Every choice has an opportunity cost (Opportunity Cost), and a whole society makes millions of choices a day. Every society has to answer three questions: what to produce, how to produce it, and for whom. Economic systems are different ways of answering them.
Key idea
In a market economy, households and firms answer the three questions through buying and selling, guided by prices and profits. In a command economy, government planners decide. In a traditional economy, custom and habit decide. Every real economy is mixed: markets and government both play a part, in different balances.
Why it works
How can a market answer "what to produce" with no one in charge? Prices carry information and incentives. When more people want a good, its price rises; that tells sellers people value it more and rewards them for making more. A planner has to gather the same information from millions of people and firms, which is hard to do quickly. But markets also leave some jobs undone or done badly: roads, national defense, pollution and help for people with little income come up later in this course. So the real question in every country is where to draw the line, and that is debated.
Worked example: Who answers the question?
In Country A, most prices are set by buyers and sellers, but the government runs schools and courts, taxes income and pays pensions. In Country B, a central plan sets output targets, but families may sell vegetables from their own plots at whatever price they can get. How would you describe each?
- Country A relies mainly on markets, with an important government role: a mixed economy that leans toward markets.
- Country B relies mainly on planning, with a small market: a mixed economy that leans toward command.
- Neither is "pure"; they differ in the balance.
Answer: Both are mixed: A leans market, B leans command.
Common mistake
Picturing a real country as a pure market or a pure command economy. No modern economy is either: even the most market-based ones have public schools, courts, regulations and taxes, and even heavily planned economies have had private plots and informal markets. Check: when you classify a country, ask how much of each question is answered by prices and how much by government, and expect "some of both."
Economists broadly agree that prices coordinate most everyday goods well, and that some goods and problems need government. How large government's role should be is a normative question, and people answer it differently.