ICAI Notes- Unit 2: Basic Problems of an Economy & Role of Price Mechanism | Business Economics for CA Foundation PDF Download

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 producing electricity, 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?

(i) 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, equipment’s, 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. 

(ii) 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. 

(iii) 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. 

(iv) 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

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. In short, private property is the mainstay of capitalism and profit motive is its driving force. Decisions of consumers and businesses determine economic activity. Ideally, the government has a limited role in the management of the economic affairs under this system. Some examples of a capitalist economy may include United States and United Kingdom, Hong Kong, South Korea etc. However, many of them are not pure form of capitalism but show some features of being a capitalist economy.

An economy is called capitalist or a free market economy or laissez-faire economy if it has the following characteristics: 

• Right to private property: The right to private property means that productive factors such as land, factories, machinery, mines etc. can be under private ownership. The owners of these factors are free to use them in any manner in which they like and bequeath it as they desire. The government may, however, put some restrictions for the benefit of the society in general. 
• Freedom of enterprise: Each individual, whether consumer, producer or resource owner, is free to engage in any type of economic activity. For example, a producer is free to set up any type of firm and produce goods and services of his choice. 
• Freedom of economic choice: All individuals are free to make their economic choices regarding consumption, work, production, exchange etc. 
• Profit motive: Profit motive is the driving force in a free enterprise economy and directs all economic activities. Desire for profits induces entrepreneurs to organize production so as to earn maximum profits. 
• Consumer Sovereignty: Consumer is supposed to be the king under capitalism. Consumer sovereignty means that buyers ultimately determine which goods and services will be produced and in what quantities. Consumers have unbridled freedom to choose the goods and services which they would consume. Therefore, producers have to produce goods and services which are preferred by the consumers. In other words, based on the purchases they make, consumers decide how the economy's limited resources are allocated. 
• Competition: Competition is the most important feature of the capitalist economy. Competition brings out the best among buyers and sellers and results in efficient use of resources. 
• Absence of Government Interference: A purely capitalist economy is not centrally planned, controlled or regulated by the government. In this system, all economic decisions and activities are guided by self-interest and price mechanism which operates automatically without any direction and control by the governmental authorities. 

How do capitalist economies solve their central problems? 

A capitalist economy has no central planning authority to decide what, how and for whom to produce. In the absence of any central authority, it looks like a miracle as to how such an economy functions. If the consumers want cars and producers choose to make cloth and workers choose to work for the furniture industry, there will be total confusion and chaos in the country. However, this does not happen in a capitalist economy. Such an economy uses the impersonal forces of market demand and supply or the price mechanism to solve its central problems. 

Deciding ‘what to produce’: The aim of an entrepreneur is to earn as much profits as possible. This causes businessmen to compete with one another to produce those goods which consumers wish to buy. Thus, if consumers want more cars, there will be an increase in the demand for cars and as a result their prices will increase. A rise in the price of cars, costs remaining the same, will lead to more profits. This will induce producers to produce more cars. On the other hand, if the consumers’ demand for cloth decreases, its price would fall and profits would go down. Therefore, business firms have less incentive to produce cloth and less of cloth will be produced. Thus, more of cars and less cloth will be produced in such an economy. In a capitalist economy (like the USA, UK and Germany) the question regarding what to produce is ultimately decided by consumers who show their preferences by spending on the goods which they want. 

Deciding ‘how to produce’: An entrepreneur will produce goods and services choosing that technique of production which renders his cost of production minimum. If labour is relatively cheap, he will use labour-intensive method and if labour is relatively costlier he will use capital-intensive method. Thus, the relative prices of factors of production help in deciding how to produce. 

Deciding ‘for whom to produce’: Goods and services in a capitalist economy will be produced for those who have buying capacity. The buying capacity of an individual depends upon his income. How much income he will be able to make depends not only on the amount of work he does and the prices of the factors he owns, but also on how much property he owns. Higher the income, higher will be his buying capacity and higher will be his demand for goods in general. 

Deciding about consumption, saving and investment: Consumption and savings are done by consumers and investments are done by entrepreneurs. Consumers’ savings, among other factors, are governed by the rate of interest prevailing in the market. Higher the level of income and interest rates, higher will be the savings. Investment decisions depend upon the rate of return on capital. The greater the profit expectation (i.e. the return on capital), the greater will be the investment in a capitalist economy. The rate of interest on savings and the rate of return on capital are nothing but the prices of capital.
Thus, we see above that what goods are produced, by which methods they are produced, for whom they are produced and what provisions should be made for economic growth are decided by price mechanism or market mechanism.

