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Any economic system is essentially a network of relationships (among households, businesses, and government), organizations, and the framework for producing, distributing, and consuming the goods and services produced in an economy while protecting the rights of future generations to the earth and the environment that all must share. An economic system includes how the output of the economy is produced and divided among members of society, how incentives and decision making are formulated, the extent of government intervention and its provision of goods and services, the role of markets and their regulation and supervision, and, in the legal system of property rights, ownership of factors of production and contracts and their enforcement. Although there are a number of ways to classify the range of economic systems, one classification could divide them into these five traditional economies, market economies, mixed market economies, mixed socialist economies, and command (planned) economies. In 2014, the most prominent economic system is the mixed market economic system, which is still evolving, followed by the mixed socialist economic system, the communist (command) system, and the recent rebirth of the Islamic economic system.

The most critical characteristic that distinguishes economic systems is the relative importance of markets and governments in determining what goods and services are produced, how they are produced, and who gets the output. A secondary distinguishing attribute has increasingly become the role of morality and justice in the economic system.

Traditional Economic Systems

Today, traditional economic systems are those that prevail largely in the tribal regions of a number of developing countries. They are predominantly agricultural with little or no labor specialization. Government services, where governments exist, are severely limited. These economies invariably rely on tradition, customs, and religion to decide what and how goods are produced and distributed, what occupations are chosen, and what form of governance is followed. Paper money is rarely used. Commodities, animals, and land provide a store of wealth, and barter is quite common.

Pure Market (Capitalist) Economic System

The father of modern capitalist market system was Adam Smith, the author of two books that have shaped the capitalist market economic systems around the world. His most widely cited text is The Wealth of Nations (more precisely, An Inquiry into the Nature and Causes of the Wealth of Nations), published in 1776. It was preceded by what we consider his masterpiece, the much less quoted The Theory of Moral Sentiments, published in 1759. For many mainstream economists, the year 1776 marks the birth of modern economics. In The Wealth of Nations, Smith took the bold stance that markets, left alone, were self-regulating and required no government rules, intervention, and regulation, and that government intervention would, in practice, do more harm than good. At the foundation of a market economy is the belief that the best outcome for all involved – namely the maximum output of goods that people want at the lowest price – results from individual sellers and buyers, acting individually and independently through the language of price (as the signaling device). Consumers vote what they want with their purchases; producers respond by producing what is demanded by consumers. If demand goes up, prices increase to balance supply and demand, and the higher price is a signal to producers to increase output. Producers, in pursuit of profits, produce the goods demanded most efficiently depending on the relative price of factors of production (land, labor, and capital) by increasing their inputs into the production process. People acquire goods and services on the basis of their voting power (ownership of factors of production and accumulated wealth).

For Smith, markets worked best if largely left alone. He saw markets as being self-regulating and having the special feature that they afforded the needed incentive to market participants. Profit incentives drive producers to produce the goods and services demanded in the most efficient way. Consumers are given a wide range of choice by registering their demand (what they buy) through the markets and can increase their income through education and savings. Smith coined the now-famous term “invisible hand” that would lead consumers and producers to pursue their self-interest and, unknowingly, in the process support the economic interests of all. Smith went even further and also argued that well-intentioned government rules and regulations were not needed and might in fact be detrimental to the growth of economic prosperity. He thus advocated a laissez-faire economic philosophy. This was the foundation of the capitalist economic system that fueled the Industrial Revolution in England and later in the rest of Europe and the United States.

Smith saw markets at the center of the economic system. Markets are not limited to those for final goods and services. Markets for factors of production, labor, and capital work in the same way as those for goods and are just as crucial for a smooth functioning economic system. Without factors of production, goods and services cannot be produced. In fact, one can imagine a market for almost everything in life.

Although Smith preached laissez-faire market economics, he was also a man of God. Smith believed in the deity and that “the Author of Nature” had prescribed the rules of human behavior in all things, including for economic behavior. It was left to humans to operationalize these rules and develop laws to provide the required institutional scaffolding for the ideal and efficient economy, an economy in which the government plays a minimal role but where rules (institutions) and especially the rule of law (and rule enforcement) guide the economy along its ideal path. Smith saw effective institutions as the scaffolding of the economic system. He was anything but the cold-hearted promoter of market economics that has become his mantra in most justifications of laissez-faire market economics. The Smith of Moral Sentiments envisaged the market system functioning if market participants complied with rules, including the rules of human behavior that had been prescribed by the Author of Nature. In Moral Sentiments, he advocated the importance of morality; he believed that for market participants, the love of self would result in sympathy for others as they entered market (more on this in the following paragraph). Without morality and government rule/legal intervention, the pure market system could lead to a veritable jungle – possibly maximum output but with the rise of harmful monopolies and price gauging; extreme income inequalities (poverty alongside great wealth); inhumane working conditions; discrimination by race, religion, age, and sex; unsafe foods and medicines; harmful spillovers or externalities (such as environmental degradation that is not cleaned up by those responsible); information that is not shared (asymmetric) with all market participants; and broken social systems. In others words, there could indeed be market failure in a number of areas with adverse social consequences. Adam Smith, the champion of free enterprise and limited government intervention, still acknowledged as fact that businessmen left to themselves could not be trusted and that they might take advantage of consumers through collusion or natural monopolies.

