CHAPTER 1 An Introduction to Financial Institutions, Instruments, and Markets

      THE ROLE OF AN ECONOMIC SYSTEM

      Economic systems are designed to collect savings in an economy and allocate the available resources efficiently to those who either seek funds for current consumption in excess of what their resources would permit, or else for investments in productive assets.

      The key role of an economic system is to ensure efficient allocation. Efficient and free flow of resources from one economic entity to another is a sine qua non for a modern economy. This is because the larger the flow of resources and the more efficient their allocation, the greater is the chance that the requirements of all economic agents can be satisfied, and consequently the greater are the odds that the economy's output will be maximized.

      The functioning of an economic system entails making decisions about both the production of goods and services and their subsequent distribution. The success of an economy is gauged by the extent of wealth creation. A successful economy consequently is one that makes and implements judicious economic decisions from the standpoints of production and distribution. In an efficient economy, resources will be allocated to those economic agents who are able to derive the optimum value of output by employing the resources allocated to them.

      Why are we giving so much importance to the efficiency of an economic system? The emphasis on efficiency is because every economy is characterized by a relative scarcity of resources as compared to the demand for them. In principle, the demand for resources by economic agents can be virtually unlimited, but in practice, economies are characterized by a finite stock of resources. Efficient allocation requires an extraordinary amount of information as to what people need, how best goods and services can be produced to cater to these needs, and how best the produced output can be distributed.

      Economic systems may be classified as command economies or as free market economies. This definition refers to the two extreme ends of the economic spectrum. In practice, most modern economies tend to display characteristics of both kinds of systems, and they differ only with respect to the level of government control.

A COMMAND ECONOMY

In a command economy, such as the former Soviet Union, all production and allocation decisions are taken by a central planning authority. The planning authority is expected to estimate the resource requirements of various economic agents, and then rank them in order of priority based on their relevance to social needs. Production plans and resource allocation decisions are then made so as to ensure that resources are directed to users in descending order of need. In practice, communist and socialist systems, which were based on this economic model, ensured that citizens complied with the directives of the state by imposing stifling legal, and occasionally, coercive measures.

      The failure of the command economies was inherent in their structure. As we have discussed, efficient economic systems needed to aggregate and process an enormous amount of information. When this task was entrusted to a central planning authority, this not only proved to be infeasible in practice, but the quality of information was also substandard. The central planning authority was supposed to be omniscient and was expected to have perfect information as to what resources were available and what the relative requirements of the socioeconomic system were. This was necessary for them to ensure that optimal decisions were made about production as well as distribution.

      Command economies were in practice plagued by blatant political interference. The planning authority was often prevented from making optimal decisions due to political pressures. The system gave the planners enormous powers that permeated all facets of the social system and not just the economy. One of the hallmarks of such systems was the absence of pragmatism, and a naïve idealism that was out of touch with realities. Planners used their authority to devise and impose stifling rules and regulations. These regulations, which were in principle intended to ensure optimal decision making, sometimes went to the ridiculous extent of imposing penalties on producers whose output exceeded what was allowed by the permit or license given to them.

      Such economies were a colossal failure in practice and were characterized by an output that was invariably far less than the ambitious targets that were set at the outset of each financial year. When confronted with the specter of failure the planners tended to place the blame on those who were responsible for implementing the plans. The bureaucrats in charge of implementation passed the buck back by making allegations of improper decision making on the part of the planners. Eventually the contradictions in the system lead either to the total repeal of such systems or else to substantial structural changes that brought in key features of a market economy.

A MARKET ECONOMY

Such economies work in principle as follows. Economic agents are expected to make the most profitable use of the resources at their disposal. What is profit? Profit is defined as the revenues from sales less the costs of production of the goods sold. Thus, profit is a function of the prices of the inputs or the factors of production, such as land, labor, and capital, and the prices of the output. An optimal economic decision is defined as the one that maximizes profit. Economic agents who generate surpluses of income over expenditure will obviously be able to attract more and better resources. Failure, as manifested by sustained losses,