Table of contents |
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Basic Problems of an Economy |
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Capitalist Economy |
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Socialist Economy |
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The Mixed Economy |
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Every economic system, whether capitalist, socialist, or mixed, must confront this fundamental issue of resource scarcity in relation to the demands for them. This is commonly referred to as ‘the central economic problem’. The central economic problem can be further categorized into four primary economic questions:
(i) What to produce?: Given limited resources, every society must determine which goods and services to produce and in what quantities. An economy must decide between producing more guns or butter, or whether to focus on capital goods like machinery and dams versus consumer goods like cell phones. Essentially, a society needs to establish how much wheat, hospitals, schools, machines, and meters of cloth should be produced.
(ii) How to produce?: There are various methods to produce a commodity. For instance, cotton cloth can be made using handlooms, power looms, or automatic looms. Handloom production is more labor-intensive, while automatic looms require more capital. A society must choose between labor-intensive and capital-intensive techniques based on the availability and cost of production factors. The goal is to utilize production methods that optimize the use of available resources.
(iii) For whom to produce?: A critical decision for any society is determining for whom to produce goods and services. Since not all wants can be satisfied, a society must decide how to distribute the total output among its members, essentially determining the shares of different individuals in the collective production of goods and services.
(iv) What provision should be made for economic growth?: Societies must not allocate all resources solely for current consumption. Failing to do so risks stagnating production capacity, which could lead to a decline in living standards. Therefore, decisions must be made regarding the amount of savings and investments necessary for future progress.
An economic system refers to the complete arrangement for the production and distribution of goods and services within a society. It encompasses all mechanisms that facilitate economic choices, involving various individuals and economic institutions.
The world's economies tackle these central problems differently, and they can be broadly classified into three categories based on their production, exchange, distribution methods, and the role of government in economic activities.
Capitalism is the primary economic system in today's global economy, characterized by private individuals owning and controlling all means of production for profit. In essence, private property is central to capitalism, and the profit motive drives economic activity. Consumer and business decisions dictate economic dynamics, and ideally, the government's role in economic management is minimal. Examples of capitalist economies include the United States, United Kingdom, Hong Kong, and South Korea, although many exhibit mixed traits rather than pure capitalism.
An economy is termed capitalist, free market, or laissez-faire if it possesses the following features:
A capitalist economy operates without a central planning authority to determine what, how, and for whom to produce. This absence of central control might seem chaotic, especially if consumers prefer cars, producers focus on cloth, and workers choose the furniture sector. However, this chaos does not manifest in a capitalist economy. Instead, it utilizes the impersonal forces of market demand and supply, or the price mechanism, to address its central issues.
Deciding ‘what to produce’: Entrepreneurs aim to maximize profits, prompting competition among businesses to create the goods consumers desire. For instance, if there is a higher demand for cars, their prices will rise. An increase in car prices, assuming costs remain stable, will lead to higher profits, incentivizing producers to manufacture more cars. Conversely, if demand for cloth decreases, its price will drop, reducing profits and thereby discouraging production of cloth. This results in an increased production of cars and decreased production of cloth. In capitalist economies (like the USA, UK, and Germany), the decision regarding what to produce is ultimately governed by consumer preferences, reflected through their spending on desired goods.
Deciding ‘how to produce’: Entrepreneurs select production techniques that minimize costs. If labor is inexpensive, a labor-intensive method will be adopted; if labor is costly, a capital-intensive method will be chosen. Thus, the relative costs of production factors influence the decision on how to produce.
Deciding ‘for whom to produce’: Goods and services are produced for those with purchasing power. An individual's buying capacity is determined by their income, which is influenced by their work effort, the value of the factors they own, and their property ownership. Higher income results in greater buying capacity and increased demand for goods.
Deciding about consumption, saving, and investment: Consumption and savings are determined by consumers, while investments are made by entrepreneurs. Consumers' savings are affected by the prevailing interest rate; higher income and interest rates lead to increased savings. Investment decisions are based on expected returns; the higher the anticipated profit (i.e., return on capital), the more investment occurs in a capitalist economy. The interest rate on savings and the return rate on capital serve as the pricing mechanism for capital.
In summary, the production of goods, the methods employed, the target consumers, and considerations for economic growth are all determined by the price mechanism or market mechanism.
The concept of a socialist economy was introduced by Karl Marx and Frederic Engels in their 1848 work, The Communist Manifesto. In this economic system, the material means of production—such as factories, capital, and mines—are owned collectively by the community, represented by the State. All individuals have the right to benefit from the outcomes of this socialized planned production based on equal rights. A socialist economy is also referred to as a "Command Economy" or a "Centrally Planned Economy," where resources are allocated according to the directives of a central planning authority, rendering market forces ineffective in resource allocation. The primary aim of production and distribution of goods in a socialist economy is to maximize the welfare of the community as a whole. Consequently, the central economic issues are addressed through planning within this framework.
The former U.S.S.R. exemplified a socialist economy from 1917 to 1990. Currently, no country operates purely as a socialist state, though examples include Vietnam, China, and Cuba. North Korea is also recognized as a socialist economy and is considered the most totalitarian state in the world.
The mixed economic system relies on both markets and governments for resource allocation. In reality, all economies utilize both markets and governments, making them inherently mixed economies. The goal of a mixed economy is to create a system that incorporates the best elements of both controlled and market economies while minimizing their drawbacks. It values the benefits of private enterprise and property, emphasizing self-interest and profit motives. The significant economic development in countries like England and the USA can be attributed to private enterprise. However, the interests of private property, profit, and self-interest may not always align with the community's well-being, necessitating government intervention to address these issues. Therefore, the government must oversee essential industries and mitigate the free rein of profit motives and self-interest, while still allowing private enterprise to positively contribute. The state enforces necessary regulations to ensure that the private sector aligns with national welfare objectives.
Features of Mixed Economy
Merits of Mixed Economy
However, a mixed economy is not always a perfect compromise between capitalism and socialism; it can also face significant uncertainties.
Demerits of Mixed Economy
124 videos|191 docs|88 tests
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1. What are the basic problems faced by an economy? | ![]() |
2. How does a capitalist economy address economic problems? | ![]() |
3. What are the key features of a socialist economy? | ![]() |
4. What is a mixed economy and how does it function? | ![]() |
5. What role does the price mechanism play in an economy? | ![]() |
124 videos|191 docs|88 tests
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