Because our description of the “real” Adam Smith may not be familiar to most, it may be helpful to give an extensive quote from his other book —The Theory of Moral Sentiment. Smith expresses his remarkable insight regarding rules of conduct, which he believed were:

the ultimate foundations of what is just and unjust in human conduct…Those general rules of conduct, when they have been fixed in our mind by habitual reflection, are of great use in correcting the misrepresentations of self-love concerning what is fit and proper to be done in our particular situation. The regard to those general rules of conduct is what is properly called a sense of duty, a principle of the greatest consequence in human life, and the only principle by which the bulk of mankind are capable of directing their actions…Without this sacred regard to general rules, there is no man whose conduct can be much depended upon. It is this which constitutes the most essential difference between a man of principle and honor and a worthless fellow…Upon the tolerable observance of these duties depends the very existence of human society, which would crumble into nothing if mankind were not generally impressed with a reverence for those important rules of conduct. This reverence is still further enhanced by an opinion which is first impressed by nature, and afterward confirmed by reasoning and philosophy, that those important rules of morality are the commands and Laws of the Deity, who will finally reward the obedient, and punish the transgressors of their duty…The happiness of mankind as well as of all other rational creatures seems to have been the original purpose intended by the Author of Nature when he brought them into existence. No other end seems worthy of that supreme wisdom and benignity which we necessarily ascribe to him; and this opinion, which we are led to by the abstract consideration of his infinite perfections, is still more confirmed by the examination of the works of nature, which seem all intended to promote happiness, and to guard against misery. But, by acting according to the dictates of our moral faculties, we necessarily pursue the most effectual means for promoting the happiness of mankind, and may therefore be said, in some sense to co-operate with the Deity, and to advance, as far as is in our power, the plan of providence. By acting otherwise, on the contrary, we seem to obstruct, in some measure, the scheme, which the Author of Nature has established for the happiness and perfection of the world, and to declare ourselves, if I may say so, in some measure the enemies of God. Hence we are naturally encouraged to hope for his extraordinary favor and reward in the one case, and to dread his vengeance and punishment in the other…When the general rules which determine the merit and demerit of actions comes thus to be regarded as the Laws of an all-powerful being, who watches over our conduct, and who, in a life to come, will reward the observance and punish the breach of them – they necessarily acquire a new sacredness from this consideration. That our regard to the will of the Deity ought to be the supreme rule of our conduct can be doubted of by nobody who believes his existence. The very thought of disobedience appears to involve in it the most shocking impropriety. How vain, how absurd would it be for man, either to oppose or to neglect the commands that were laid upon him by infinite wisdom and infinite power. How unnatural, how impiously ungrateful not to reverence the precepts that were prescribed to him by the infinite goodness of his creator, even though no punishment was to follow their violation! The sense of propriety, too, is here well supported by the strongest motives of self-interest. The idea that, however, we may escape the observation of man, or be placed above the reach of human punishment, yet we are always acting under the eye and exposed to the punishment of God, the great avenger of injustice, is a motive capable of restraining the most headstrong passions, with those at least who, by constant reflection, have rendered it familiar to them.2

As we shall see through this volume, Smith's deist views, the sacred rules of nature, the required legislation, and the well-functioning market system converge with what we visualize as an “ideal Islamic system.” Viewed in this light, Smith's thoughts then become systematic and complete in the sense that the Moral Sentiments covers the first part, his Lectures on Jurisprudence covers the second part, and The Wealth of Nations, the third part. This view holds the promise of opening a line of communication between Islamic economics and conventional economics to illuminate how the original visions of Islam and Smith converge. Our position in this regard is of course diametrically opposed to the position held by most that the two disciplines have nothing in common and that the only way to define Islamic economics is to jettison conventional economics: throw the baby out with the bathwater.

Because of market failures and social considerations, truly pure market economies do not exist today. Instead, market or capitalist economies are mixed systems, with the word “mixed” referring to government participation and intervention. Crucially, the questions have become: How much government intervention is acceptable? In what areas?

