Basic Economic Problem
The fundamental economic problem is the issue of scarcity and how best to produce and distribute these scare resources .
. Scarcity means there is a finite supply of goods and raw materials.
supply of goods and raw materials. Finite resources mean they are limited and can run out.
Unlimited wants mean that there is no end to the quantity of goods and services people would like to consume.
mean that there is no end to the quantity of goods and services people would like to consume. Because of unlimited wants – People would like to consume more than it is possible to produce (scarcity)
Fundamental economic question
Therefore because of scarcity, economics is concerned with:
What to produce?
How to produce?
For whom?
Examples of the economic problem
Consumers
Households have limited income and they need to decide how to spend their finite income. For example, with an annual income of £20,000, a household may need to spend £10,000 a year on rent, council tax and utility bills. This leaves £10,000 for deciding which other food, clothes, transport and other goods to purchase.
Workers
Householders will also face decisions on how much to work. For example, working overtime at the weekend will give them extra income to spend, but less leisure time to enjoy it. A worker may also wish to spend more time in learning new skills and qualifications. This may limit their earning power in the short-term, but enable a greater earning power in the long-term. For example, at 18 a student could go straight into work or they could go to university where they will hope to gain a degree and more earning power in the long-term.
Producers
A producer needs to remain profitable (revenue higher than costs). So it will need to produce the goods which are in high demand and respond to changing demands and buying habits of consumers – for example, switching to online sales as the high street declines. Producers will need to constantly ask the best way of producing goods. For example, purchasing new machines can increase productivity and enable the firms to produce goods at a lower cost. This is important for fast-changing industries where new technology is frequently reducing costs of production. Without firms adapting to how they produce, they can become unprofitable.
Firms may also need to make long-term investment decisions to invest in new products and new means of production.
Government
The government has finite resources and its spending power is limited by the amount of tax that they can collect. The government needs to decide how they collect tax and then they need to decide whom they spend money on. For example, the government may wish to cut benefits to those on low income to increase incentives to work. However, cutting benefits will increase inequality and relative poverty.
Opportunity cost and the economic problem
The economic problem can be illustrated with the concept of opportunity cost.
Opportunity cost is the next best alternative foregone. A consumer with a limited income of £20,000 year continually faces choices, if they spend £3,000 on a new car, then that is £3,000 they cannot spend on food and drink
If a student spends three years in education, the opportunity cost is the lost potential of earning from a full-time job.
Government
A government may have choices on how to spend limited resources. In this simple model, they have a choice between health care and military spending. If they increase spending on the military, the opportunity cost is less spending on health care.
Basic Problems of an Economy
The fundamental problem in economics is the issue with the scarcity of resources but unlimited wants. Economics has also pointed out that a man's needs cannot be fulfilled. The more our needs are fulfilled, the more wants we develop with time. By definition, scarcity implies a limited quantity of resources. As a result of scarcity, there is constant opportunity cost. Opportunity cost means that if you use your resources to consume a particular good, you cannot consume any other good with the given resource. Therefore, economists are concerned with dealing with the optimum allocation of resources in society to make the usage of these resources efficient as well as practical.
Introduction to Basic Problems of an Economy
1. What to Produce?
Ans: No country can produce all the goods because there are limited resources available to them. Therefore, a choice has to be made between the different types of commodities that a country can produce with its available resources. For instance, a farmer who has a piece of land can produce either wheat or rice. Similarly, the government of a country needs to decide where to allocate its resources whether in consumer goods or defence goods or both, if both, then what will be the proportion of allocation of resources in the two categories of goods.
2. How to Produce?
Ans: This economic problem is concerned with the technique of producing a commodity. This problem arises only when there is more than one way of manufacturing goods. The techniques of production can be classified into two broad categories:
Labour Intensive techniques (extensive use of labour)
Capital Intensive techniques (extensive use of machinery)
Labour intensive technique is known to promote employment, whereas capital intensive techniques promote growth and efficiency in manufacturing.
3. For whom to Produce?
Ans: All wants of people in a society can not be satisfied. So, a decision has to be made on who should get the amount of total output of goods and services produced. Society decides on the amount of luxury and standard goods that have to be produced. The further distribution of these goods directly relates to the purchasing power of the economy.
4. How Market Mechanisms Solve the Basic Problems of an Economy?
Ans: All the three kind of economies, Capitalistic economy, Socialistic economy and Mixed economy, solve the basic problems of an economy in two methods:
Free price mechanism
Controlled price system which is also called State intervention
The Basic Problem of an Economy and Free Price Mechanism
A system of guiding the decisions of individuals within an economy through the price which is determined with the help of market forces of demand and supply is called price mechanism. This system is free of any government intervention. When the market equilibrium is reached by market forces of demand and supply, the quantity supplied becomes equal to the quantity demanded, then the price of a commodity is determined. Price mechanism also facilitates the determination of resource allocation, consumption and production as well as determining the level of savings and factor income. This method mostly takes place in a capitalistic economy.
The Basic Problem of an Economy and State Intervention System
This system is defined by administering the fixed prices of every commodity. In a socialist economy, the government plays a vital role in determining the price of commodities. Ceiling price or floor price may be introduced by the government to regulate the prices of certain commodities.
Explain Briefly the Basic Economic Problem of an Economy in India
In India, the basic economic problems are
What to produce?
For whom to produce?
How to produce?
Starting in the early 1950s, India adopted a system of a mixed economy. The basic problem of economics is solved with the help of a mixed economy in India. A Mixed economy is a system where the private and public sectors co-exist. In other words, a mixed economy is a blend of a capitalist and socialist economy. In mixed economies, all the economic problems are solved with the help of free as well as controlled price mechanisms.
