Economy and Its Basic Problem

  • Post last modified:1 February 2022
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Basic Problems of an Economy

The basic problems of economic decisions and form the basis of economic studies and generalisation.The major economic problems faced by an economy whether capitalist, socialist or mixed may be classified in two broad groups:

  • Microeconomic problems, which are related to the working of the economic system.
  • Macroeconomic problems related to the growth, employment, stability, external balance and macroeconomic policies for the management of the economy as a whole. We will first discuss microeconomic problems, which are immediately relevant to our simplified economic system. Macroeconomic problems will be taken up in the following subsection.

Microeconomic Problems

The basic microeconomic problems are :

  • What to produce and how much to produce
  • How to produce
  • For whom to produce or how to distribute the social output

What to produce and how much to produce

These problems assume a macro nature when considered at the economy level. However, we will discuss them first at the micro level because these problems have to be resolved. I What to produce‘ is the problem of choice between commodities.

This dilemma arises mainly for two reasons:

  1. Insufficiency of resources does not allow production of all the goods and services that people would like to consume.
  2. All the goods and services are not equally esteemed in terms of their usefulness by the consumers. Some supplies yield higher utility than the others.

How to Produce

The difficulty as to how to produce‘ is the problem of choice of method. Here the problem is how to decide an optimal blend of inputs, labour and capital, to be used in the production of goods or services. This question arises mostly because of lack of resources. If labour and capital existed in infinite quantities, any amount of labour and capital could be put together to produce goods.

Another very significant cause, which results into this problem, is that a given measure of a commodity can be produced with a number of substitute methods, i.e. alternative input combinations. For example, it is always practically possible to produce a given quantity of wheat with more of labour and less of capital (i.e. with a labour-intensive technology) and with more of capital and less of labour (i.e. with a capital-intensive technology), The same is true with most commodities.

For Whom to Produce: How to Distribute Social Output

How to Distribute Social Output in a modern economy, all the goods and services are produced by the business firms. The total output generated by the business firms is known as society’s total product or national output. The total output ultimately flows to the households.

Macroeconomic Problems

The economic problems discussed above are of micro nature. These problems taken together make the subject matter of Microeconomic Theory or Price Theory‘. Apart from micro problems, there are certain macroeconomic problems of prime importance confronted by an economy.

Following Lapse, these problems may be specified as follows.

  1. How can Production Capacity of the economy be increased
  2. Stabilising the economy :
  3. Other Problems of Macro Nature

How can Production Capacity of the economy be increased

This is essentially the problem related to economic growth of the country. The need for increasing production capacity of the economy arises for at least two reasons.

  • First, most economies of the world have realised by experience that their population has grown at a rate much higher than their productive resources. This leads to the poverty especially in the less developed countries.
  • Secondly, over time some economies have grown faster than others have while some economies have remained almost stagnant. The poor nations have been subjected to exploitation and economic discrimination.

Stabilising the economy

An important feature of the free enterprise system has been the economic fluctuation of these economies. Though economic vicissitudes are not unknown in the controlled economies, free enterprise economies have experienced it more frequently and more severely.

Other Problems of Macro Nature

The macro problems mentioned above, there are many other economic problems of this nature, which economists have studied extensively and intensively. The most important problem of this category is the problem of unemployment and inflation.


How Market Mechanism Solves the Basic Problems

The way basic problems of an economy are solved depends on the nature of its economic system. While in a socialist economy they are solved by the government agencies, like central planning authority, in a free enterprise or mixed capitalist economy, the basic economic problems are resolved by price mechanism or market mechanism.

Market Mechanism

Market Mechanism refers to a process through which market forces of demand and supply interact to determine the price and output of each good and service. A free market economy functions through the market forces of demand and supply.

The demand and supply forces interact to determine the price of each good and service. in the process, a price system is generated. Prices perform two functions in the market system. One, price serves as signals for the producers to decide what to produce‘ and for the consumers to decide what to consume‘. Second, prices force the demand and supply conditions to adjust themselves to the prevailing prices.

