Economic System: Its Definition, Functions, 3 Types, Approaches

What is Economic System?

An economic system is the wealth and resources of a country realized from sound economic exercises such as production, distribution, and consumption of goods and services.

As per Professor A G Brown, “Economy is a system by which people get their living.”

In sociology, an “economy or economic system” is the social institution that organizes a society’s production, distribution, and consumption of goods and services needed for the satisfaction of human wants. In other words, the economy is the way the resources (both human and natural) of a country are allocated, used and goods and services are produced, distributed, and consumed. The economic status of a country, therefore, depends upon the exploitation of its resources.

The economic activity such as production takes place at several economic institutions such as schools, hospitals, factories, mines, shops, banks cinema houses, workshops, government and private offices, farms, etc. All these economic activities (such as production, distribution, consumption, investment) by the economic institutions that produce income for the people involved are collectively known as an economy.

Just like a machine or a human body (as a system) is made up different parts that perform specific functions, an economy is also made up of different part, which has different functions, due to which an economy is called an ‘economic system’. An economy as a ‘system’ is made up of different organs like producers (production), distributors (distribution), consumers, investors (investment), entrepreneurs, etc. perform different functions and work together, just like a system is made up of different organs and when any one of the organ dysfunctions, then the whole system collapse or does not exist.


The functions of the economy/economic system include all the activities which provide a living (income) to the people or satisfaction of their wants are;

  • Production
  • Consumption
  • Investment or capital formation

Production: It is an activity that produces material goods and services or which increases the value of commodities already produced. E.g. farmer producing rice or wheat or vegetables is producing goods, a carpenter who converts wood into furniture, a miller who converts wheat into flour, a weaver who makes cloth from raw cotton are all producing goods. Just like material goods, services can also satisfy human wants. E.g. transporters, doctors, mechanics, accountants, judges, office clerks, teachers, offices, policemen, etc. who earn an income, by providing services are all producing services.

Consumption: Consumption is the process of using up goods. An individual or a household purchase a large number of goods such as food grains, clothes, computer, cars, etc. and pay for services like transport, education, health insurance, banking, etc. to satisfy individual wants. All these processes of the use of goods and services for the direct satisfaction of individual or collective human want are called consumption.

Investment or capital formation: The third and important function of the economic system is called capital formation. Usually, all the goods produced by an economy in a year are not consumed in the same year. The excess goods produced are set apart for the consumption of the coming year. This excess of production over consumption is called investment or capital formation. Goods like transport equipment machines, factories, buildings that can be used for further production for many years are called capital goods. To meet the growing demand, an economy needs to set aside a portion of its production as capital goods.

Types of Economic System

The way how every country manages (i.e. prioritize and allocate) their limited income, time, and resources may not be the same. So, different nation or society has developed different approaches to manage their resources. The way production, distribution, and consumption of g and services are made and how the people are employed in a country tell us the form (type) of economic system in that country.

In general, there are two types of the economic system; formal and informal economic systems. Economists generally recognize four basic types of economic systems (or approaches) as follows;

Informal Economy: These operate without formalized policies or regulations. E.g. traditional economy

Formal Economy: These operate within limits of established and monitored policies and regulations.

  • Free Market economy (also called ‘Capitalist economy controlled by Private sector)
  • Socialist economy (also called ‘planned’ or ‘command’ or ‘state-led’ economy)
  • Mixed economy (Socialist + Capitalist)

The important types of economic system are:

  • Capitalism
  • Socialism
  • and, Mixed economic system

Let’s describe,


Capitalism is an economic system in which means of production are largely in private hands and the main incentive for economic activity is accumulation. Goods and services under this economic system are produced for the market. Merely earning profit is expected in this system.

Rural lifestyle gradually transforms into urbanization and industrialization which brings an immense change in social structure. Production activities in this system are done based on the division of labor and expertise in work. People become more materialistic and lifestyle become more luxurious in a capitalist economy.

Demands and supply are self-balanced through market mechanisms. Personal and partnership firms, corporations, industries, and academies are developed. The economy is likely to suffer from unbalanced situations like economic depressions while producing without planning.

Due to competition in production new technologies are developed and plentiful production is made. Possibilities of economic development appear in society. Due to monopolistic use of surplus-value, this is gained from the production of sophisticated peoples, rich become richer, laborers become poorer. In the process of the development of capitalism, changes also appear in politics, the economy, and the social system.

