Economics

What Are the 5 Basic Economic Problems?

February 21,2023

Central Problems of an Economy

Production, Distribution, and Exchange of goods and services are among the basic economic activities of life. During the period of these economic activities, every society has to suffer from scarcity of resources and it is the scarcity of resources that arises the problem of choice. The scarce resource of an economy has several usages. In other words, every society decides how to use scarce resources optimally? The problems of an economy are often summarized in the following three ways:

What to produce and in what quantity?

How to produce?

For whom to produce?

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What are the Three Central Problems of an Economy?

The three Central Problems of an Economy are?

What to Produce and in What Quantity?

How to Produce?

For Whom to Produce?

These are known as central problems because every society has to face them and look for its solutions. Let us understand these three central problems in detail.

1. What to Produce

This problem refers to the decisions regarding the selection of different commodities and the quantities that need to be produced. Labour, land, machines, capital, equipment, tools and natural resources are limited. So, it is not possible to fulfil society’s every demand. Therefore, it is important to decide what goods and services are required to be produced and in what quantity? For example, if Rita has a piece of land, she needs to think about what crop she should produce on her land. Let us consider that she can grow either Jowar or wheat. Given that the natural resource land is limited, she needs to choose whether she wants to use the land to produce Jowar or wheat or both. Once Rita has taken the decision regarding the goods to be produced, she needs to think about the quantity of the crop that she would like to produce. For example, 5 quintals, 10 quintals, or 100 quintals. This problem of ‘what to produce and in what quantities to produce is almost faced by everyone in society. Also, an economy needs to make decisions regarding whether it wants to use its scarce resources to produce consumer goods or producer goods. Also, to what extent should luxury goods be produced in comparison to producer goods? Also, the economy may be faced with the question of how many civilian goods and defense goods need to be produced. The problem of what to produce and in what quantities to be produced can be solved by a government that retains the authority to allocate resources in different areas of production. Alternatively, it can be solved based on the preferences of people in an economy and on the price of goods and services available in the market.

2. How to Produce?

This problem is about the choice of techniques that need to be adopted and used in the production of goods and services. The two majorly-used techniques are-

LIT or Labour Intensive Techniques

In this technique more units of labor in proportion to capital are used in the production process.

Capital Intensive Techniques

On the other hand, the Capital Intensive Technique involves more capital and less utilization of labor. For instance, footwear can be manufactured either in factories where a large portion of manufacturing is carried out by machines or by skilled teams of cobblers.

The solution to the problem of how to produce is based on the amount of quantity that needs to be produced for a given level of resources. At the same time, the cost of using a technique to produce goods is equally very important. A producer will use that particular technology which is available at minimum cost.

3. For Whom to Produce?

One of the most crucial problems of the economy is to decide which commodities shall be produced for which sections of society. For instance, essential goods and services are in demand from all sections of society, but only certain sections of society have a demand for luxury commodities. At the same time, choices of goods and services rest on prevalent tastes and preferences in an economy. Hence, considerations regarding the socio-economic conditions of a country or market are highly pertinent to this problem.

Lastly, it is important to know that other than resource allocation, central problems of an economy have two more aspects – efficient utilization of the resource and development of resources. Thus, to explain the central problems of an economy, one needs to delve into its core, choices concerning the limited resources available to maximize socio-economic utility.

Economic Problems: 3 Basic Questions For An Economic System To Answer

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What’s it: Economic problems arise because we face scarcity. Our resources are limited to satisfy our unlimited wants and needs. Economics has its roots in it and studies how we allocate limited resources to meet our needs and wants.

Scarcity requires us to use resources for their best use. We use them to fulfill the goods and services we most desire.

Then, our decision to allocate our resources raises three basic economic questions:

What do we produce? How to produce it? And for whom is the product?

And our decision to answer these three questions has an opportunity cost, a cost associated with the next best alternative we didn’t choose. For example, we have land to produce apples and oranges. But, say, the land is limited, and to meet demand, we can only grow one type: apples or oranges. We cannot produce both at the same time.

For example, if we grow apples, oranges are an opportunity cost. We cannot satisfy our needs and desires for oranges because there is not enough land to produce them.

What is a resource?

Economists point to resources as factors of production. They are land, labor, capital, and entrepreneurship.

Economists define land broadly. It doesn’t just cover agricultural areas or the like. However, it also includes various natural resources, including metallic minerals, wood, fossil fuels, etc.

Meanwhile, labor refers to our physical and mental efforts to help the production process. For example, workers work in agriculture or mining to produce raw materials. Or they may work in factories to produce various manufacturing outputs. They may also work in the service sector, relying more on mental than physical effort.