What to Produce

The goods and services that are produced in a market economy are determined by the consumers‘ demand. Only those goods and services which are demanded by the consumers or users are produced by the producers. Each penny a consumer spends on a commodity is treated as a vote for producing that commodity.

Continuing demand is a continuous process of voting. increasing demand for a good causes increase in its price. Rise in price makes profits to go up. The profit-seeking producers concentrate on the production of this commodity. if they produce a commodity not in demand, it will go waste and their profit motive will be defeated.

How to Produce

How to produce‘ is the question of choice of technology. The proportion in which labour and capital are combined to produce a commodity is also determined by the market forces, i.e. the supply of and demand for labour and capital. Firms produce for profit and try to maximize it. it requires, among other things, minimising cost of production.

. Costs can be minimised by using more of a cheap factor and less of a costly factor. if labour is cheaper than capital then more of labour and less of capital is used to produce a commodity. On the contrary, if capital is cheaper, more of capital and less of labour is used.

What makes a factor cheaper or costlier

It depends on the supply of and demands for that factor. if supply of a factor exceeds its demand, price of that factor will be lower and the factor will be treated as a cheaper factor. But if demand for a factor exceeds its supply, the price of that factor will be high and the factor will be treated as a costly factor.

Given the factor prices, firms combine labour and capital in such proportions that minimise cost of production. This determines the production technology.This is how market forces offer a solution to the problem how to produce.

For Whom to Produce

The problem for whom to produce is also solved by the market mechanism. The simple market rule is: produce for those who have ability and willingness to pay. Ability to pay depends on incomes and incomes are determined by employment pattern of factors. Market mechanism determines the pattern of demand for factors of production.

Given the supply of factors, market mecha. Given the supply of factors, market mecha-nism determines the price of each factor—rent, wages, interest and profits, respectively, for land, labour, capital and organisation. Once factor prices and employment pattern of factors of production (i.e., what factor is employed in what quantity and at what price) are determined, the distribution pattern of national income is simultaneously determined. in simple words, employment pattern determines the share of labour, property owners, investors and entrepreneurs in the national income.

Once the pattern of income distribution is determined, it determines the demand pattern for the goods and services, for there is a relationship between incomeand consumption pattern. Thus, in a free enterprise economy, goods and services are produced for those who possess the ability to pay.

Efficiency of Market System

How efficient is the Market System

In a perfectly competitive market economy—if such an economy exists at all—the whole system functions smoothly, efficiently and in an orderly manner. Despite the fact that millions of people, often with conflicting interests and motivations, participate in the working of the economic system at individual and group levels, there is no chaos or anarchy.

The market forces organise the whole economic system to the benefit of majority of its participants. Consumers get what they want to consume. Producers produce goods and services, which maximise their profits. This social organism functions automatically without being directed or managed consciously by the participants. The market system is governed by what Adam Smith called ‘invisible hands’.

It may seem from the above description of market mechanism that all is well with free enterprise economies. However, it is not quite so.A genuinely efficient free enterprise system is supposed to ensure:

  • All those who are willing to work at the prevailing wage rate get employment.
  • Factor payments must be commensurate with their productivity.
  • All factors of production are optimally allocated.
  • Slitcher suggests, the goods must go to the consumers who derive the greatest utility from them.
  • Goods must be produced by the most efficient producers-by those who can produce them at the minimum possible cost However, the world experience has shown that the free enterprise system wherever it exists or it existed has not worked as efficiently as expected at least during the Post World War I period.

    Although it is difficult to quantify the satisfaction derived from a good by rich or poor persons, it cannot be denied that a woollen coat hanging idle in the wardrobe of a rich person would give more satisfaction to a scantly clothed domestic servant shivering with cold But the domestic servant who needs it more does not get the coat because he does not have the adequate purchasing power.

    Similarly, in a free enterprise system jobs too are not distributed among the people on the least-pain basis. People are prepared to work for their living irrespective of pains and sacrifices they have to make for a meager income. Under the condition of prolonged unemployment, people would be willing to work at an extremely low wage rate whatever their cost in terms of pains. Let us now look into the shortcomings of the free enterprise system in detail.

