems – traditional, socialist/command, capitalist/market, and a mixed economy.
  3. Most countries in the world operate under a mixed economy – relying both on aspects of a capitalist and socialist system.

An initial surge in demand can create a multiplying effect that ripples throughout the economy. This surge in demand sends a signal to the whole supply chain that more of these products are required, so more are made.

An economic system can change the way by which these supply and demand signals transfer through society. For instance, some economic systems may be more restrictive and place tariffs or quotas on imports. In turn, this can affect the signal between, buyer, seller, and supplier.

A tariff makes it more expensive to bring the final good to the market, which can have a suppressive impact on demand. So the signal between buyer and seller, demand and supply, is altered from its natural state. Therefore, to define an economic system in one sentence – it is the foundation that sets the rules of supply and demand between buyers and sellers.

Types of Economic Systems

Each country has a slightly different economic system. Germany’s is different from France and France’s system is different from that of the US. For instance, France has stricter labor laws such as the 35-hour working week. Yet both the US and France are a mixed economic system – a mixture of government involvement and free markets.

If we were to categorize economic systems by their specific characteristics, there would be close to 200 types of economic systems. Instead, there are four types of economic systems – the traditional system, socialist system, the capitalist system, and a mixed economy.

These are broad types of economic systems but will capture the different varieties that exist in the world today.

1. Traditional Economic System

Out of the four types of economic systems, the traditional economic system is the most basic. There is no involvement by the government, so people are largely left to conduct economic activities without influence. However, it is a very basic system that relies on basic customs and traditions.

Economic advances such as technology, property rights, and capital investment are largely absent. The way of life is much simpler and the economic relationships are basic. Bartering is commonplace and the use of cash as a medium of exchange is almost non-existent.

Characteristics of traditional economic system

Under a traditional economic system, subsistence is the main driver for economic trades, whilst profit is not the main motive. Instead, this system relies on communities and the cohesion between them to provide and sustain each other.

Although it is seen as backward by many, it is highly sustainable. By relying on the community to provide for each other, they are able to produce exactly what it needs. As a result, there is little waste.

To put this system into perspective, it revolves around small tribes and local communities that provide for each other on a micro basis. So there could be thousands of these communities across a large country. In fact, examples in today’s world include Bhutan and Haiti.

2. Socialism – Command economic system

A command economic system is often referred to as a socialist or communist system. Under this structure, power is centralised either to the government or a sole ruler. In turn, they decide the rules of the game and command how economic interactions take place.

Economic decisions such as what goods to produce, how much to produce, and its price are decided upon by central powers. So it’s up to them to decide whether it is socially optimal to make iPhones or PlayStations, or whether it’s best to divert these resources to house building or agriculture.

characteristics of command economic system

Under a command economic system, central powers own the means of production, so can, therefore, shift it to where they see fit. For instance, if the nation’s central powers want to start making more steel, they may move workers from a construction site and transfer them to a steel factory.

Moving workers may be necessary in order to fulfil long-term economic plans created by central planners. These long-term plans are a key part of command economies – such as the five-year plans adopted in the Soviet Union. In order to organise an economy from the top-down, clear and concise information needs to be passed through the chain of command – which is why a plan is necessary for everyone to understand their role.

Whilst planning can be effective, the issue with such command systems is slow and sluggish to change to economic trends. Where people are wanting more of Product A, central powers produce more of Product B.

Examples include North Korea, Cuba, and the former Soviet Union.

3. Capitalism – Market economic system

A capitalist economic system is where the means of production is owned and controlled by private enterprise rather than the government. Instead of government dictating what goods and services should be produced, these are driven by supply and demand mechanisms.

When consumers demand goods, it sends a signal to businesses for them to produce more. Equally, when demand for goods falls, it sends a signal to businesses to produce less. This in turn forces the business to offer new products that consumers may desire instead.

Under this form of economic system, government involvement is almost non-existent – other than enforcing law and legal contracts. Instead, the economy is regulated by the fluctuations in supply and demand, as well as other factors such as brand trust and competition.

The capitalist economic system relies on private individuals using capital to produce goods and return a profit. In turn, this increases the private enterprise’s capital stock. The issue with this however is that many individuals can amass great economic power and wealth. Not only does this create social discontent, but can also lead to unscrupulous business practices.

