Basic Economic Problem and Resource Allocation

Topic 1

BASIC ECONOMIC PROBLEM & RESOURCE ALLOCATION

The central problem of all economies is often described as the issue of scarcity. This problem arises
because resources are limited, while human wants and needs are virtually unlimited by our imaginations. We
want food, clothing, housing, education and health care we call them necessities. But we also want many other
things like car, cell phone etc these are luxuries. As a result, every economy must make choices about what to
produce, how to produce it, and for whom to produce it. This is commonly referred to as the economic problem.
It's the foundation of the study of economics and drives discussions about allocation, efficiency, and equity
within societies.

It leads to following Central Problems that are faced by every economy:

1.What goods and services to produce: This problem involves selection of goods and services to be produced
and the quantity to be produced of each selected commodity. Every economy has limited resources and thus,

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cannot produce all the goods and services. More of one good or service usually means less of others. For
example, production of more sugar is possible only by reducing the production of other goods. Production of
more war goods is possible only by reducing the production of civil goods.
2. How to Produce:
This problem refers to selection of technique to be used for production of goods and services. A good can be
produced using different techniques of production. By ‘technique’, we mean which particular combination of
inputs to be used. Generally, techniques are classified as: Labour intensive techniques (LIT) and Capital
intensive techniques (CIT).
i. In Labour intensive technique, more labour and less capital (in the form of machines, etc.) is used.
ii. In Capital intensive technique, there is more capital and less labour utilization.
For example, textiles can be produced either with a lot of labour and a little capital or with less labour and more
capital. Availability of factors and their relative prices helps in determining the technique to be used. The
selection of technique is made with a view to achieve the objective of raising the standard of living of people
and to provide employment to everyone. For example, in India, LIT is preferred due to abundance of labour,
whereas, countries like U.S.A., England, etc. prefer CIT due to shortage of labour and abundance of capital.
3. For Whom to Produce:
This problem refers to selection of the category of people who will ultimately consume the goods, i.e. whether
to produce goods for more poor and less rich or more rich and less poor. Since resources are scarce in every
economy, no society can satisfy all the wants of its people. Thus, a problem of choice arises.
Factors of production
Factors of production refer to the resources we have available to produce goods and services. We
make a distinction between physical and human resources.
Land
In economics, "land" refers to all natural resources that are used in the production process. This includes
not only the surface of the earth but also all the natural resources beneath and above it. Land is considered one
of the factors of production, along with labor, capital, and entrepreneurship. Land includes plains, mountains,
forests, and bodies of water, minerals, fossil fuels, and precious metals.

Labour
In economics, "labor" refers to the physical and mental effort exerted by human beings in the production
process to create goods and services. Labor is one of the essential factors of production, along with land,
capital, and entrepreneurship.
Labor includes factory workers, engineers, teachers, doctors, singers and sportsmen.
Capital
To an economist, investment is not the money that people put into the stock market or into bank and
building society accounts. Instead, In economics, "capital" refers to the assets, resources, or financial wealth
used to produce goods and services. Capital is one of the key factors of production, along with labor and land.
It represents the tools, equipment, machinery, buildings, infrastructure, and financial resources employed in the
production process to create output.
▪ Fixed capital includes machinery, plant and equipment, new technology, factories and other
buildings.
▪ Working capital refers to stocks of finished and semi-finished goods (or components) that will
be either consumed in the near future or will be made into finished consumer goods.

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• Social capital
Infrastructure is the stock of capital used to support the entire economic system. Examples of
infrastructure include road & rail networks; airports & docks; telecommunications e.g. cables
and satellites to enable web access.
Entrepreneurship
▪ An entrepreneur is an individual who seeks to supply products to a market for a rate of return
(i.e. to make a profit).
▪ Entrepreneurs will usually invest their own financial capital in a business (for example their
savings) and take on the risks associated with a business investment.
▪ Many economists agree that entrepreneurs are in fact a specialised part of the factor input
'labour'.
Renewable Resources
▪ Renewable resources are commodities such as solar energy, oxygen, biomass, fish stocks or
forestry that is inexhaustible or replaceable by new growth providing that the rate of extraction
of the resource is less than the natural rate at which the resource renews itself.

▪ Finite resources cannot be renewed. For example with plastics, crude oil, coal, natural gas
and other items produced from fossil fuels, no mechanisms exist replenish them.

