Fundamental Problems of Economic System

UNIT 1 – FUNDAMENTAL PROBLEMS OF ECONOMIC SYSTEMS 1. 1 INTRODUCTION In this unit you will get acquainted with the fundamental problems of the economy. The understanding of the concept will help you bring closer to the basic idea of the economy’s problems as well as remedies of such problems. In this unit you will get detailed description of what is an economic system, problems of economic system, factors of production, concept of production possibility curve, and the fundamental of allocation of resources in different types of economies. 1. 2 AN ECONOMIC SYSTEM

Before we further move on we have to know about the sources of economic problems and a brief about the economic system. 1. 2. 1 Scarce Means and Unlimited Wants Want is Want is an effective desire for a thing, which can be satisfied by making an effort for obtaining it. We have unlimited wants and as one want gets satisfied another arises. For instance, one may have the desire to buy a car or a flat. Once the car or the flat is purchased, the person wishes to buy a more spacious and designable car and the list of his wants does not stop here but goes on one after another.

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As human wants are unlimited, we have to make a choice between the most urgent want and less urgent wants. Thus the problem of choice arises. Means also known as resources are limited. Means are the ways to derive the satisfaction of the various wants. For instance, money is an important means to satisfy many of our wants. As stated, means are scarce and as such these are to be used optimally. In other words scarce or limited means are to be judicially used and economized to get the maximum satisfaction. Another problem which is to be viewed is that resources have alternative uses i. e. the same resource can be used for more than one purpose.

For example, money can be used either buying a laptop or a play station, all depends on how you perceive the urge of the desire or want you want to satisfy. 1. 2. 2 An Economic System or Economy The term economic system can be defined as a set of techniques by which a society decides and create balance between resources and unlimited human wants. It therefore clearly signifies that being a part of social system not only natural resources but also man made resources also get included in the economic system. The economic system thus comprises of people and institutions like banks, markets etc.

The set of parameters thus used to determine the components of economic system is very dynamic and depends upon various factors like social, political, geographical and climatic etc. This shows that we can distinguish the two economies, no economy in the world will be same. The difference can be judged on the basis of control of the economy For Example: The economic system of the country can also be based on the basis of involvement of society, more involvement of society in the economy and the decision are taken with a view of society and equitable distribution of wealth is characteristic of Socialist Economy.

Contrarily if the economy is decentralized and the power lies in the hands of private enterprises then the said economy is capitalist economy. Primarily the difference is done on the basis of the control but other things like growth, production of the economy can also be used to judge the economic scenario of the two economies, the production done in a fiscal year, purchasing power of the people and employment are primarily the factors considered. 1. 2. 3 Economic Agents Economic agents are the key units of the economic system, the whole economy revolves around them.

Producers, consumers, institutions and various other bodies come under this category. The agents are considered to be the most critical part of the economy as they guide and drive the economy by their actions. Check your progress A 1. What is an economic system? Ans. Economic system or economy is known a set of principles by which problems of economics are addressed, such as the economic problem of scarcity through allocation of finite productive resources. The economic system thus comprises of people and institutions like banks, markets etc. . 3 FACTORS OF PRODUCTION Production process is an end to end activity which means that there is a relational pedagogy between input and output. Factors of production also known as productive inputs are the resources employed to produce goods and services, thus it constitutes the input part of the production process. Factors of production involve in the production process and improves the working of the process but do not form the ultimate part of the product. Factors of production can be broadly classified as: 1. Land . Labour 3. Capital 4. Entrepreneurship 1. 3. 1 Land In economics, land includes all natural resources which are free gift of nature. Thus, by land economists do not mean only agricultural soil, but also other natural resources such as minerals, water, climate and forests. Payment for use of land per period is called Rent. Land as factor of production implies the ground used to built and start the production moreover it serves as a pool of various minerals and valuable natural resources which facilitates the human mankind.

Land is a fixed factor of production and thus it is not possible to increase. Land helps to facilitate the production only if the efficient workforce is used to generate the maximum output out of the limited resource. This means optimum utilisation of resources. 1. 3. 2 Labour Labour represents all physical and mental abilities which people can make available for production of goods and services. Labour is usually measured by the time spent in working during a period. Reward made per period of labour is called Wages. Labour is a non homogeneous factor of production.