Capital refers explicitly to physical capital. They include machinery and production equipment. They are available to help us in the production process, so we don’t have to use our hands. Financial capital, such as money, is excluded in this definition because it does not contribute directly during the production process.

Meanwhile, entrepreneurship represents our efforts to collect and unite the other three resources under a business. An entrepreneur takes risks when starting a business. They risk failing and losing the competition.

What are needs and wants?

We all have needs and wants. Need refers to something essential. We have to fulfill it. If it can’t be fulfilled, it could cause serious problems. For example, we need food and water to survive. Without them, we can die.

Meanwhile, want is our desire for something that we cannot fulfill or is not yet available at this time. Thus, a need may become a want as long as we cannot fulfill it.

Unlike needs, wants are not essential to us. So, not meeting it does not cause serious problems. Of course, we may be disappointed because we cannot fulfill our wants. But, it doesn’t cause severe problems like death when we don’t meet our food needs.

What are the three basic questions regarding economic problems?

Needs may be more limited than wants. Want is limitless because we all want to go beyond our current capabilities. And our wants are not limited by the resources we have.

For example, we want a luxury car. Indeed, we can’t buy it now because we don’t have enough money.

In that case, luxury cars are the things we want. And money is our resource. Because of little money, we cannot satisfy our wants.

However, not having money does not limit our wants. One day, we hope to fulfill it when we have a lot of money.

In economics, we call this problem “scarcity.” It occurs when limited resources must satisfy unlimited needs and wants. In a broad scope, resources refer to the factors of production above. And money is not an economic resource even though, at the individual level, it is.

And scarcity raises three basic questions:

What goods and services do we need to produce?

How do we produce them?

For whom do we produce goods and services?

Scarcity forces every economy to answer three basic questions regardless of the economic system adopted.

What to produce

There are so many goods and services we need and want. First, however, we must determine which goods and services we produce and in what quantities. We must make this decision because we cannot produce all goods and services using existing resources.

So what goods should we produce? It requires us to determine the goods and services we need most. It is useless if we use resources only to produce goods we need less.

Say, food and clothing are what we need most. We then mobilize the factors of production to produce both. We allocate some resources to produce food and others to produce clothing.

How to produce

Answering this question requires us to determine the production method we use. Then, once we have chosen the goods and services we most want to produce, we must answer the following question: how do we produce them?

For example, we might use labor-intensive methods. We rely on labor rather than machines to produce goods and services. Agricultural products and consulting services are good examples. Capital such as machinery and equipment may not be too dominant to contribute to this method.

In other cases, we might use a capital-intensive method. For example, we rely more on physical capital and less labor. We use sophisticated machines and are assisted by computers to control them.

And to control the production system, we need skilled labor. However, unlike labor-intensive methods, labor is more involved in controlling operations and may not be directly involved in operations.

For whom production

The economy must choose how to distribute goods and services among the population. Answering this question also has to do with income among individuals in the population.

We get income from supplying factors of production. Each resource supplier is compensated. Landowners get rent. The capital owner earns interest. Labor suppliers earn wages. And entrepreneurship makes a profit.

So how are goods and services distributed? Does everyone get the same amount? Or do they acquire goods and services based on their contribution – their compensation? So, some people get more than others. This question is answered through the adopted economic system (including answering the previous two basic questions).

How does the economic system answer the three questions above?

An economy must answer the three basic questions above. How they answer these questions gives rise to the chosen economic system. And in general, there are two poles: the command economy system and the market economy system.

Under a command economy, the government regulates everything, from what is produced to how and for whom to produce. Likewise, the government also controls resources without the private sector’s participation.

In contrast, a market economy system relies on the private sector to answer the above questions without government intervention. Market mechanisms determine what goods and services are produced. How to produce is also left to the market.

Thus, businesses only produce goods and services that the market needs (there is demand). They also pursue the most efficient production methods to maximize profits.

Then, for whom goods and services also depend on the market mechanism. So, how much goods and services we get depends on how much we can buy, which in turn depends on the income or compensation we receive.

The two economic systems above have advantages and disadvantages. Then came the mixed economy, which combined the two systems. Under this economic system, the government and the private sector both participate in answering three basic questions in economics. However, the government focuses on the public sector, and the rest is left to the private sector.

Currently, all countries adopt mixed systems with some inclination. For example, the United Kingdom and the United States are inclined towards a market economy. Meanwhile, China and Cuba are leaning towards a command economy.