Positive and Normative Economics:

In economics, the distinction between normative science and positive science is crucial for understanding how
economic analysis is conducted and interpreted.
Positive economics deals with objective analysis and facts. It is descriptive and based on empirical
evidence. Positive economics seeks to explain how things are in the economy without making
judgments about whether outcomes are good or bad. It focuses on cause-and-effect relationships and
relies on testable hypotheses. Positive statements can be proven true or false through observation
and data.
• Example: "An increase in the minimum wage will lead to a reduction in employment for low-
skilled workers." This statement can be tested and validated with data.
• A rise in consumer incomes will lead to a rise in the demand for new cars.

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Normative Statements
Normative statements express an opinion about what ought to be rather than describing what is.
They are subjective statements rather than objective statements – i.e. they carry value judgments. For
example:
• The level of duty on petrol is too unfair and unfairly penalizes motorists.
• The government should increase the national minimum wage to £6 per hour in order to reduce relative
poverty.
• The government is right to introduce a ban on smoking in public places.
• The retirement age should be raised to 75 to combat the effects of our ageing population.

Common words and phrases used in normative statements include:

Should,Ought to,Must,Better, Fair/Unfair, Desirable/ Undesirable, Appropriate/ Inappropriate,

Preferable,Welfare, and Harmful

Integration of Both

➢ In practice, economic discussions and policy-making often involve a combination of both positive and
normative economics. While positive economics provides the data and analysis of what is happening
or what might happen under certain conditions, normative economics helps in making decisions about
what should be done based on the goals and values of a society.
➢ For example, an economist might use positive economics to analyze the potential impact of a tax cut
(such as its effects on government revenue and economic growth) and then use normative economics
to argue whether such a tax cut is desirable or not, based on the values of fairness, efficiency, or
social welfare.

Making choices
In economics, making choices refers to the process of selecting among alternative uses of scarce
resources to satisfy unlimited wants and needs. Due to scarcity, individuals, businesses, and societies must
make decisions about what goods and services to produce, how to produce them, and for whom they should
be produced.
Take for example the choices that people make in the city of London about how to get to work. Over six
million people travel into London each day, they have to make choices about when to travel, whether to use the
bus, the tube, to walk or cycle – or indeed whether to work from home.

Opportunity Cost
There is a well-known saying in economics that “there is no such thing as a free lunch!” Even if we are not
asked to pay a price for consuming a good or a service, scarce resources are used up in the production of it
and there must be an opportunity cost involved.

Opportunity cost measures the cost of any choice in terms of the next best alternative foregone.
Many examples exist for individuals, firms and the government.
Work-leisure choices: The opportunity cost of deciding not to work an extra ten hours a week is the
lost wages foregone. If you are being paid £6 per hour to work at the local supermarket, if you choose
to take a day off from work you might lose £48 from having sacrificed eight hours of paid work.
Government spending priorities: The opportunity cost of the government spending nearly £10 billion

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on investment in National Health Service might be that £10 billion less is available for spending on
education or the transport network.
Investing today for consumption tomorrow: The opportunity cost of an economy investing
resources in new capital goods is the current production of consumer goods given up. We may have
to accept lower living standards now, to accumulate increased capital equipment so that long run living
standards can improve.
The opportunity cost of bunking economics classes encompasses not only the
immediate consequences of missing out on lectures or assignments but also the long-
term implications for your education, career, and personal development.
Tangible and Intangibles
In economics we classify goods as “tangible” products, example might include food and drink, cars,
digital televisions, flat-screen televisions, energy products and cricket bats!

Services are sometimes known as intangibles, education and health-care are two important services
and tourism, business consultancy, cleaning and home insurance are all examples of services.

Various types of goods and services

1. Economic goods
Economists sometimes distinguish between economic goods and free goods. Economic goods are
those goods which are created from scarce resources. Because they are created from scarce resource there is
a limit on the amount of economic goods that society can produce at any given time. For example, if we pick
apples from a tree, it means that other people will not be able to enjoy them. If we devote resources to mining
gold, the opportunity cost is that we can’t devote this time and effort to growing corn.

2. Free goods

However, not all goods are created from scarce resource. An example of such a good is sand in the desert.
This is freely available in the desert and increased consumption by one person does not deprive another person
of the ability to consume. Because of this only economic goods have an opportunity cost.