Mixed Market (Capitalist) Economic System

A number of the shortcomings of a pure market economic system have been noted. We also should add that markets need a “referee” to make sure that important market rules are respected and negative fallouts are contained and limited. Markets are the medium for effective economic performance; they are not an ideology to be placed on a pedestal and untouched, as some would have it.

Private property rights and secure contracts are essential features of a market economy. Property rights give individuals the right to own property and to use that property as they wish. Property rights, in turn, are of no value unless they are secure and legally enforced. Similarly, most economic transactions that are outside the simple retail sphere rely on contracts that must be secure and enforced. In other words, business development needs security and confidence. Without government intervention as the referee, business conditions could become problematic. Moreover, in the absence of business regulations, supervision, and enforcement, businesses could collude and fix prices to the detriment of consumers and society at large. Even without price fixing, monopolies could develop to the detriment of society. At the same time, there are a number of areas where there are natural monopolies, such as defense and some areas of infrastructure. Again, we see a role for government. Most important, even if markets are self-regulating and operate smoothly without government intervention, (namely, how market output is divided among members of society) they may yield results that are socially abhorrent – a few wealthy individuals alongside mass poverty. And most practically, governments needing revenues have to collect taxes to provide even the minimum level of public and social services.

Mixed Socialist Economic System

In large part because of significant income inequality, poverty, human dissatisfaction, and increasing social concerns, some mixed market economies adopted a socialist mantle as an offshoot of Marxism. In Western Europe, socialist parties emerged as strong political contenders to nurture key nationalized industries and expand the available welfare programs. Some countries adopted limited industrial plans. Key sectors, such as banking, telecommunications, railroads, energy, healthcare, and education, were nationalized. The provision of social benefits was expanded to include free education and healthcare, extended unemployment benefits, early retirement for those in hardship industries, minimum retirement benefits, and reduced working hours. These programs increased the role and economic contributions of the state while reducing the role of markets. In the 1980s, the United Kingdom reversed a number of earlier socialist decisions, denationalized some industries, and reduced a number of social programs. This reversal of socialist policies and programs spread to a number of other countries in Western Europe. It was adopted by the International Monetary Fund as the recommended policy prescription and was even forced on some countries during the financial crisis of 2007–2008, in part because of significant public debt and the belief that societies could no longer afford what became considered to be social programs that were too generous.

Command (Planned) Economic System

A command or planned economic system is the polar opposite of a market-based economy. In a command economy, a central public authority makes decisions on the specific goods to be produced, decisions that would be made by individual producers and consumers in a market system. Moreover, in a command economic system, there are no private property rights. Property and resources are collectively owned by groups or by the state. The state or planning organization determines the output of each final good and service sector and those of intermediate goods and services. It decides on wages to be paid and on all remuneration of incomes. From these wage and income figures, consumption and savings are determined. In order to have useful consumption (demand) figures, the planning directives literally go down to the kind and even sizes of shoes to be produced. The output of shoes is so specified (what to be produced), and the inputs have to be dictated (how the goods are produced and the required materials), and so on down the line. In a planned economy, the authorities use an input-output model to derive the needed inputs of different sectors. The planners determine prices and thus the incomes (who can buy the economy's output). Thus the planning entity determines all that the markets do “invisibly” in a market system.

In practice, no planner can predict individual demands for goods as well as the invisible hand of the market as consumers register their votes (by what they demand) and prices send the signal to producers. Similarly, planners cannot tell producers the best (most efficient) way to combine the inputs they need to produce the planned output. Instead, producers who have the profit incentive and who know the technologies and the relative cost of inputs are best placed to produce the highest-quality output at the lowest cost. Moreover, there is little incentive to innovate and work hard in a system where there are no private property rights and no ownership. It is easy to see why it would be difficult to develop a thriving economy in such a system. Economic waste, chaos, and stagnation are the likely outcome.

Planned economies had their heyday after World War II in the Soviet Union and China but lost their cachet as the Soviet economy faltered. With the collapse of the Soviet Union, the mixed market economic system began to rule almost supreme. Russia turned to a market-supported system through shock therapy, and China started to gradually move toward a market-based system. We say “almost supreme” because income and wealth inequalities became glaring in a number of market economies. Economists began to question the relative importance of economic output for individual well-being as material success was no longer seen as synonymous with human happiness and welfare. Since the financial crises of the 1980s, excessive national debt and, more recently, the most serious economic downturn and stagnation since the Great Depression have renewed doubts about the ability of markets and governments to deliver economic prosperity and well-being.