UNIT – 2

BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE

MECHANISM
BASIC PROBLEMS OF AN ECONOMY-

Every economic system, be it capitalist,

socialist with this central problem of or mixed
has to deal 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:

CENTRAL PROBLEMS OF ECONOMY-

1. 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
Choice of goods
due to Limited
2. How to produce? Resource
Labour Intensive Technique
(Water)
There are various alternative techniques
of producing a commodity 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
Capital Intensive Technique make the best use of the available

3. 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.
4. What provisions (if any) are to 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.
 Topic – I
BASIC PROBLEMS OF ECONOMY

Question 1
Which of the following is the central problem of an economy?
a) Assigning limited resources in a way b) Ensuring a minimum income for
that unlimited desires and needs of each citizen
the society are satisfied
c) Assuring that production happens in d) Analysing the demand with market
the most effective way economies

Question 2
Central Economic Problem is?
a) What to Produce b) How to Produce
c) For whom to Produce d) All the above

Answer: 1(a), 2(d)

TYPES OF ECONOMY:-
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:

Socialist
economy
Capitalist Mixed
economy economy

Types of
Economic
System

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

1. 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.

2. Freedom of enterprise: Each individual, whether consumer, producer or resource

owner, is free to engage in any type of economic activity.

3. Freedom of economic choice: All individuals are free to make their economic choices
regarding consumption, work, production, exchange etc.

4. 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.

5. Consumer Sovereignty: Consumer is 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.

6. 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.
7. 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
PROBLEM?

1. 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 I will produce
those goods
more cars, there will be an increase in the demand which are most
for cars and as a result their prices will increase. profitable
A rise in the price of cars, costs remaining the
same, will lead to more profits. This will induce
producers to produce more cars.

2. 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 Cost
method and if labour is relatively costlier Profit
he will use capital-intensive method.

3. 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. Higher the income, higher will be his
buying capacity and higher will be his demand
for goods in general.

4. 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 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.

MERITS OF CAPITALIST ECONOMY:

1. Capitalism is self regulating and works automatically through price mechanism

2. The existence of private property and the driving force of profit motive result in greater
efficiency and incentive to work.
3. The process of economic growth is likely to be faster under capitalism..
 4. Resources are used in activities in which they are most productive. This results in optimum
allocation of the available productive resources of the economy.
5. There is usually high degree of operative efficiency under the capitalist system.
6. Cost of production is minimized as every producer tries to maximize his profit by
employing methods of production which are cost-effective.
7. Capitalist system offer incentives for efficient economic decisions and their
implementation.
8. Consumers are benefitted as competition forces producers to bring in a large variety of
good quality products at reasonable prices.
9. Capitalism offers incentives for innovation and technological progress.
10. Capitalism preserves fundamental rights such as right to freedom and right to private
11. Capitalism rewards men of initiative and enterprise and punishes the imprudent and
inefficient.
12. Capitalism usually functions in a democratic framework.
13. The capitalist set up encourages enterprise and risk taking and emergence of an
entrepreneurial class willing to take risks.

DEMERITS OF CAPITALISM:
1. 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.
2. Under capitalism, there is precedence of property rights over human rights.
3. Economic inequalities lead to wide differences in economic opportunities and
perpetuate unfairness in the society.
4. The capitalist system ignores human welfare because, under a capitalist set up, the aim
is profit and not the welfare of the people.
5. Due to income inequality, the pattern of
demand does not represent the real needs of the
society.
6. Exploitation of labour is common under
capitalism.
7. Consumer sovereignty is a myth as consumers
often become victims of exploitation
8. There is misallocation of resources as resources
will move into the production of luxury goods.
9. Less of merit goods like education and health
care will be produced.
Inequality
10. 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.
11. There is enormous waste of productive resources as firms spend huge amounts of
money on advertisement and sales promotion activities.
12. Capitalism leads to the formation of monopolies as large firms may be able to drive out
small ones by fair or foul means.
13. Excessive materialism as well as conspicuous and unethical consumption lead to
environmental degradation.
 TOPIC – 2
CAPITALISTIC ECONOMY

Question 1
Capitalistic Economy user___ as principal means of allocating resources
e) Demand f) Supply
g) Price h) All of these
Question 2
Capitalist economy is characterized by ____.
a) Profit Motive b) competition among sellers and
buyers
c) inequalities of income d) All the above
Question 3
Price Mechanism is the main feature of which economy?
a) Capitalistic Economy b) Mixed Economy
c) Social Economy d) All the above
Question 4
In capitalistic economy __ and __ will be more.
a) Inequalities, exploitation b) Exploitation, equalities
c) Equalities, non exploitation d) Non exploitation, inequalities

Answer: 1(c), 2(d), 3(a), 4(a)

SOCIALIST ECONOMY

The Concept was Propounded by Karl Marx & Frederic Engles 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 socialized planned production on the basis of equal rights. A socialist
economy is also called as “Command Economy” or a “Centrally Planned 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.

 Economic planning: There is a Central Planning Authority to set and accomplish

socio- economic 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.

 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.
  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.

 Absence of Competition: Since the state is the sole entrepreneur, there is absence of
competition under socialism.

Merits of Socialism
 Equitable distribution of wealth and income and provision of equal opportunities
 Rapid and balanced economic development is possible in a socialist economy
 Socialist economy is a planned economy so better utilization of resources and it ensures
maximum production
 unemployment is minimised, business fluctuations areeliminated and stability
 absence of profit motive
 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
 state direction and control of nearly all economic activity. & State Ownership
 Socialism takes away the basic rights such as the right of private property.

 not provide necessary incentives to hard work in the form of profit.

 State monopolies created by socialism will sometimes become uncontrollable

 the consumers have limited freedom of choice

 No importance is given to personal efficiency and productivity &

Labourers are notrewarded according to their efficiency

 The extreme form of socialism is not at all practicable.

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TOPIC – 3
SOCIALISTIC ECONOMY

Question 1
A Socialistic economy is also called as :-
a) Profit oriented economy b) Self-regulatory economy
c) Centrally planned economy d) unorganized economy
Question 2
Inequalities of income do not perpetuate in____
a) Socialism b) Mixed economy
c) Capitalism d) None

Answer: 1(c), 2(a)

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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.

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.

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

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TOPIC – 4
MIXED ECONOMY

Question 1
Which economic system depends on both markets and government for allocation of resources?
a) Mixed Economy b) Capital Economy
c) Social Economy d) None

Question 2
In India, Mixed Economy exists due to:-
a) Coexistence of public sector b) Individual forces of demand and
private sector
c) Orders by government d) None
Question 3
In which economy market and government both play on important role?
a) Mixed Economy b) Socialistic economy
c) Capitalistic economy d) None
Question 4
In which economy, cost benefit analysis is used to answer the fundamental questions of
economy?
a) Mixed Economy b) Socialistic economy
c) Capitalistic economy d) Regulatory economy

Answer: 1(a), 2(a), 3(a), 4(a)