3. Capital Goods and Consumer Goods

Capital goods, which are also known as producers goods, investment goods and intermediate goods,
are not bought by households for final consumption; instead they are bought by other firms as raw materials or
inputs for the purposes of production.
4. Consumer goods or final goods are bought by person or households for the purpose of final
consumption, to satisfy wants and needs. Cars television sets, washing machines and similar
goods purchased by individuals or households for ordinary consumer use are examples of
consumer durables.
5. Private Good
This is a good which has rivalry and excludability. E.g. If you sell a bottle of Coca-Cola to one individual – others
cannot consume it.

• Also, private goods have an opportunity cost, if we use resources to produce a bottle of Coca-
Cola, we cannot use that glass, sugar and water to produce other goods.
• These goods are provided in a free market when a firm can make a profit from them.
6. Public Good
A public good has two characteristics:
• Non-rivalry – consuming the good doesn’t reduce the amount available to other people.

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• Non-excludable – once provided you can’t stop anyone consuming it.

Examples of public goods include street lights, law and order and national defence.

• Typically, public goods are not provided in a free market because firms cannot charge people
directly and there is scope for ‘free-riding on other people paying for it.
• Note: Goods provided by the public sector (government) are not necessarily public goods. e.g.
government provide education, but education is a merit good, not a public good)

7. Merit Goods
Merit goods are products or services that are considered to have positive external effects,
meaning their consumption generates benefits not only for the individual consumer but also for
society as a whole. Examples of merit goods include education, healthcare, vaccinations, and
environmental conservation measures.

8. Demerit Goods

Demerit goods are products or services that are considered to have negative externalities,
meaning their consumption generates costs not only for the individual consumer but also for
society as a whole. Examples of demerit goods include tobacco, alcohol, recreational drugs, and
environmentally harmful products.

Division of Labour:
Meaning of Division of Labour:
In economics, the division of labor refers to the specialization and distribution of tasks or jobs within a production
process or an economy. It is the practice of dividing the production process into distinct and specialized tasks
performed by different individuals or groups. Each individual or group focuses on performing a specific task or
a narrow set of tasks, often based on their skills, expertise.

Essential Conditions or Pre-Requisites of Division of Labour:

Complete success of division of labour depends on the following factors:
(1) Wide Market:
It is the opinion of the economists that Division of Labour will function well and its success depends on wide
market. If there will be small market Division of Labour will not develop much.

(2) The Quantity of Capital Available:

Sufficient capital is needed for a successful and better Division of Labour. Shortage of capital and money not
available on time may help the company not to go for Division of Labour.
(3) Organising Ability:
Division of Labour involves the employment of a large number of workers in one factory. To handle them
properly and to assign to each worker a suitable job requires judgment of human nature of a high order. Hence,
the entrepreneur must have the necessary ability to organise production on a large scale.
(4) There should be Development of Means of Transport and Communication:
For the success of Division of Labour means of transport and communication must be developed. If there is
development of means of transport raw-materials can be easily available and finished goods can be sent outside
for sale.

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Advantages of Division of Labour:

1. Increase in Production:
With the adoption of Division of Labour, the total production increases.
2. Reduction in the Cost of Production:
Division of Labour increases production which reduces the average cost of production. Saving of capital tools
and machinery etc. also help in the reduction of cost of production.
3. Maximum Utilisation of Machinery:
The Division of Labour is the result of the large scale production which implies more use of machines. On the
other-hand, the Division of Labour increases the possibility of the use of machines in the small-scale production
also. Therefore, in modern times the use of machines is increasing continuously due to the increase in the
Division of Labour.
4. Saving of Time:
There is no need for the worker to shift from one process to another. He is employed in a definite process with
certain tools. He therefore goes on working without loss of time, sitting at one place. Continuity in work saves
time and helps in more production at less cost.
5. Production of Goods of Superior Quality:
Division of Labour is beneficial in making goods of superior quality. When the worker is entrusted with the work
for which he is best suited he will produce superior quality goods.
6. Increase in Profit:
Division of Labour gives more profit to the producer of the goods as the cost of production of the commodity
diminishes.
7. Availability of Commodities at a Cheaper Price:
Division of Labour helps in mass production. Thus, production becomes less expensive and more economical.
Therefore, cheaper goods are produced by manufacturers. Availability of cheaper goods for consumers improve
the standard of living of the consumers and the people.
8. It is an Index of Economic Growth:
Establishment of good organisation, earning more profit and distributing more bonus and dividend to workers
and investors is an index and sign of economic growth of the country. Therefore, we can say that Division of
Labour has contributed enough for the development and growth of an individual to company and organisation.

