Business Economics

CHAP 1 – UNIT 2 - BASIC PROBLEMS

OF AN ECONOMY AND ROLE OF
PRICE MECHANISM
The basic problem of an economy is,
Scarcity of resources relative to the wants
for them. This is generally called ‘the
central economic problem’

The Central economic problem can be

further divided into four basic economic
problems
1.What to produce?
2.How to produce?
3.For whom to produce?
4.What provisions (if any) are to be made
for economic growth?
WHAT TO PRODUCE :

1.What kind of goods and services should be produced and

how many units of each goods or service should be produced?
2.A society must decide how much wheat, how many
hospitals, how many schools, how many machines, how many
meters of cloths etc. have to be produced.

HOW TO PRODUCE:

1.There are various alternative techniques of producing a

commodity. For example, cotton cloth can be produced using
handlooms, power looms or automatic looms. A society has to
decide whether it will produce cotton cloth using labour
intensive techniques or capital-intensive techniques.
2.The choice would depend on the availability of different
factors of production (i.e. labour and capital) and their relative
prices. It is in the society’s interest to use those techniques of
production that make the best use of the available resources.
FOR WHOM TO PRODUCE:
1.A society cannot satisfy each and every want
of all the people.
2.It has to decide on who should get how much
of the total output of goods and services

WHAT PROVISION SHOULD BE MADE FOR

ECONOMIC GROWTH :
1.A society would not like to use all its scarce
resources for current consumption only.
2.A society has to decide how much saving
and investment (i.e. how much sacrifice of
current consumption) should be made for
future progress.
To see how different economies of the world would
be solving their central problems, we divide all the
economies into three broad classifications based
on their mode of production, exchange,
distribution and the role which their governments
plays in economic activity

i.Capitalist economy ( Free Market Economy)

ii.Socialist economy

iii.Mixed economy
CAPITALIST ECONOMY (FREE MARKET
ECONOMY)
Capitalism, the predominant economic system in the
modern global economy, is an economic system in which
all means of production are owned and controlled by
private individuals for profit.

CHARACTERSTICS :
1.Right to Private Property
2.Freedom of Enterprises
3.Freedom of economic choice
4.Profit motive
5.Consumer Sovereignty
6.Competition
7.Absence of Government Interference
CAPITALIST ECONOMY (FREE MARKET ECONOMY)
How do capitalist economies solve their
central problems?

-
CONTINUED
CAPITALIST ECONOMY (FREE MARKET ECONOMY)

How do capitalist economies solve their

central problems?

What Provision Should Be Made For

Economic Growth :
Determined by the rate of interest on savings
and the rate of return capital
CAPITALIST ECONOMY (FREE MARKET ECONOMY)
Merits and Demerits of Capitalist
Economy :
MERITS DEMERITS
No need of Having a Central In equal Distribution of
Planning Authority Income
Higher level of Efficiency Precedence of Property
rights over Human Rights
Optimum Allocation of Labour Exploitation
resources
Cost of Production is Waste of productive
minimized resources as firms spend
heavily on Advertisement
and marketing activities
Competition and Freedom of Creation of Monopolies
choice
Innovation and Excessive materialism as
Technological Progress well as conspicuous and
unethical consumption
Right to Freedom and Right
to Private Property
 SOCIALIST ECONOMY ( COMMAND ECONOMY)
The concept of socialist economy was propounded
by Karl Marx and Frederic Engels in their work
‘The Communist Manifesto’ published in 1848.
In this economy, the material means of production
i.e. factories, capital, mines etc. are owned by the
whole community represented by the State.
CHARACTERSTICS
Collective Ownership
Economic planning
Absence of Consumer Choice
Relatively Equal Income Distribution
Minimum role of Price Mechanism or Market
forces
Absence of Competition
SOCIALIST ECONOMY ( COMMAND ECONOMY)
How do socialist economies solve their central
problems?

What Provision Should Be Made For Economic

Growth :
Determined by government preferences
SOCIALIST ECONOMY ( COMMAND ECONOMY)
Merits and Demerits of Capitalist
Economy :
MERITS DEMERITS
Equitable Distribution of Predominance of
income and wealth bureaucracy
Rapid and Balanced Restricts the freedom of
economic development individual
Planned Economy – Better No basic rights like Right to
utilization of resources private property
Right to Work and Minimum No incentive for Hardwork
standard of living to all
people
Laborers and consumers are No freedom of choice for
protected from exploitation consumers
Mixed Economy
The mixed economic system depends on both markets
and governments for allocation of resources.
The aim is to develop a system which tries to include
the best features of both the controlled economy and
the market economy while excluding the demerits of
both.
CHARACTERSTICS:
Co-existence of private and public sector - In fact, in
a mixed economy, there are three sectors of
industries:
1.Public Sector
2.Private Sector
3.Combined Sector
Mixed Economy
How do socialist economies solve their central
problems?

What Provision Should Be Made For Economic

Growth :
Determined partly by government
preferences and partly by rate of returns on
savings
Mixed Economy
Merits and Demerits of Mixed Economy:
Merits
Economic Freedom and
Right to Private Property
Price Mechanism and
Competition
Consumers Sovereignty and
freedom of choice
Disadvantages of cut throat
competition averted through
govt legislation,
environment and labour
regulations
Comparitively greater
economic and social
Demerits
Excessive State control
resulting in constrained
growth of private sector
Higher Rates of Tax
Lack of efficiency,
Corruption and Wastage
of resources
Difficult to maintain a
balance between public
and private sector
resulting in excessive
growth of private sector