Every society has to answer three questions

• What goods and services should be produced in the country?
• How should the goods and services be produced? Should producers use more human labour or more capital (machines) for producing things?
• How should the goods and services be distributed among people?

One answer to these questions is to depend on the market forces of supply and demand. In a market economy, also called capitalism, only those consumer goods will be produced that are in demand, i.e., goods that can be sold profitably either in the domestic or in the foreign markets. If cars are in demand, cars will be produced and if bicycles are in demand, bicycles will be produced. If labour is cheaper than capital, more labour-intensive methods of production will be used and vice-versa. In a capitalist society the goods produced are distributed among people not on the basis of what people need but on the basis of Purchasing Power—the ability to buy goods and services. That is, one has to have the money in the pocket to buy it. Low cost housing for the poor is much needed but will not count as demand in the market sense because the poor do not have the purchasing power to back the demand. As a result this commodity will not be produced and supplied as per market forces. Such a society did not appeal to Jawaharlal Nehru, our first prime minister, for it meant that the great majority of people of the country would be left behind without the chance to improve their quality of life.

A socialist society answers the three questions in a totally different manner. In a socialist society the government decides what goods are to be produced in accordance with the needs of society. It is assumed that the government knows what is good for the people of the country and so the desires of individual consumers are not given much importance. The government decides how goods are to be produced and how they should be distributed. In principle, distribution under socialism is supposed to be based on what people need and not on what they can afford to purchase. Unlike under capitalism, for example, a socialist nation provides free health care to all its citizens. Strictly, a socialist society has no private property since everything is owned by the state. In Cuba and China, for example, most of the economic activities are governed by the socialistic principles.

The United States of America and the United Kingdom are examples of capitalist economies.  They are also examples of developed economies.  The erstwhile Soviet Union Cuba and China are both socialist economies.  But while the Soviet Union is developed, China like India is still a developing economy.

Most economies (including ours) are mixed economies, i.e. the government and the market together answer the three questions of what to produce, how to produce and how to distribute what is produced. In a mixed economy, the market will provide whatever goods and services it can produce well, and the government will provide essential goods and services which the market fails to do.

Another important distinction that is often made is between developed and developing economies.

Developed, Less Developed, Developing Economies

Countries of the West, which had long been industrialized, and Japan, Korea and other newly industrialized countries of Asia are developed economies.  They are relatively rich countries that have the usual characteristics of a modern industrial society.  The poorer countries have relatively small industrial sectors.  They also have very little access to modern technology whether in industry or agriculture.  The poorest countries are generally described as least developed countries (LDCs). Some of them however, should be called developing economies because through they have only a small modern industrial sector, they are going through a distinct process of industrialization.  In a developing economy the modern industrial sector, though small, keeps increasing in size and the traditional agricultural or rural sector keeps shrinking.

As against them, High Income economies which comprise only 15 per cent of world population account for 78 per cent of world GNP. The situation has worsened during the period 1979-2000 since in 2000, 14.9 per cent of the population of the height income (industrial market) economies accounted for 80 percent of the world GNP. In other words, bulk of the poor people reside in the low income and middle income developing countries.

World Bank classifies all its member countries (188 of them) and all economies with a population of 30,000 or more (another 24; altogether 209) by various classifications. One of the most commonly referred to classifications is by Per Capita income.

World Bank Classification

Each year on July 1, The World Bank revises the classification of the world’s economies based on estimates of gross national income (GNI) per capita for the previous year. The updated GNI per capita estimates are also used as input to the Bank’s operational classification of economies, which determines their loan eligibility, e.g. Low Income countries are eligible for concessional IDA loans.

The classification of countries is determined by two factors:

• A country’s GNI per capita, which can change with economic growth, inflation, exchange rates, and population. Revisions to national accounts methods and data can also influence GNI per capita.
• Classification threshold: The thresholds are adjusted for inflation annually using the SDR deflator.

Low and middle-income economies are sometimes referred to as developing economies. The term is used for convenience; it is not intended to imply that all economies in the group are experiencing similar development or that other economies have reached a preferred or final stage of development.