Dis-Advantages of Division of Labour:

1. Danger of Over-production:
Over-production means that the supply of production is comparatively more than its demand in the market.
Because of the Division of Labour when production is done on a large scale, the demand for production lags
much behind its increased supply. Such conditions create over-production which is very harmful for the
producers as well as for the workers when they become unemployed.
2. Loss of Responsibility:
Many workers join hands to produce a commodity. If the production is not good and adequate none can be held
responsible for it. It is generally said that “every man’s responsibility is no man’s responsibility.” Therefore, the
Division of Labour has the dis-advantage of loss of responsibility.
3. Increased Dependence:
When the production is divided into a number of processes and each part is performed by different workers, it
may lead to over-dependence. For example – In the case of a readymade garments factory, if the man cutting

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cloth is lazy, the work of stitching, buttoning etc. will suffer. Therefore, increased dependence is the result of
Division of Labour.
4. Evils of Factory System:
The modern industrial or factory system has been developed as a result of the Division of Labour. This system
further gives rise to the evils like dense population, pollution, class conflict, bad habits of gambling and drinking,
low standard of living, poor food, clothes and housing etc.
5. Administrative Difficulties and Industrial Disputes:
Industrial disputes mean strikes by workers, closure of factory, etc. due to clashes between the employees and
the employers. This creates acute administrative problems and difficulties. Division of Labour results in the
division of society into workers and employers.
The employer always tries to increase his profits by exploiting the workers and workers from trade unions
against the employees to put an end to their exploitation or to make them increase their wages. It gives rise to
a severe conflict between the employers and the workers in the form of strikes, closures and lockouts of
factories.
6. Monotony of Work:
Under Division of Labour a worker has to do the same job time and again for years together. Therefore, after
sometime, the worker feels bored or the work becomes irksome and monotonous. There remains no happiness
or pleasure in the job for him. It has an adverse effect on the production.
Overall, the division of labor plays a crucial role in increasing productivity, promoting efficiency, and harnessing
the benefits of specialization within an economy.

Economics and Efficiency

Economics is the social science concerned with the problem of using or administering scarce resources
(the means of producing) so as to obtain the wants (the goal of producing).The nature of the economizing
problem can be brought into even clearer focus by the use of a production possibilities table. This device reveals
the core of the economizing problem: because resources are scarce, a full employment, full production economy
cannot have an unlimited output of goods and services. Furthermore, choices must be made on which goods
and services to produce and which to forgo.

Assumptions: We make several specific assumptions to set the stage for our illustration.
▪ Efficiency: The economy is operating at full employment and achieving full production.
▪ Fixed resources: The available supplies of the factors of production are fixed in both quantity and
quality.
▪ Fixed technology: The state of the technological arts is constant this is, technology does not change
during the course of our analysis.
▪ Two products: Suppose our economy is producing just two products ⎯ industrial robots and Pizza.

Necessity of Choice:
Let us generalize by noting in Table 1.1 some alternative combinations of robots and pizza which our
economy might conceivably choose. Though the data in this and the following tables are hypothetical, the points
illustrated are of tremendous practical, significance. At alternative A, our economy would be devoting all its
resources to the production of robots, that is, capital goods. At alternative E all available resources would be
devoted to the production of pizza, that is, consumer goods. Both these alternatives are clearly unrealistic
extremes; As we move from alternative A to E, we step up the production of consumer goods (pizza).

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Remember that consumer goods directly satisfy our wants, any movement towards alternative E looks
tempting. In making this move, society increases the current satisfaction of its wants. But there is a cost involved.

TABLE 1.1 Production possibilities of pizza and robots with full employment, (hypothetic data)

Type of product Production alternatives

A B C D E
Pizza (in hundred thousands) 0 1 2 3 4
Robots (in thousands) 10 9 7 4 0

In short, in moving from alternative A towards E, society is in effect choosing “more now” at the expenses
of “much later”. In moving from E towards A, society is choosing to forgo current consumption. This sacrifice of
current consumption frees resources which can now be used to increase the production of capital goods. By
building up its stock of capital in this way, society can anticipate greater production and, therefore, greater
consumption in the future.