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5 Basic Problems of an Economy (With Diagram)
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The following points highlight the five basic problems of an economy. The problems are: 1. What to Produce and in What Quantities? 2. How to Produce these Goods? 3. For whom is the Goods Produced? 4. How Efficiently are the Resources being Utilised? 5. Is the Economy Growing?.
Problem # 1. What to Produce and in What Quantities?
The first central problem of an economy is to decide what goods and services are to be produced and in what quantities. This involves allocation of scarce resources in relation to the composition of total output in the economy. Since resources are scarce, the society has to decide about the goods to be produced: wheat, cloth, roads, television, power, buildings, and so on.
Once the nature of goods to be produced is decided, then their quantities are to be decided. How many tonnes of wheat, how many televisions, how many million kws of power, how many buildings, etc. Since the resources of the economy are scarce, the problem of the nature of goods and their quantities has to be decided on the basis of priorities or preferences of the society.
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If the society gives priority to the production of more consumer goods now, it will have less in the future. A higher priority on capital goods implies less consumer goods now and more in the future. But since resources are scarce, if some goods are produced in larger quantities, some other goods will have to be produced in smaller quantities.
This problem can also be explained with the help of the production possibility curve as shown in Figure 1.
Suppose the economy produces capital goods and consumer goods. In deciding the total output of the economy, the society has to choose that combination of capital goods and consumer goods which is in keeping with its resources.
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It cannot choose the combination R which is inside the production possibility curve PP 1 because it reflects economic inefficiency of the system in the form of unemployment of resources. Nor can it choose the combination R which is outside the current production possibilities of the society. The society lacks the resources to produce this combination of capital goods and consumer goods.
It will, therefore, have to choose among the combinations В, E, or D which give the highest level of satisfaction. If the society decides to have more capital goods, it will choose combination B; and if it wants more consumer goods, it will choose combination D.
Problem # 2. How to Produce these Goods?
The next basic problem of an economy is to decide about the techniques or methods to be used in order to produce the required goods. This problem is primarily dependent upon the availability of resources within the economy.
If land is available in abundance, it may have extensive cultivation. If land is scarce, intensive methods of cultivation may be used. If labour is in abundance, it may use labour-intensive techniques; while in the case of labour shortage, capital-intensive techniques may be used.
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The technique to be used also depends upon the type and quantity of goods to be produced. For producing capital goods and large outputs, complicated and expensive machines and techniques are required. On the other hand, simple consumer goods and small outputs require small and less expensive machines and comparatively simple techniques.
Further, it has to be decided what goods and services are to be produced in the public sector and what goods and services in the private sector. But in choosing between different methods of production, those methods should be adopted which bring about an efficient allocation of resources and increase the overall productivity in the economy.
Suppose the economy is producing certain quantities of consumer and capital goods at point A on PP curve in Figure 2. у adopting new techniques of production, given the supplies of factors, the productive efficiency of the economy increases. As a result, the PP 0 curve shifts outwards to P 1 P 1 .
It leads to the production of more quantities of consumer and capital gods from point A on PP 0 curve to point С of PP with be the new production possibility curve and the economy will move from point A to В where more of both the goods are produced.
Problem # 3. For whom is the Goods Produced?
The third basic problem to be decided is the allocation of goods among the members of the society. The allocation of basic consumer goods or necessities and luxuries comforts and among the household takes place on the basis of among the distribution of national income.
Whosoever possesses the means to buy the goods may have then. A rich person may have a large share of the luxuries goods, and a poor person may have more quantities of the basic consumer goods he needs. This problem is illustrated in Figure 3 where the production possibility curve PP shows the combinations of luxuries and necessaries.
At point В on the PP curve, the economy is producing more of luxuries ОС for the rich and less of necessaries ОС for the at whereas at point D more of necessaries OH are being produced for the poor and less of luxuries OF for the rich.
Problem # 4. How Efficiently are the Resources being Utilised?
This is one of the important basic problems of an economy because having made the three earlier decisions, the society has to see whether the resources it owns are being utilised fully or not. In case the resources of the economy are lying idle, it has to find out ways and means to utilise them fully.
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If the idleness of resources, say manpower, land or capital, is due to their male allocation, the society will have to adopt such monetary, fiscal, or physical measures whereby this is corrected. This is illustrated in Figure 4 where the production possibility curve PP reflects idle resources within the economy at point A, while the production possibility curve P 1 P 1 reflects the full utilisation of the resources at point В or C.
It is for the society to decide whether to produce more capital goods at point В or more consumer goods at point C, or both at point D at the level of full employment represented by the In an economy where the available resources are being fully utilised, it is characterised by technical efficiency or full employment.
To maintain it at this level, the economy must always be increasing the output of some goods and services by giving up something of others.
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Problem # 5. Is the Economy Growing?
The last and the most important problem is to find out whether the economy is growing through time or is it stagnant. If the economy is stagnant at any point inside the production possibility curve, says in Figure 5, it has to be moved on to the production possibility curve PP whereby the economy now produces larger quantities of consumer goods and capital goods.
Economic growth takes place through a higher rate of capital formation which consists of replacing existing capital goods with new and more productive ones by adopting more efficient production techniques or through innovations.
This leads to the outward shifting of the production possibility curve from PP to P 1 P 1; (in Figure 5). The economy moves, say after 5 years, from point A to В or С or D on the P 1 P 1 curve. Point С represents the situation where larger quantities of both consumer and capital goods are produced in the economy. Economic growth enables the economy to have more of both the goods.
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Conclusion:
All these central problems of an economy are interrelated and interdependent. They arise from the fundamental economic problems of scarcity of means and multiplicity of ends which lead to the problem of choice or economizing of resources.