Merits of Capitalist Economy 

• Capitalism is self-regulating and works automatically through price mechanism. There is no need of incurring costs for collecting and processing of information and for formulating, implementing and monitoring policies. 
• The existence of private property and the driving force of profit motive result in greater efficiency and incentive to work. 
•  The process of economic growth is likely to be faster under capitalism. This is because the investors try to invest in only those projects which are economically feasible. 
• Resources are used in activities in which they are most productive. This results in optimum allocation of the available productive resources of the economy. 
• There is usually high degree of operative efficiency under the capitalist system. 
• Cost of production is minimized as every producer tries to maximize his profit by employing methods of production which are cost-effective. 
• Capitalist system offer incentives for efficient economic decisions and their implementation. 
• Consumers are benefitted as competition forces producers to bring in a large variety of good quality products at reasonable prices. This, along with freedom of choice, ensures maximum satisfaction to consumers. This also results in higher standard of living. 
• Capitalism offers incentives for innovation and technological progress. The country as a whole benefits through growth of business talents, development of research, etc. 
• Capitalism preserves fundamental rights such as right to freedom and right to private property. Therefore, the participants enjoy maximum amount of autonomy and freedom. 
• Capitalism rewards men of initiative and enterprise and punishes the imprudent and inefficient. 
• Capitalism usually functions in a democratic framework. 
• The capitalist set up encourages enterprise and risk taking and emergence of an entrepreneurial class willing to take risks. 

Demerits of Capitalism 

• There is vast economic inequality and social injustice under capitalism. Inequalities reduce the aggregate economic welfare of the society as a whole and split the society into two classes namely the ‘haves’ and the ‘have-nots’, sowing the seeds of social unrest and class conflict. 
• Under capitalism, there is precedence of property rights over human rights. 
• Economic inequalities lead to wide differences in economic opportunities and perpetuate unfairness in the society. 
• The capitalist system ignores human welfare because, under a capitalist set up, the aim is profit and not the welfare of the people. 
• Due to income inequality, the pattern of demand does not represent the real needs of the society. 
• Exploitation of labour is common under capitalism. Very often this leads to strikes and lock outs. Moreover, there is no security of employment. This makes workers more vulnerable. 
• Consumer sovereignty is a myth as consumers often become victims of exploitation. Excessive competition and profit motive work against consumer welfare. 
• There is misallocation of resources as resources will move into the production of luxury goods. Less wage goods will be produced on account of their lower profitability. 
• Less of merit goods like education and health care will be produced. On the other hand, a number of goods and services which are positively harmful to the society will be produced as they are more profitable. 
• Due to unplanned production, economic instability in terms of over production, economic depression, unemployment etc., is very common under capitalism. These result in a lot of human misery. 
• There is enormous waste of productive resources as firms spend huge amounts of money on advertisement and sales promotion activities. 
• Capitalism leads to the formation of monopolies as large firms may be able to drive out small ones by fair or foul means. 
• Excessive materialism as well as conspicuous and unethical consumption leads to environmental degradation.

Socialist 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. All members are entitled to get benefit from the fruits of such socialised planned production on the basis of equal rights. A socialist economy is also called as “Command Economy” or a “Centrally Planned Economy”. Here, the resources are allocated according to the commands of a central planning authority and therefore, market forces have no role in the allocation of resources. Under a socialist economy, production and distribution of goods are aimed at maximizing the welfare of the community as a whole. Hence the central problems are solved through planning under socialist economy. 

Some important characteristics of this economy are: 

• Collective Ownership: There is collective ownership of all means of production except small farms, workshops and trading firms which may remain in private hands. As a result of social ownership, profit-motive and self- interest are not the driving forces of economic activity as it is in the case of a market economy. The resources are used to achieve certain socio-economic objectives. 
• Economic planning: There is a Central Planning Authority to set and accomplish socioeconomic goals; that is why it is called a centrally planned economy. The major economic decisions, such as what to produce, when and how much to produce, etc., are taken by the central planning authority. 
• Absence of Consumer Choice: Freedom from hunger is guaranteed, but consumers’ sovereignty gets restricted by selective production of goods. The range of choice is limited by planned production. However, within that range, an individual is free to choose what he likes most. The right to work is guaranteed, but the choice of occupation gets restricted because these are determined by the central planning authority on the basis of certain socioeconomic goals before the nation. 
• Relatively Equal Income Distribution: A relative equality of income is an important feature of Socialism. Among other things, differences in income and wealth are narrowed down by lack of opportunities to accumulate private capital. Educational and other facilities are enjoyed more or less equally; thus the basic causes of inequalities are removed. 
• Minimum role of Price Mechanism or Market forces: Price mechanism exists in a socialist economy; but it has only a secondary role, e.g., to secure the disposal of accumulated stocks. Since allocation of productive resources is done according to a predetermined plan, the price mechanism as such does not influence these decisions. In the absence of the profit motive, price mechanism loses its predominant role in economic decisions. The prices prevailing under socialism are ‘administered prices’ which are set by the central planning authority on the basis of socio-economic objectives. 
• Absence of Competition: Since the state is the sole entrepreneur, there is absence of competition under socialism. 

The erstwhile U.S.S.R. was an example of socialist economy from 1917 to 1990.In today’s world there is no country which is purely socialist. Other examples include Vietnam, China and Cuba. North Korea, the world’s most totalitarian state, is another example of a socialist economy. 