Reasons for the Failures of the Market System

The economists attribute the failures of the free market system to the following reasons:

The necessary conditions for the efficient working of the market system do not exist in reality. The necessary condition are free competition, increasing cost in all markets, applicability of the exclusion principle in consumption, absence of public goods, perfect knowledge and mobility of factors. But the existence of such a perfect market system in the world economy is a very rare possibility. Besides, mere existence of perfect competition is not enough to ensure the efficient working of the system.

As Scitovsky remarks perfect competition would not ensure perfect efficiency, if there were differences between social and private values and social and private marginal products. It may not be possible to quantify the difference between social and private values and social and private costs but the existence of such differences cannot be denied.

The free enterprise system works on the philosophy that each individual is the best judge of his own interests and therefore, his choices and decisions would best serve his interest. However, most choices and decisions made by individuals, particularly concerning consumer goods, are generally influenced by impulses, habits, prejudice, ignorance or clever sales talks and too little by reflection, investigation of facts and comparison of alternative opportunities. if it is not so, a person would not spend more on liquor and smoking and less on milk, education or health care.

Congruently, Auto mobile drivers will not violate traffic rules; politicians and bureaucrats will not go corrupt; people will not vote for criminal politicians and people will grow more trees than they fell.

As mentioned above, the motivating force for private enterprises is profit. The private entrepreneurs would therefore not like to invest their capital in the industries or sectors, which have lower profitability, even if the industries are of essential nature and of strategic importance for the national economy. So is the case with regional distribution of industrial undertakings.

known as public utilities‘ like medical care, education, water, electricity, sanitation, etc., are equally important for all the individuals— rich and poor. Certain other facilities in the field of transport and communication (including roadways, railways airways, telephones, post and telegraph, etc.) are necessary for the overall growth of the economy. Private capital normally does not flow into these sectors in adequate measures, for at least three reasons:

  1. they require huge initial investment.
  2. the return rate in these sectors is very low and remote.
  3. most public utility services are in the nature of collective consumption to which principle of exclusion cannot be applied. Apart from this fact, the public utilities‘ and other essential services cannot be left to the private sector. For, the pricing system of free enterprise system is such that only rich can afford these services and hence there will be inequitable distribution of essential services.

Free enterprise system works through free and perfect competition. Perfect competition requires equality between the competitors. However, two firms are not equal in efficiency. The competition therefore generally becomes imperfect, which leads to the growth of monopolies and unequal distribution of income. This is one of the greatest drawbacks of the free enterprise system.

The free-market mechanism does not function efficiently where the exclusion principle is not applicable specially, where externalities are involved. Application of exclusion principle requires that those who do not pay for a good be excluded from the benefit from that good and those who do not derive any benefit from a good are excluded from bearing the cost of that good.

In a modern complex society, there are numerous activities, which imposed is advantages on those not benefitting from them and there are those who benefit even if they do not pay for such goods and services. For instance, smoke-emitting factories, automobiles playing in the cities, use of loudspeakers on marriage ceremonies and people playing their radio and music system loudly harm their neighbours by causing atmosphere and noise pollution.

Free enterprise system not only has failed to achieve the cherished goals of the society but also has caused growth of monopolies, unequal income distribution, unemployment and poverty. Besides, though free enterprise system is capable of bringing economic growth, it does not ensure stable, sustained and balanced growth.


The Government and the Economy

the market mechanism becomes inevitable because of failures of the market system. Now, the question arises as to what should be the appropriate role of the government in economic management of the country and what should be the form, nature and extent of government‘s interference with market mechanism.

the economic role of the government can be broadly categorized based on the three economic systems which presently prevail in the world, viz., capitalist system or free enterprise system, loyalist system and the mixed- economy system.


Government Role in the Capitalist Economy

A capitalist society works on the principles of free enterprise system or a laissez-faire system. in this system, the primary roles of the government are:

  • To preserve and promote free market mechanism wherever it is possible to ensure a workable competition.
  • To remove all unnecessary restrictions on the free operation of competitive market.
  • To provide playground and rules of the market game through necessary interventions and controls so that free competition can work effectively Besides.

