The Three Economic Questions Addressed

In This Article

1. What Are the Three Economic Questions?

2. 5 Types of Economic Systems

3. Market Economies and the Circular Flow Diagram

4. What Is Left Out of the Circular Flow Diagram

What Are the Three Economic Questions?

Society has to grapple with three main questions in deciding how to organize the economy.

These questions are:

1. What should be produced?

2. How should it be produced?

3. For whom should it be produced?

Each of these questions is motivated by the same underlying problem. Resources in the economy are scarce. There is not enough time, money, or goods and services to satisfy every want of every person, so somehow, society must decide how to produce and allocate goods and services using their limited resources.

5 Types of Economic Systems

Throughout history and across countries, society has answered the three economic questions in distinct ways. An economic system (or economic order) refers to a particular way societies organize their economy.

The main economic systems are:

• Traditional economies

• Command economies

• Planned economies

• Capitalist or market-based economies

• Mixed economies

1. Traditional Economies

Humans lived in traditional (or primitive) economies throughout much of history. In a traditional economy, households produce most of what they consume. Division of labor and market exchanges are limited in traditional economies, meaning the extent to which households exchange goods and services with people outside of their household and community is limited. The standard of living in traditional economies is low compared to many other economic systems, because of lower productivity and slower technological progress.

2. Command Economies

In a command economy, a central authority controls the means of production and makes most production and allocation decisions. Industries in a command economy are publicly owned, and private property is limited. North Korea is an example of a country with a command economy.

3. Planned Economies

A planned economy is like a command economy in that authorities such as a central government make decisions and exercise control over the production and distribution of goods and services. These authorities can allocate resources and set prices at their discretion. Planned economies differ from command economies because firms and industries may be privately owned. Private companies, however, must operate according to the plans and regulations set forth by the government. The former Soviet Union and Cuba are examples of planned economies.

4. Capitalist or Market-Based Economies

Most economies today are market-based economies. In a market-based economy, economic decisions are determined mainly by markets and left up to individual decision making by households and businesses. The key features of a market-based economy are markets, private property, and firms. A market-based economy is also sometimes called a free market economy or a laissez-faire economy.

5. Mixed Economies

A mixed economy is an economic system with elements of two or more well-established economic systems. If a country uses both markets and state planning to produce goods and services, it is a mixed economy. China, which was once a centrally planned economy, is now a mixed economy. It is neither a pure planned economy or pure market economy.

Market Economies and the Circular Flow Diagram

What Is the Circular Flow Diagram?

Circular flow diagrams, such as the one shown below, are used to model the production and allocation of goods and services in a market-based economy.

In a circular flow diagram, there are two main actors — firms and households. Firms and households interact in two types of markets: markets for goods and services and markets for factors of production.

In the market for goods and services, firms sell their products to households. Households pay for these products using money they make in factor markets.

In factor markets, businesses buy or rent factors of production such as labor and capital from households. These factors are what firms use to produce their products. In exchange for the factors of production, households receive money in the form of income.

Market-Based Economies and the Three Basic Economic Questions

Looking at the diagram, you can see how market-based economies address the three basic economic questions.

What should be produced?

Firms decide what to produce based on consumer demand in a market-based economy. If firms can’t sell their products to consumers in the goods and services market, firms won’t earn revenue and will not be able to stay in business.

How should it be produced?

Goods and services are produced through entrepreneurship and free enterprise. Privately owned firms produce their goods using labor, capital, and other factors of production. Firms buy, rent, or hire these inputs from households in factor markets.

For whom should it be produced?

Firms sell products to consumers who are willing to pay the price set by the market. The interaction of supply and demand in the market determines the market price.

What Is Left Out of the Circular Flow Diagram

Keep in mind that the circular flow diagram is a simplified model of market-based economies. Market-based economies use markets as the primary way of producing and allocating goods and services. Still, economic activity can occur outside of factor markets and goods and services markets. For example, household work, such as cleaning and child care, are economic activities that stay contained within the household. Such activities involve no market interactions.

Households might also exchange these services with other households. Firms might sell or buy goods, services, and factors of production with other firms. And finally, the government plays a role in market-based economies by providing citizens with public goods and services such as national defense, public education, and healthcare. Rather than orchestrating the economy as it would in a planned economy, the role of government in market-based economies is to provide a safety net and to provide the goods and services that markets are not good at allocating. Government intervention is limited, but still necessary in market economies.