At present, Hong Kong, Singapore, New Zealand, Switzerland, and some of the European countries are leading this system of economy.


A system in which ownership of entire means of production happens to be public and these are mobilized as per the central level planning is called a socialist economic system. Why produce, what kinds of changes do the production process brings in society, how to produce, etc are all activities handled by the state through specific planning. Thus, socialism is a type of economy in which the means of production and distribution in a society are collectively rather than privately owned.

In the economies, the focus and goal of the production process are oriented toward bringing social equality and welfare in society rather than maximizing profits. Socialism irregularities are less likely to appear due to the lack of private property in society. The pursuit of private profit is regarded as fundamentally immoral because one person’s profit is another person’s loss. The aims of a socialist economic system are the efficient production of needed goods and services and the achievement of equality by preventing the accumulation of private wealth.

In socialism feelings of the citizens developed due to the equal responsibility of the state in social sectors like education, wealth, employment, settlement, nutrition, etc. Individual knowledge and expertise are materializing as none of the individuals are treated unequally regarding their class, status, sex, gender caste, etc.

The clearest e.g. of socialism today are China, Cuba, North Korea, Vietnam, etc. but due to the effects of economic liberalization and economic globalization, even China is seen to be attracted towards the capitalist mode of production.

Mixed Economic System

Any economy in which private (corporate) sector enterprises and public sector enterprises exist side-by-side i.e. there is a mixture of private and public (state) ownership of the means of production and distribution, such economy is called mixed economic system.

Under this economic system, many economic decisions are made in the market by private individuals. But the government also plays a role in the allocation, use, and distribution of resources. This system overcomes the disadvantages of both the market and planned economic systems.

Many Eastern European and some South American countries have mixed economies. Key industries are nationalized and directly controlled by the government; however, most businesses are privately owned and regulated by the government. Developing countries like Nepal have adopted mixed economies to accelerate the pace of economic development. Even the developed countries like the UK, the USA, etc. have also adopted the ‘Mixed Capitalist System’.

Capitalism vs. Socialism

The major differences between capitalism and socialism revolve around the role of the government and the equality of economics.

  • Capitalism is an economic system where the means of Production such as money and other forms of capital are owned and controlled by private individuals. Whereas, Socialism is an economic system where the means of production, such as money and other forms of capital, are owned and controlled by the state or public.
  • Under capitalism, everyone works for their own wealth or profit. Whereas, under a socialist system, everyone works for wealth that is in turn distributed to everyone.
  • Capitalism provides economic freedom, consumer choice, and economic growth in terms of profit. Whereas, socialism provides for a greater social welfare and decreases business fluctuations.
  • Capitalism is an economy not regulated and controlled by the government rather is market-led. Whereas, socialism is an economy controlled by the state (state. led) and planned by a central planning authority.
  • Capitalist economy, however, may promote monopolies and inequality and lead to an economic recession. Whereas, socialist economy aims for equality in access to services and economic opportunities to public.
  • Capitalist economies, for e.g. the economy of the USA in1990s. Whereas, socialist economies for e.g. the economy of Cuba, North Korea, Soviet Union etc.

Theoretical Approaches To Economic System

Functionalist approach to the economic system: The functionalists assume that a healthy economy (i.e. production, distribution, and consumption) is vital to the health of the nation because a healthy economy ensures the effective and efficient distribution of goods and services thus meeting the needs of the society. However, the functionalists agree that sometimes a dysfunction occurs which disrupts social institutions (i.e. economic institutions) because they fail to adapt quickly enough to changing social conditions.

Conflict approach to the economic system: The conflict theorist assumes that the economy is not a source of stability for society. Instead, the economy reproduces economic inequality, particularly in a capitalist society as the bourgeoisie (ruling class) accumulates wealth and power by exploiting and oppressing the proletariat (working-class people).

Symbolic-Interactionist approach to the economy: Symbolic interactionist relates work to economy and from their microanalysis of interactions among people, they have developed the concept career inheritance. This concept means that children tend to enter the same or similar occupations as their parents. For e.g. the children of police officers already are familiar with the norms and values of law enforcement and this pushes them to similar kinds of jobs.

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