Types of Economies: Capitalist, Socialist and Mixed

Every country has limited land, labour and capital and unlimited wants, so every country must answer three questions: what to produce, how to produce it, and for whom to produce it. These are called the central problems of an economy. The way a country answers them decides what kind of economy it has. If private owners answer through prices and profit, it is a capitalist economy. If the state answers through a plan, it is a socialist or centrally planned economy. If both answer together, it is a mixed economy. Examiners ask the features, the thinkers and the Indian application of this classification, so this note takes them in that order.

The capitalist economy

A capitalist or market economy rests on private ownership of the means of production and on the profit motive. Nobody directs it: what is produced is decided by what buyers are willing to pay for, and resources move towards whatever gives the highest return. Adam Smith, in An Inquiry into the Nature and Causes of the Wealth of Nations published in 1776, called this the invisible hand, and the system is also described as laissez-faire, meaning that the state should leave business alone and keep to defence, law and order. Its merits are efficiency, innovation and a wide choice for the consumer, who is said to be sovereign because production follows demand. Its defects are equally clear: wide inequality of income, monopoly when a few firms grow large, neglect of goods that do not pay such as public health and village roads, and repeated cycles of boom and depression.

The socialist economy

A socialist or centrally planned economy rests on social ownership of the means of production, with a plan rather than a price deciding what is produced and for whom. The aim is the welfare of society rather than private profit, so the state fixes targets, allocates materials and often fixes prices too. Karl Marx is its best known thinker, through the Communist Manifesto of 1848, written with Friedrich Engels, and Das Kapital of 1867; earlier writers such as Robert Owen, Saint-Simon and Charles Fourier, who are called the Utopian socialists, were the real pioneers of socialist thought. The Soviet Union, which began planning in 1928, was the model such economies followed, and Cuba and North Korea are later examples. The merits are an equal distribution of income, the absence of exploitation and the provision of basic needs. The defects are the absence of incentive to work harder, the loss of consumer choice, and a heavy bureaucracy that cannot gather and use information as quickly as prices do.

The mixed economy

A mixed economy keeps a public sector and a private sector side by side. The state takes the industries that need very large capital or that serve strategic and social purposes, regulates the rest through law, and leaves the ordinary production of goods to private enterprise; welfare, employment and the removal of poverty remain government responsibilities. The idea answers the central charge against each of the other two systems: inequality in capitalism and inefficiency in socialism. Most countries today are mixed in some degree, the difference being only how far the state goes.

India's choice and its two turning points

India adopted a mixed economy at independence. The Directive Principles in Part IV of the Constitution, particularly Articles 38 and 39, asked the state to secure a social order in which wealth and the means of production are not concentrated in a few hands, and the word socialist was added to the Preamble by the Forty-second Amendment in 1976. The Industrial Policy Resolution of 1948 made the first division of work between the state and private enterprise; the Industrial Policy Resolution of 1956, which followed the Congress session at Avadi that called for a socialistic pattern of society, placed industries in three schedules: Schedule A for industries to be developed by the state alone, Schedule B for those where the state would progressively take the lead, and Schedule C for the rest, left to private enterprise within the licence system. The Planning Commission had been set up in March 1950 by a resolution of the government, the First Five Year Plan began in 1951 on agriculture, and the Second Plan of 1956 followed the Mahalanobis model with its stress on heavy industry.

The second turning point came in 1991, when a balance of payments crisis led to the New Economic Policy and the reforms known by the initials LPG: liberalisation, privatisation and globalisation. Industrial licensing was abolished for most industries, the list of industries reserved for the public sector was cut sharply, foreign investment and technology were allowed in more freely, and the rupee was devalued and later made convertible on the current account. The state did not disappear: it continues to run railways, atomic energy and large banks, to regulate through bodies created by law, and to spend on food, employment and health. India remains a mixed economy, but the mixture has shifted towards the market since 1991.

Related terms often asked

• Command economy: another name for a centrally planned socialist economy.
• Laissez-faire: the policy of non-interference by the state in business, associated with capitalism.
• Consumer sovereignty: the idea that in a market economy the consumer's spending decides what is produced.
• Welfare state: a state that accepts responsibility for the minimum standard of living of its citizens.
• Communism: the stage Marx described beyond socialism, with no classes and no private property at all.