Understanding a Simple Economy

An Economy is a set of production and consumption activities that help in determining the scarcity of the necessary resources. 

These activities, which include production and consumption of goods and services, are required to meet the demands of those who are operating within such an Economy, which can also be referred to as an Economic system.

One of the various iterations of Economic systems is the Simple Economics model. 

What do you Mean by a Simple Economy?

A simple Economy can be defined as an Economic system in which each and every individual is required to partake in the manufacture of goods and services. These manufactured items are then allocated among the individuals of the Economy.

In other words, a Simple Economy is a simplified version of realistic trade which enables us to grasp the fundamentals and thereby make logical predictions about our current Economic behaviour. A well-designed Simple Economic model helps an analyst to take a confusing, real-life situation and pare its features down into a group of essentials. 

Before we carry on with our discussion on the Simple Economy meaning, take note of the following section to brush up your knowledge on the fundamentals on Economic systems. 

Test Your Knowledge

1. What are the Types of Economy, and how can they be Classified Further?

Ans: The economy of a region, Country or State can be broadly categorised into various types. These can be Industrial Economy, Developed & Undeveloped Economies, free-enterprise Economy, Planned & Unplanned Economy, etc. The Industrial Economy can be further classified as a socialist Economy or a capitalist Economy. 

In the case of a socialist Economy, all productions are socialised that are owned by the State, which means, there is no private sector. In contrast, Economic decisions, related to production and the expected rate of profit on such productions, are taken by private entrepreneurs.

• Traditional Economy: In this kind of Economy, the approach is traditional which means that the goods and services are manufactured to match the traditions, customs and beliefs of the community. They essentially focus on agriculture, fishing, etc. This Economy also uses the barter system instead of the modern concept of currency. There can be no market surplus found as they centre around tribal communities and they produce just enough that is required. This approach later evolved into farming where the crop surplus is available in the market. Thus, making it a traditional mixed Economy with the commanding market in the picture. 

• Command Economy: The characteristic feature of a command economy is that it has a centralized power. It is best found in communist countries where the government of the state makes all the laws regulating the Economy of the Country and such government also determines the price and flow of the goods and services. They are also known as the planned Economy and examples of this Economy are Cuba and China. A significant drawback of this kind of Economy is that the government fails to look after all the citizens of the Country. 

• Market Economy: This type of Economy is completely opposite to the command Economy. This is the concept of free-market where the trends of the market are free from the leverage of the government and its controlling discretion. This implies that there are no rules to regulate the Economy or buyers and sellers. This is solely regulated by the laws of demand and supply that are determined by the participants of the market trend. It promises a very high level of growth and makes the private sector powerful in the Country. This also has a higher risk of creating an imbalance of the flow of wealth in the Economy where the rich gets richer and the poor get poorer with the concentration of wealth. There are laws that prevent monopolistic trade practices too, however, this type of Economy is a subjective concept. 

• Mixed Economy: This is a great balance and mix of command Economy and free-market so on a larger scale, the market is free from the control of the government but the government, on the other hand, is free to regulate certain areas of the Economy that require attention and are sensitive by nature such as defence, transportation, etc. It is also known as a dual Economy and two great examples of a mixed Economy are, India and France. This allows private businesses to operate freely while the government protects the public interests. So both the sectors of the Economy can coexist in harmony and balance. It is the right blend of socialism and capitalism. 

2. What Does it Mean by Market System and Command System?

Ans: Economic systems can be broadly categorised into two parts, market systems and command systems.

In the case of a market system, the Economy of the concerned community is governed by the laws of supply and demand. If a certain product has high demand or its production requires substantial resources and skill levels, individuals have to pay a high price to purchase it. Alternatively, the price of a product will be low if there are a comparatively lower demand and minimum requirement of resources or skill associated with its production.

Meanwhile, a command system is a type of Economic system where decisions (regarding production in every sector) are centralised, i.e. the State handles both manufacture and allocation of goods and services. A socialist economy is a prime example of this kind of Economic system.

Major Sectors in a Simple Economy

For a Simple Economic model, the existence of two sectors is assumed, these are –

1.  Household Sector

Household sectors refer to the social unit comprising those individuals living together under the same Economic system. In Simpler terms, households are not only the owners of various factors of production but also the consumers of goods and services.

2.  Firm Sector

A firm sector can be referred to as the industrial sector, in which companies, firms and enterprises put an effort in manufacturing products for a profit. In other words, this sector produces all types of goods and services and sell them to the household sector.

Presence of only these two sectors occurs only in case of a closed Economy where there are no government actions or foreign trade involved. 

Before we head to the next and final section of your topic, go through this exercise below to revise the above discussions.

3.  Government sector

This is the sector that only includes the businesses and services owned by the government. It is an agency of the government that is responsible for welfare such as protecting laws and preserving them, defence and other public services. This grants services that are responsible for benefiting society at large instead of one person. These consist of commercial companies that are regulated by the government solely. 

4.  The External sector

For a Country that interacts and trades with International markets, the rest of the world is known as the external sector to the private and public sector of the Country. A few components of the external sector include Foreign Investment, Portfolio investment and Exchange rate. 

Test Your Knowledge

1.  A Closed Economy is One Which      

1. Has no Economic relation with rest of the world

2. Has Economic connection with rest of the world

3. Both

4. None of the above

       2.   In the Case of a Simple Economy, the Source of Income is From.

1. Industries and services

2. Government of the State

3. Households and firms

4. None of the above

Circular Flow of Income in a Simple Economy

In order to construct a circular flow of income for a two-sector or Simple Economy model, several essential assumptions are taken. These are –

• Households and firms are the only two existing sectors in this Economic model. This indicates that there is no government sector or foreign trade involved in such a system.

• Household sectors are the suppliers of factor services to firms only and firms hire services from none other than the household sectors.

• The items produced by the firms, i.e. goods and services, are sold to the household sector in their entirety. 

• From the services provided by the household sectors, an income is earned, which is spent totally on the consumption of goods and services. 

One of the primary features of such an Economic system is that both sectors are not allowed any form of savings. The total income earned by household sectors is used for the consumption of goods and services. In contrast, the profit generated by firms is spent to hire the services of household sectors.

Such a Circular Flow of Income can be Explained with the Help of this Illustration 

From the above illustration, it is assumed that the diagonally opposite elements are in one single loop. 

So, the 1st loop indicates the flow of factor services from households to firms along with the corresponding flow of goods and services to households from firms. The 2nd loop indicates the flow of factor payments earned by households for their factor services to firms along with the corresponding flow of expenses of consumption from households to firms.

At Vedantu, we hope that our study material on this topic of Simple Economy will be useful for your preparations in the upcoming exams. Make sure to visit our website and download our mobile app to know more about other topics in the Economics curriculum!