Private monopolies can arise and over-charge consumers and provide low-quality goods. On the other hand, it can be argued that the capitalist system is self-regulating over the long-term. Monopolies don’t last long as customers go elsewhere and new businesses come in to compete. Whilst bad businesses that offer low-quality goods will get a bad reputation and go out of business.

4. Mixed Economy

A mixed economy is one of the most common forms of economic systems in the world today. We see it in many developed nations such as the US, Japan, and throughout most of Europe. It is simply a mixture of capitalist and command economic systems.

A mixed economic system often has some level of private ownership of the means of production. However, in a mixed economy, some industries are controlled by the government, whilst others are privately owned. For example, healthcare in the UK is controlled by the government, as well as the BBC – the UK’s main broadcaster.

It is argued that by mixing together aspects of a command and capitalist economy, we can achieve the best of both. However, there is a constant balancing act that needs to be achieved. Too much government intervention and markets become suffocated and the ‘invisible hand’ has little effect – leading to shortages or wasteful oversupply. By contrast, too little government intervention may lead to unscrupulous business practices.

A mixed economy extends beyond just mixed control of the means of production, but also governments involvement through regulation and other forms of intervention. Subsidies, tariffs, and quotas are just some interventionist tools than many mixed economy nations such.

By employing these tools, they interfere in the supply and demand mechanism that allocates resources. Prices become distorted and therefore demand is artificially altered from its equilibrium with supply – thereby contributing to shortages, undersupply, or other socially suboptimal outcomes.

Economic System Examples


The UK is an example of a mixed economic system. It has a partial command element to it in the fact the government owns entities such as the BBC, the NHS, and Network Rail. Yet it is also capitalist in the fact that the majority of resources are owned by private enterprises.

Although most resources are owned by private entities, the UK government still controls 40 percent of the economy. This is because government spending accounts for around 40 percent of GDP. By spending this much, it has a significant impact on the allocation of resources throughout the economy.

The vast majority of this expenditure is driven by taxation – although much comes from borrowing. So this money is taken from private hands and into the pockets of government officials who decide on where and what to spend it on. In turn, we can conclude that the UK economy is a mixed economic system.


In the same fashion as the UK, the US is also a mixed economy. For example, the US Federal government owns entities such as Amtrak, Fannie Mae, and Freddie Mac – whilst state governments own entities such as Alascom, New York Port Authority, and TVA.

As with the UK, the US is largely privately owned, but the government has a big hand in the pie. It controls roughly 38 percent of the nation’s GDP. That means the US government decides where 38 percent of the nation’s economic output goes. In most years – a significant amount of this goes towards the army.

Under a capitalist system, money would only be diverted to the army if it was profitable. Equally, money is diverted off to thousands of other government entities, which do not always coincide with the demands of the public.

At the same time, the US government has many regulations such as occupational licenses that make it difficult for individuals to conduct their business freely – something that is commonly associated with command economies.


China is very different from both the US and the UK, in the fact that it originates from a command economy. The main difference is that China is more in line with a command economy than the US, but has a number of capitalist elements that define it as a mixed system.

Although private ownership of the means of production is limited, there are private enterprises that exist in China. Companies such as Amazon, Walmart, and Apple have all got some level of involvement in the market. However, many companies are required to work with local suppliers in order to enter.

The biggest companies in China are all stated-owned and corruption is still a big issue within the country. It still remains a nation where people get ahead from knowing someone in authority rather than through merit – something which still stems from the command system it has traditionally employed.

With that said, China is a mixed system – despite government controlling the majority of the means of production. This is because it still has aspects of a capitalist system. There is some level of private ownership, and part of the economy has limited government involvement so allows supply and demand to interact.

FAQs on Economic Systems

What are the 4 main types of economic systems?

The main 4 types of economic systems are:
1. Traditional Economic system
2. Socialist / Command Economic system
3. Capitalist / Market Economic system
4. Mixed Economic system

What are the examples of economic system?

The US, UK, and most of Europe operate on a mixed economy. Although we know them as ‘capitalist’, they have a significant level of government involvement which cannot define it as a pure capitalist system. We also have the likes of North Korea and Cuba that operate under a command economic system that relies on government to control the means of production and allocate its output.

How does the economic system work?

An economic system is the network that forms the economic relationships between individuals in society. In other words, how the people of a nation come together to create a complex whole.

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