Government intervention and its economic activities should deliver what free market mechanism cannot. Meade has recommended eight kinds of activities for the state to perform for this purpose:

  • Control of inflation and deflation mainly through indirect measures, like fiscal and monetary regulations.
  • Control and regulation of monopolistic powers of large corporate concerns with a view to avoiding unemployment and wastage of resources.
  • Creation and ownership of state monopoly of essential goods and service, e.g., railway transport, generation and distribution of electricity 29 and such like services on the ground of efficiency and economies of large scale.
  • Promoting equality of opportunity by providing equal access to educational opportunities and restricting the restrictive activities of trade unions.
  • Administration of justice and maintenance of law and order and ensuring freedom of activities.

Tackling the problems of environmental controls, of the use of exhaustible resources and of population growth it may be inferred from the above that the government‘s role in a capitalist society is supposed to be limited,

  • restoration and promotion of necessary conditions for efficient working of free market mechanism.
  • To enter those are as of production and distribution in which private entrepreneurship is lacking or is inefficient.

Government Role in the Socialist Economy

In contrast to the capitalist system, the role of government in a socialist economy is much more exhaustive. Whilein the former, the government is supposed to play a limited role in the economic sphere, in the latter, it exercises comprehensive control on almost all economic activities. in the socialist system, not only there is a completed is regard free enterprise and market mechanism but also these systems are abolished by law. The private ownership of factors of production is replaced by the state ownership.

All economic activities are centrally planned, controlled and regulated by the State. All decisions regarding allocation of productive resources, employment, pricing etc. are centralised in the hands of government or the Central Planning Authority. The individual freedom of choice and decision-making concerning economic activities is drastically curtailed. This, however, should not mean that thereis no scope for individual decisions. individuals are provided freedom to make their own choices but within the policy framework of the socialist economy.

The Soviet economic system was until 1990 the most prominent example of socialist system of economic management. Other countries, which had adopted socialist economic system, were China, Poland, Slovakia and Yugoslavia. All these economies are, however, liberalising their economic system and transforming socialist system into free enterprise system. The social aims of the socialist economic system are the same as in free enterprise system, viz.,efficiency, growth, social justice and maximisation of social welfare.

However, while the motivating force in a capitalist economy is private profit, in the socialist economy, it is maximisation of social welfare. Socialist way of management of the economy eliminates many evils of capitalist system. For example, exploitation of labour by capitalists, elimination of forces generating economic fluctuations, prevention of unemployment providing social, political and economic equality can be achieved in a socialist economy.


Government Role in a Mixed Economy

A mentioned earlier, a mixed economy is an economic system, which combines the features of both the free enterprise and socialist (or centrally planned) economic systems. in this system, a major part of the economy, the private sector, is allowed to function on the principles of free enterprise system or free market mechanism within a broad political and economic policy framework of the country.

The other part of the economy, the public sector, is organised, owned and managed along the socialist pattern. The public sector is created by reserving certain industries, trade, services and activities for the government control and management. The government prevents by law theentry of private capital into the industries reserved for the public sector. Another way of creating or expanding the public sector is nationalisation of private industries.

The promotion, control and management of the public sector industries are the responsibilities of the State. The Indian economy is a mixed economy. Apart from controlling and managing public sector industries, the government controls and regulates the private sector through its industrial, monetary and fiscal policies. if necessary, direct controls are also imposed.


what is basic problems of an economy

The basic problems of economic decisions and form the basis of economic studies and generalisation.The major economic problems faced by an economy whether capitalist, socialist or mixed may be classified in two broad groups

How Market Mechanism Solves the Basic Problems

The way basic problems of an economy are solved depends on the nature of its economic system. While in a socialist economy they are solved by the government agencies, like central planning authority, in a free enterprise or mixed capitalist economy, the basic economic problems are resolved by price mechanism or market mechanism.

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