There are set of people in the underlying category which can be distinguished as skilled and unskilled worker. The workers that are skilled and educated are used in the operations of a more complex job requiring special skills and training and the other category belongs to the lower level working operations. The two factors which highlight the labour are efforts put in and performance which correlates the efficiency. The efforts put in by a labour can be modified with the motivational analysis that can help the person to make the worker work produce more.

As land is the natural or passive factor in all production, so labour is the human or active factor. All the production results with the action of labour thus it can be said that labour is producer of all wealth. In economics the labour and capital is said to be the primary factors of production and from their union all of the production comes. 1. 3. 3 Capital Capital, which is not in itself a distinguishable element, but which it must always be kept in mind consists of wealth applied to the aid of labour in further production, is not a primary factor.

There can be production without it, and there must have been production without it, or it could not in the first place have appeared. It is a secondary and compound factor, coming after and resulting from the union of labour and land in the production of wealth. Capital refers to man made resources of production. Labour plays an integral role in the capital formation, here too state of labour effects and relates with the capital formation an efficient worker will generate additional capital with additional production. Here the term investment arise which is the amount of capital formation in a year.

The capital formation with a viewpoint of economy will include the accumulated part of the production process. The production is a continuous process and hence a halt can hamper the production in a big way, thus there is always some production in progress and some products add to the production of other products appreciating the value of the products will lead to the capital formation. 1. 3. 4 Entrepreneurship Entrepreneur represents a special human resource which provides his entrepreneurial abilities to the enterprise.

Entrepreneur plays a crucial role in a free market economy it integrates all the factors of production land, labour and capital to produce the output with a view of anticipating all the losses if the output fails in the free market. Entrepreneur always is in the risky situation as he is the one who bears all d cost of inducing the other factors of production into the production process and the profits are the rewards of the entrepreneur at the end of everything. Nowadays Venture Capitalists and other financer are willing to diversify the risk of the new entrepreneur.

The existence of the entrepreneurship as a part of factor of production is still debatable. Check Your Progress B 1. List the major factors of production? Ans. Major Factors of production are as follows: a. Land b. Labour c. Capital d. Entrepreneurship 1. 4 FUNDAMENTAL PROBLEMS OF AN ECONOMY Every economy has to face some problems as scarcity of resources having alternative uses in relation to demand give rise to the choice problem. The allocation of resources is the fundamental problem of the economy. These Fundamental problems are: 1. What to produce? 2. How to produce? 3.

For whom to produce? 4. The choice between current consumption and growth through saving and investment. 1. 4. 1 What to produce? This question arises from the fact of limited resources in the society now apparently society has to decide which goods have to be produced and in which quantities, now it is clear that some of the goods have to be produced and some have to be foregone. This lead us to take an intermediate solution of what we must produce and what we must not as the goods that are foregone also have some wants associated with it which leads some of the customers dissatisfied.

Another problem attached with the production is allocation of resources like for example if we have to produce product A and product B, both of them will require the exhaustion of the resources, here the problem of allocation of resources comes into picture as to how much resources we must allocate to which product. This is necessarily not an issue of the developing countries as developed countries can also face the problem of allocation of resources. 1. 4. 2 How to Produce?

This is the problem of choosing method or technique of production which means that what combinations of factors a society decides to produce goods. For example if the economy decides to produce product A then how the production will take place and allocation of resources has to be decided. A combination of factors in appropriate amount for the production is known as the technique of production. The things that come into consideration while taking the decision of how to allocate the factors and which factors to be used can be decided with the current economic scenario.

For example in developing countries where there is abundance of labour and relatively lesser amount of capital there we can use Labour Intensive Technique for the production and similarly in developed countries where labour is relatively less and capital is more, then Capital Intensive Technique can be adopted for the production purposes. The basic criteria of choosing the different types of technique in the different kind of scenario would be based on 1. Availability of the supplies of resources 2. Prices of the different resources which must lead to most cost effective way of production.

The problem here is that the scarcity of resources which requires that the available resources must be used judicially and efficiently, if not economy has to face the inefficiency and thus productivity will hamper. 1. 4. 3 For Whom to Produce? This is the problem related with the issue of the distribution of the national product among the society. Society is a very vast term and includes a lot of components and consumers which include the ultimate consumers of the national produce thus it is very critical to state an effective distribution strategy, society thus itself decides how much is to distributed in what quantities.