Production Possibilities Curve

To realize the various combinations of pizza and robots which fall on the production possibilities curve,
society must achieve full employment and full production. All combinations of pizza and robots on the curve
represents maximum quantities attainable only as the result of the most efficient use of all available resources.
Points lying outside the production possibilities curve, like point W, are unobtainable, given the current supplies
of resources and technology. The production barrier of limited resources prohibits the production of any
combination of capital and consumer goods lying outside the production possibilities curve.

FIGURE 1.1 The production possibilities curve

As shown in the graph below, any spot inside the curve (D,E) reflects inefficient production, since not all the
country's resources are fully utilized. on the other hand, any spot beyond the curve (F) is impossible to achieve
because of its resource constraints. in contrast, all spots (a, b, c) on the curve show full utilization of resources,

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where each point demonstrates the opportunity cost. every additional unit of one good decreases the output of
the other good.

Figure1.2

SLOPE, PRODUCTION POSSIBILITIES CURVE:

The slope of a production possibilities curve illustrates the tradeoff between the production of two goods. This
tradeoff occurs due to limited resources. If all available resources are engaged production, then an increase in
the production of one good requires a reduction in the production of the other good. This tradeoff reflects the
fundamental concept of opportunity cost.

The slope of a line is measured by calculating the change in the value measured on the vertical axis divided by
the change in the value measured on the horizontal axis. Another way of saying this is to divide the rise by the
run.

For a production possibilities curve that illustrates the production of industrial robots and pizzas, this is the
change in the quantity of industrial robots (rise) divided by the change in the quantity of pizzas (run).

Here is a handy formula for calculating the slope of the production possibilities curve.

rise change in industrial robots

slope = =
run change in pizzas

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For example, the slope of the production possibilities curve between points C ( 7 robots and 2 pizzas) and D (4
robots and 3 pizzas). The slope between C and D is -3. The rise is a decrease of -3 and the run is an increase
of 1.

change in robots -3
slope, C to D = = = -3
change in pizzas 1
Another Example of Measuring Slope

Figure 1.3

Law of Increasing Opportunity Costs

We have stressed that resources are scarce relative to unlimited wants which these resources can be
used to satisfy. As a result, choices among alternatives must be made. In our case the amount of Y (robots)
which must be forgone or given up to get another unit of X (pizza) is the opportunity cost, or simply the cost, of
that unit of X. In moving from possibility A to B in Table 1.1, we find that the cost of 1 unit pizza is 1 unit robots.
But, as we now pursue the concept of cost through the additional production possibilities ⎯ B to C, C to D, and
so forth ⎯ an important economic principle is revealed to us. In moving from alternative A to alternative E,
the sacrifice or cost of robots involved in getting each additional unit of pizza

increases. In moving from A to B, just 1 unit of robots for 1 more pizza; then 3 of robots for 1 of pizza; and
finally 4 for 1..

Rationale: What is the economic rationale for the law of increasing opportunity costs? Why does the sacrifice
of robots increase as we get more pizza? The answer to this query is rather complex. But, simply stated, it
amounts to this:

• Heterogeneous Resources: Resources (such as labor, capital, and land) are not equally efficient in all uses.
Some resources are better suited for producing certain goods than others.
• Economic resources are not completely adaptable to alternative uses. As an economy reallocates
resources from producing one good to another, the resources are likely to be less well-suited to the new

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production. This results in diminishing returns, meaning that each additional unit of input contributes less
to output.
• Increasing Costs: As production of one good increases, the opportunity cost of diverting resources from their
best alternative use (where they are most productive) increases. Thus, producing additional units of one good
requires sacrificing increasingly larger amounts of the other good.

Shifts in Possibility Curve

A production possibility curve is drawn on the assumption that the quantity and quality of resources
and the state of technology are fixed. Through time, of course, economies can gain or lose resources; the
quality of resources and the state of technical knowledge can change. Such changes will shift the production
possibility curve to a new position.

Technological Advancements: Innovations in technology can lead to more efficient production processes,
allowing for higher levels of output with the same amount of resources. As a result, the PPC shifts outward,
indicating that the economy can produce more goods and services than before.

