This lesson explores formal and informal economies by discussing the differences between capitalism, socialism, and the underground economy. Key characteristics, advantages, and disadvantages of these economies will be covered.
Formal and Informal Economies
‘Economy’ is defined in this lesson as the wealth and resources of a region in terms of the production and consumption of goods and services. There are two types of economies: formal and informal. Formal economies consist of those driven by the market or government, while informal economies exist without formalized policies or regulations.
This lesson will discuss formal economy systems in terms of capitalism and socialism and the underground economy, which is considered an informal economy. We will cover the key characteristics, advantages, and disadvantages of these types of economies.
Capitalism vs. Socialism
Formal economies operate within limits of established and monitored policies and regulations. Capitalism and socialism are formal economies.
The major differences between capitalism and socialism revolve around the role of the government and equality of economics. Capitalism affords economic freedom, consumer choice, and economic growth. Socialism, which is an economy controlled by the state and planned by a central planning authority, provides for a greater social welfare and decreases business fluctuations.
Capitalist Economy: Key Characteristics
Capitalism is characterized in the following ways:
It is a market-based economy made up of buyers (people) and sellers (private or corporate-owned companies).
The goods and services that are produced are intended to make a profit, and this profit is reinvested into the economy.
The government should not interfere in the economies of the free market, meaning, the market determines investments, production, distribution and decisions, and government interference is only allowed when making and enforcing rules or policies governing the conduct of business.
There is a need for continual production and purchase for a capitalistic economy to operate efficiently.
Capitalists believe that government does not use economic resources as efficiently as private enterprise.
The U.S. is considered to be a capitalist economy, along with most of the modern world; however, economists are quick to point out that almost every society has a socialist aspect or program within it.
Capitalism: Advantages and Disadvantages
The advantages of capitalism include:
Consumer choice – Individuals choose what to consume, and this choice leads to more competition and better products and services.
Efficiency of economics – Goods and services produced based on demand create incentives to cut costs and avoid waste.
Economic growth and expansion (which is possible in the capitalist economy system) – This increases the gross national product and leads to improved living standards.
The disadvantages of capitalism include:
A chance of a monopoly of power – Firms with monopoly power (when a specific person or enterprise is the only supplier of a particular commodity) can abuse their position by charging higher prices.
Inequality – A capitalist society is based on the right to pass wealth down to future generations. If a small group of people hold all the wealth and that wealth continues to be passed down to the same groups of people, inequality and social division occur.
Recession and unemployment – An economy based on the market of consumers and producers is invariably going to experience growth and decline.
Socialist Economy: Key Characteristics
Socialism is characterized in the following ways:
The means of production are owned by public enterprises or cooperatives (the state), and individuals are compensated based on the principle of individual contribution.
There is equal opportunity for all. Large-scale industries are cooperative efforts, and thus, the returns from these industries must be returned to and benefit society as a whole.
Economic activity and production are planned by the central planning authority and based on human consumption needs and economic demands.
Socialists believe economic inequality is bad for society, and the government is responsible for reducing it via programs that benefit the poor.
For example, in the U.S., we have Medicare, social security benefits, and social nutrition assistance programs that are considered socialist in nature.
Socialism: Advantages and Disadvantages
The advantages of socialism include:
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