Merits of Socialism 

• Equitable distribution of wealth and income and provision of equal opportunities for all help to maintain economic and social justice. 
• Rapid and balanced economic development is possible in a socialist economy as the central planning authority coordinates all resources in an efficient manner according to set priorities. 
• Socialist economy is a planned economy. In a socialistic economy, there will be better utilization of resources and it ensures maximum production. Wastes of all kinds are avoided through strict economic planning. Since competition is absent, there is no wastage of resources on advertisement and sales promotion. 
• In a planned economy, unemployment is minimised, business fluctuations are eliminated and stability is brought about and maintained.
•  The absence of profit motive helps the community to develop a co-operative mentality and avoids class war. This, along with equality, ensures better welfare of the society. 
• Socialism ensures right to work and minimum standard of living to all people. 
• Under socialism, the labourers and consumers are protected from exploitation by the employers and monopolies respectively. 
• There is provision of comprehensive social security under socialism and this makes citizens feel secure. 

Demerits of Socialism 

• Socialism involves the predominance of bureaucracy and the resulting inefficiency and delays. Moreover, there may also be corruption, red tapism, favouritism, etc.
•  It restricts the freedom of individuals as there is state ownership of the material means of production and state direction and control of nearly all economic activity. 
• Socialism takes away the basic rights such as the right of private property.
• It will not provide necessary incentives to hard work in the form of profit. 
• Administered prices are not determined by the forces of the market on the basis of negotiations between the buyers and the sellers. There is no proper basis for cost calculation. In the absence of such practice, the most economic and scientific allocation of resources and the efficient functioning of the economic system are impossible. 
• State monopolies created by socialism will sometimes become uncontrollable. This will become more difficult to regulate than the private monopolies under capitalism. 
• Under socialism, the consumers have limited freedom of choice. Therefore, what the state produces has to be accepted by the consumers. 
• No importance is given to personal efficiency and productivity. Labourers are not rewarded according to their efficiency. This acts as a disincentive to work. 
• The extreme form of socialism is not at all practicable. 

The Mixed Economy

The mixed economic system depends on both markets and governments for allocation of resources. In fact, every economy in the real world makes use of both markets and governments and therefore is mixed economy in its nature. In a mixed economy, 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. It appreciates the advantages of private enterprise and private property with their emphasis on self-interest and profit motive. Vast economic development of England, the USA etc. is due to private enterprise. At the same time, it is noticed that private property, profit motive and self-interest of the market economy may not promote the interests of the community as a whole and as such, the Government should remove these defects of private enterprise. For this purpose, the Government itself must run important and selected industries and eliminate the free play of profit motive and self-interest. Private enterprise which has its own significance is also allowed to play a positive role in a mixed economy. However, the state imposes necessary measures to control and to regulate the private sector to ensure that they function in accordance with the welfare objectives of the nation. 

Features of Mixed Economy 

Co-existence of private and public sector: The first important feature of a mixed economy is the co-existence of both private and public enterprise.
In fact, in a mixed economy, there are three sectors of industries:
(a) Private sector: Production and distribution in this sector are managed and controlled by private individuals and groups. Industries in this sector are based on self-interest and profit motive. The system of private property exists and personal initiative is given full scope. However, private enterprise may be regulated by the government directly and/or indirectly by a number of policy instruments.
(b) Public sector: Industries in this sector are not primarily profit-oriented, but are set up by the State for the welfare of the community.
(c) Combined sector: A sector in which both the government and the private enterprises have equal access, and join hands to produce commodities and services, leading to the establishment of joint sectors. Mixed economy has the following Merits available to capitalist economies and socialist economies: 

• Economic freedom and existence of private property which ensures incentive to work. 
• Price mechanism and competition forces the private sector to promote efficient decision- making and better resource allocation. 
• Consumers are benefitted through consumers’ sovereignty and freedom of choice. 
• Appropriate incentives for innovation and technological progress. 
• Encourages enterprise and risk taking. 
• Advantages of economic planning and rapid economic development on the basis of plan priorities. 
• Comparatively greater economic and social equality and freedom from exploitation due to greater state participation and direction of economic activities. 
• Disadvantages of cut-throat competition averted through government’s legislative measures such as environment and labour regulations. 

However, mixed economy is not always a ‘golden path’ between capitalism and socialism. It could also suffer from substantial uncertainties.
Mixed economy has the following Demerits available to capitalist economies and socialist economies: 

• Mixed economy, sometimes, is characterised by excessive controls by the state resulting in reduced incentives and constrained growth of the private sector, poor implementation of planning, higher rates of taxation, lack of efficiency, corruption, wastage of resources, undue delays in economic decisions and poor performance of the public sector 
• Moreover, it is very difficult to maintain a proper balance between the public and private sectors. 
• In the absence of strong governmental initiatives, the private sector is likely to grow disproportionately. The system would then resemble capitalism with all its disadvantages. 

Summary

• The basic problem of scarcity gives rise to many of the economic problems. 
• Unlimited human wants and scarcity of resources lead to the central economic problems like what to produce, how to produce and for whom to produce. 
• The basic economic problems of what, how and for whom to produce are solved by different economies in different ways.
•  A capitalist economy uses the tool of price mechanism, a socialist economy uses the tool of central planning and a mixed economy uses a mix of both price mechanism and central planning to solve its basic economic problems.