In a free market economy it is the income of the individual which is the deciding factor that how much he can purchase out of the available resources, Higher the income higher is the power to utilise the resource in his favour. The distribution strategy is also not free to operate in the economy on the basic principles of demand and supply there are certain factors which governs the marketing mechanism like from socialist perspective focus is on the providing basic necessities to all and generate motivation in the people to generate additional income by doing additional work, Similarly there has o be different strategies to be adopted in case of different economic structure. The problem of distribution does not have an easy way out it implies that there is always conflict of ideologies in setting up of the distribution strategy. 1. 4. 4 The Problem of Growth Economic growth suggests that there is an increase in the production of goods and services on a continuous basis. Growth thus implies that the economy must move on with increase in the substantial amount of the investment. Capital formation is thus necessary and for the expansion of the stock there has to be a sacrifice in the present level of consumption.

If all the stock is used up and nothing is there for the future use, there will be no capital formation and thus no growth. 1. 4. 5 Choice between Public and Private Goods 1. Public Goods: It is those types of goods that can not be restricted and bounded by the use of an individual. The basic characteristic of these types of goods are: a) Consumption of the good by one person does not lead to the reduction in the availability for the consumption of others. b) No body can not get excluded from using the good.

Free to air television channels are the examples of these types of goods. These are the goods available to all and anybody can see without getting obstruction in a way these goods comes as a right to a person. These goods satisfy a collective want of the society. 2. Private Goods: These types of goods are the just opposite of what we have just read Public Goods. The main characteristics or the Private Goods are: a) Consumptions by one consumer prevent simultaneous consumption by other consumers. b) It is reasonably possible to prevent a class of consumers from consuming the good.

Private goods are produced and marketed with a perspective of profit and it just satisfies an individual want. Bread can be one of the examples of Private Goods. 1. 4. 6 The Problem of Merit Goods The merit goods are those goods which follow the concept of need, rather than ability and willingness to pay. For example: Health Services it helps the society on the whole and caters the need at individual level, but since it is a costly merit service the same has to be privatised which results in the acquisition of services only by those whom have the power to pay the more money.

Thus Merit Goods merit remains effective till it helps the individual as well society on a holistic level. Check Your Progress C 1. What is capital formation? Ans. Capital formation is the term used to coin the additional things added into the economy on account of growth. Capital stock added in the financial year counts on account of capital formation when it comes to real and tangible products and in case of services the additional value generated by rendering services that appreciates the value of Gross National Product. 1. 5 PRODUCTION POSSIBILITY CURVE

Production possibility curve is also known as Production Possibility Frontier or Transformation Curve. Production Possibility curve is a curve which depicts Graphical representation of the alternative combinations of the amounts of two goods or services that an economy can produce by transferring resources from one good or service to the other. As the total productive resources of the economy are limited, the economy has to choose between different goods. The resources can be put into different types of goods it is therefore necessary to decide which product to be produced more and which has to be less.

Assumptions underlying: 1. Given or fixed amount of resources available in the economy. 2. Given resources are being used fully and with utmost efficiency. 3. Technology does not undergo any change. Production possibility curve can be drawn with the help of a schedule that can be depicted between the two goods which can be produced with the full utilisation and efficient employment of given resources. This can be drawn on the basis of schedule for example we take Cloth and Tanks. Production Possibilities| Cloth| Tanks| A| 0| 15| B| 1| 14| C| 2| 12| D| 3| 9| E| 4| 5|

F| 5| 0| This schedule when depicted on a graphical format takes a convex shape and depicts the optimum number of combinations of the two products with the given level of resources in hand. 1. 6. 1 Resource Allocation in a Capitalist Economy Capitalism, broadly speaking, is the economic system in which financial considerations dominate. It is a system in which the quest for financial reward is the driving force shaping what is done, by whom, how, where and when. This concept basically works on two dimensions: freedom of economic choice and freedom of enterprise.