Increase in Quantity or Quality of Resources: If there is an increase in the quantity or quality of resources
available to the economy, such as the discovery of new natural resources or improvements in human capital
(education, skills, etc.), the PPC will shift outward. This expansion reflects the economy's increased capacity
to produce a greater variety and quantity of goods and services.

Investment in Capital Goods: Investment in capital goods, such as machinery, equipment, and
infrastructure, can enhance productivity and expand the economy's production possibilities. By increasing the
stock of capital, the economy can produce more output and achieve a higher level of economic growth,
leading to an outward shift of the PPC.

FIGURE 1.4

Leftward Shift in PPC:

When there is a degradation in technology or a decrease in resources, in respect to both goods, the PPC will
shift in left direction. For example, if there is destruction of resources due to floods, the production of Apples
and Oranges will reduce. In such case, the existing curve (PP) will shift to the left (P1P1).

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Decrease in Resource Availability: If there's a reduction in the quantity or quality of available resources such
as labor, capital, land, or raw materials, the economy's production capacity diminishes, shifting the PPC inward.
Technological Regression: A backward shift in technology, where advancements are lost or outdated
technologies are reintroduced, can lead to a decrease in productivity and a reduction in the economy's potential
output, causing the PPC to shift inward.
Natural Disasters or Environmental Degradation: Events such as earthquakes, hurricanes, floods, or
other natural disasters can damage infrastructure, disrupt supply chains, or cause environmental harm, thereby
reducing production capabilities and shifting the PPC inward.
Population Decline or Unemployment: A decrease in the labor force due to factors like emigration, declining
birth rates, or high unemployment rates can result in underutilization of available resources, leading to a
decrease in potential output and an inward shift of the PPC.
Wars or Conflicts: Armed conflicts can disrupt production processes, destroy infrastructure, and divert
resources away from productive activities, causing a decrease in the economy's productive capacity and shifting
the PPC inward.

FIGURE 1.5

Rotation of PPC:
When there is a change in resources or technology with respect to only one good, the PPC curve will rotate
either for the commodity on X-axis or the commodity on Y-axis.

(i) Rotation for commodity on X-axis:

When there is advancement in technology or growth in resources for the production of the commodity on X-
axis (say, Orange as in above example), then the PPC will rotate from AB to AC; i.e., rightwards rotation.
However, if there is degradation in technology or reduction in resources, the PPC will rotate from AB to AD;
i.e., leftwards rotation.

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FIGURE 1.6

Rotation for commodity on Y-axis:

When there is advancement in technology or growth in resources for the production of the commodity on Y-
axis (say, Apple as in above example), then the PPC will rotate from AB to CB; i.e., rightwards rotation.

However, if there is degradation in technology or reduction in resources, the PPC will rotate from AB to DB;
i.e., leftwards rotation.

FIGURE 1.6

Social Cost
To explain the full social cost of productions, we must add the private cost of production, such as labour
costs, raw material costs etc to the external cost of production. External costs might impose costs on society

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such as air pollution from the operation of motor vehicles, or river pollution from the dumping of waste materials.
Hence:
Social cost = Private cost + External cost
Here private cost means the cost of an economic activity (consumption or production) generated by the person
himself and external cost is that cost which is imposed on third party of the economic activity of other.

Social Benefit
Social benefit is the mixture of private benefit and external benefit of an economic activity. Private benefit
means the utility or satisfaction derives an economic activity generated by the person himself (consumer or
producer). Production or consumption of certain goods and services may confer external benefit on third party
or the community at large for which payment is not required. For example polio immunization shots result
indirect benefit to the immediate consumer. But immunization against these diseases gives widespread and
external benefits to the entire community. Hence;
Social benefit = Private benefit + External benefit

Economic Systems
An economic system refers to the set of institutions, policies, and mechanisms through which a society
allocates its resources and organizes production, distribution, and consumption of goods and services.

The survival of any society depends on its ability to provide food, clothing, and shelter for its people.
Because these societies face scarcity, decisions concerning WHAT, HOW, AND FOR WHOM to produce must
be made.
Three major kinds of economic systems exist – traditional, command, and market. Most countries in the
world can be identified with one of these systems.

