ICAI Notes- Unit 2: Basic Problem of an Economy & Role of Price Mechanism- 1 - CA Foundation PDF Download

Learning Outcomes

At the end of this Chapter, you will be able to: 

• Explain the Basic Problems faced by an Economy.
• Describe how Different Economies Solve their Basic Economic Problems.
• Explain the Role of Price Mechanism in Solving the Basic Problems of an Economy

Basic Problems of an Economy

As mentioned in the last unit, all countries, without exceptions, face the problem of scarcity. Their resources (natural productive resources, man-made capital goods, consumer goods, money and time etc.) are limited and these resources have alternative uses.
For example: Coal can be used as a fuel for the production of industrial goods; it can be used for running trains, for domestic cooking purposes and for many other purposes. Similarly, financial resources can be used for many purposes. If the resources were unlimited, people would be able to satisfy all their wants and there would be no economic problem. Alternatively, if a resource has only a single use, then also the economic problem would not arise.
Every economic system, be it capitalist, socialist or mixed, has to deal with this central problem of scarcity of resources relative to the wants for them. This is generally called ‘the central economic problem’. The central economic problem is further divided into four basic economic problems.
These are:

• What to produce?
• How to produce?
• For whom to produce?
• What provisions (if any) are to be made for economic growth? 

What to produce?

• Since the resources are limited, every society has to decide which goods and services should be produced and how many units of each good (or service) should be produced.
• An economy has to decide whether more guns should be produced or more butter should be produced; or whether more capital goods like machines, equipments, dams etc., will be produced or more consumer goods such as, cell phones will be produced.
• Not only the society has to decide about what goods are to be produced, it has also to decide in what quantities each of these goods would be produced.
• In a nutshell, 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?

• There are various alternative techniques of producing a commodity. For example, cotton cloth can be produced using handlooms, power looms or automatic looms. 
• Production with handlooms involves use of more labour and production with automatic loom involves use of more machines and capital. 
• A society has to decide whether it will produce cotton cloth using labour-intensive techniques or capital-intensive techniques. 
• Likewise, for all goods and services, it has to decide whether to use labour-intensive techniques or capital-intensive techniques. 
• Obviously, 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?

• Another important decision which a society has to take is ‘for whom’ it should produce. 
• A society cannot satisfy each and every want of all the people. Therefore, it has to decide on who should get how much of the total output of goods and services, i.e. How the goods (and services) should be distributed among the members of the society. 
• In other words, it has to decide about the shares of different people in the national cake of goods and services.

What provision should be made for economic growth?

• A society would not like to use all its scarce resources for current consumption only. This is because, if it uses all the resources for current consumption and no provision is made for future production, the society’s production capacity would not increase. 
• This implies that incomes or standards of living of the people would remain stagnant, and in future, the levels of living may actually decline. Therefore, a society has to decide how much saving and investment (i.e. how much sacrifice of current consumption) should be made for future progress.
• We shall now examine the term ‘economic system’. An economic system refers to the sum total of arrangements for the production and distribution of goods and services in a society. In short, it is defined as the sum of the total devices which give effect to economic choice. It includes various individuals and economic institutions.
• You must be wondering how different economies of the world would be solving their central problems. In order to understand this, 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.
  These are:
  • Capitalist economy
  • Socialist economy
  • Mixed economy

Capitalist economy

• Capitalism or capitalist economy is referred to as the economic system where the factors of production such as capital goods, labour, natural resources, and entrepreneurship are controlled and regulated by private businesses.
• In a capitalist economy, the production of all the goods and services is dependent on the demand and supply in the market that is also known as a market economy. It is different from the central planning system that is also known as a command economy or a planned economy.
• The main characteristic of a capitalist economy is the motive of earning profit. The capitalist economy is also characterised by the presence of free markets and lack of participation by the government in regulating the business.
• The origin of capitalism can be traced back to 18^th century England that was undergoing the industrial revolution at that time. As there is no government intervention in this type of economy, it is also known as a free market economy.

Features of Capitalism

• Private property: This is one of the most important characteristics of capitalism where private properties like factories, machines, and equipment can be owned by private individuals or companies. 
• Freedom of enterprise: Under this system, every individual has the right to make their own economic decisions without any interference. This is applicable to both consumers and producers. 
• Profit motive: The motive of earning profit is one of the most important drivers of a capitalist economy. In this system, all the companies are looking to produce and sell their products to consumers to earn maximum profit. 
• Price mechanism: Under this system, the demand and supply in the market will determine the production level and correspondingly the price set for the products without any kind of involvement from the government. 
• Consumer sovereignty: In this system, the market is controlled by the demands of the consumer. It regulates the level of production undertaken by the companies, and the consumer is free to decide which products to purchase. 
• Free trade: In this system, the low tariff barriers exist that promote international trade. 
• Government interference: In a capitalist economy, there is no government interference in the daily activities of the business. The customers and producers are free to make their own decisions regarding any product or service. 
• Flexibility in labour markets: In capitalism, there is a flexibility in hiring and firing of the workforce. 
• Freedom of ownership: In this system, an individual can accumulate any amount of property and use it according to his will. After his death, the same property is passed on to the successors by the right of inheritance.

Advantages of Capitalist Economy

• There is more efficiency in the capitalist economy as the products are produced according to the demand of the consumers. 
• There is less intervention from the government or bureaucratic interference. 
• There is better scope for innovation as companies look to obtain a major part of the market with their offerings. 
• It discourages any form of discrimination so that the trade can take place between two parties without any barriers.

Disadvantages of Capitalist Economy

• Capitalism leads to inequalities in income.
• In capitalism, firms can get monopoly over workers and consumers.
• A high profit-earning motive of a capitalist economy is to use resources in such a way that it leads to environmental problems by destroying the natural balance.