Freedom of choice means that in a world of scarce resources the individual is free to make his own decisions. Freedom of enterprise is usually more narrowly defined as the freedom to own and operate a business. Price Mechanism plays an important role in the role of determining the process of buying and selling. Market forces determine the price and quantity to be produced in the economy with the interaction demand and supply. In such economy the goods and services produced in the society with the aim of generating profit and thus the resources are allocated to the goods which provide better results on account of profit. The biggest concern een and faced in this type of economy is of income inequality, due to the price mechanism and profit motive the goods are not supplied to the poor and the philosophy rich is become richer and poor becomes poorer prevails. 1. 6. 2 Resource Allocation in a Socialist Economy Socialist economy is a structure of the economy which aims at providing greater equality and giving the working class greater ownership over the means of production. In a socialist economy or a socialist state believes that socialism is the most equitable and socially serviceable form of an economic arrangement designed to achieve human potentialities.

Socialist economies are characterized by the means of production owned by the state or by the workers collectively called socialism. The authorities decide in a planned economy how the resource must allocate in a profitable manner which benefits the society at large, market forces are not allowed to influence the decision at all. It is the government who takes control of all the resources and decides what to produce and in what quantities. They produce with the perspective of the society at large and not with the view of the earning profit. 1. 6. 3 Resource Allocation in a Mixed Economy

A Mixed Economy is an economy in which the decisions are taken in the combined manner some is taken by the market forces and some are taken under government regulation. The mixed economy as an economic ideal is supported by social democrats as a compromise between classic socialism. The production process is governed in a semi segregated manner, Critical sectors which are important with respect to the country as a whole is kept in hands of the government and rest consumer goods are kept open in the economy to kept work accordingly to the market mechanism. Check Your Progress D 1. What is production possibility curve?

Ans. Production Possibility curve also known as Production Possibility Frontier is a curve which shows the combination of two or more goods or services that can be produced while using all the available factor resources efficiently. For Example: We can allocate the resources in the production of the cloths and tank. 1. 7. LETS SUM UP Knowledge has many branches and economics is an important and useful branch of knowledge because problems of poverty, unemployment, lack of growth, inflation which face all economies are best explained and explored and being solved with the help of Economics.

An economic system can be defined as a “set of methods and standards by which a society decides and organizes the allocation of limited economic resource to satisfy unlimited human wants. The precise nature of economic system varies from society to society. Because , Economic system is the economics category that includes the study of respective systems. Means of production are the inputs used for production. The key term production is likely to be explained as the creation of an item or a production that gives maximum satisfaction to the people.

Means of production can be classified into groups of homogenous (products having same features and can be substituted) and heterogeneous (products having different features from one another) units. There are various types of productive resources which are also generally called factors of production. Economists traditionally classify productive resources into four types: (a) Land – Includes all natural resources which are free gift of nature. Payment for use of land per period is called rent. b) Labour – Represents all physical and mental abilities which people can make available for production of goods and services. Reward made per period for labour services is called wages. (c) Capital – Refers to sum total of all man – made resources of production. Its formation in a year is called investment. (d) Entrepreneur – represents special human resource which initiates and organises the production process by combining other resources such as labour, capital and land. In every economy, scarcity of resources gives rise to four fundamental problems of economy.

These are: (i) what to produce – means which goods and in what quantity are to be produced, (ii) how to produce – means which methods of production are to be used for the production of goods and services, whether, labour or capital intensive, (iii) for whom to produce – means how the goods produced are to be distributed among the people, (iv) how much to grow – means how much to be saved and invested for increasing the productive capacity of the economy. The problem of what to produce is generally illustrated with the help of Production Possibility Curve (PPC) which is based on some simple assumptions.

It gives an idea to the economy about what to produce and in how much quantity with full utilisation of its resources with given techniques of production and thus simultaneous increase in production cannot take place without reducing any one product. With economic growth only, it is possible to move PPC outwards and make simulataneous increase in production of all goods. Allocation of resources is different in every economic system. In capitalist economy, it takes place through relation between supply, demand and price forces wherein the means of production are owned by private sectors.

Accordingly, it is the demand pattern in the economy which finally determines the resource allocation. In a socialist economy, the means of production are owned by government which tries to reduce income and wealth inequalities. Individual economic units are restricted in their decisions on the basis of economic rationality. In a mixed economy, both individual economic units and authorities take part in decision making process where even private sectors sometimes work under the government regulations such as price controls, subsidies and so on.


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