Traditional Economies:
A traditional economy is an economic system based on customs, traditions, and historical practices that have
been passed down from generation to generation. In a traditional economy, economic decisions are primarily
determined by customs, beliefs, and cultural norms rather than market forces or government intervention. Here
are some key characteristics and features of traditional economies:
Subsistence Agriculture and Gathering: Traditional economies often rely on subsistence agriculture, where
individuals or communities produce enough food to meet their own basic needs. Agriculture is typically carried
out using traditional methods and tools, passed down through generations. Gathering, hunting, fishing, and
herding livestock are also common economic activities.
Barter and Trade: Traditional economies may involve barter and localized trade. Exchange of goods and
services is often conducted through direct barter, where individuals trade one good or service for another without
the use of money. Trade occurs within communities or between neighboring communities, based on mutual
needs and agreements.
Strong Community and Family Structures: Traditional economies are often characterized by strong
community and family structures. Economic activities are typically carried out collectively or within family units,
with a focus on cooperation and sharing within the community. Economic decisions are influenced by social
relationships and communal values.
Customary Practices and Rituals: Economic decisions in traditional economies are guided by customary
practices and rituals that have cultural significance. These practices may dictate how resources are allocated,
how work is organized, and how economic benefits are distributed. Traditional beliefs and customs shape
economic behaviors and choices.

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It's important to note that traditional economies are often found in remote or isolated regions, and their
prevalence has decreased significantly with the advent of market economies and globalization. However, in
some parts of the world, traditional economic practices and customs continue to coexist with modern economic
systems, creating mixed economic models.

Command Economies:
Other societies have a command economy, one in which a central authority makes most of the WHAT,
HOW, and FOR WHOM decisions. Economic decisions are made by the government: the people have little, if
any, influence over how the basic economic questions are answered.

How a command economy works

• Government ownership of the means of production. In command economies, governments will

own some or all of the industries producing goods and services.

• Government pricing and production decisions. In a command economy, production is decided

by government agencies, who decide the most socially efficient goods to produce. Government
agencies may also set prices or give consumers rations directly.
• Government macro-economic objectives. In a command economy, the government will have
over-riding macroeconomic objectives such as employment rates and what to produce.

• Some centrally planned economies may consist of not just state-owned enterprises, but some
privately owned firms who are closely directed by state management.
Examples
There are few command economies in the world today, but they still can be found in North Korea and Cuba.
Until recently, the People’s Republic of China, the communist countries of Eastern Europe, and the former
Soviet Union also had command economies.
What Are the Advantages of a Command Economy:
➢ Reduced Income Inequality: Planned economies have the potential to reduce income inequality. By
controlling resource allocation and income distribution, the government can aim to provide equal
opportunities and a more equitable distribution of wealth. This can help address social disparities and
promote a more balanced society.
➢ Fixed Prices: A lot of the time, the government sets the prices of things and services instead of the
market. This is done to keep prices in check and make sure that people can afford to live.
➢ Social Services: Planned economies often prioritize the provision of social services, such as
healthcare, education, and welfare programs. The government can allocate resources to ensure the
availability and accessibility of these services to all citizens. This can lead to a more equitable society
where essential services are universally accessible.
➢ Rapid Industrialization: In command economies, governments can boost and speed up attempts to
industrialise. This is often seen as a good thing, especially when the economy is just starting to grow.
➢ Employment Planning: Planned economies typically involve central coordination of employment,
including decisions about job creation, distribution of labor, and workforce training. The government may
prioritize certain industries or sectors for employment generation based on national goals.
Disadvantages of Planned Economies:
➢ Lack of Market Efficiency: Planned economies may suffer from inefficiencies due to the absence of
market mechanisms. Without the price signals and competition found in market economies, there is a
risk of misallocation of resources, overproduction or underproduction, and inefficiencies in production
processes. This can lead to suboptimal economic performance.

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➢ Limited Individual Freedom and Innovation: Planned economies often restrict individual freedom and
entrepreneurship. Centralized planning can limit the ability of individuals to pursue their own business
ideas or engage in market-based activities. This can stifle innovation, creativity, and the dynamic
entrepreneurship that drives economic growth.
➢ Lack of Consumer Choice: Planned economies tend to limit consumer choice since production
decisions are predetermined by the government. Consumers may have limited options in terms of
products, brands, or services. This lack of choice can lead to lower quality, reduced diversity, and a
mismatch between consumer preferences and available goods and services.
➢ Bureaucratic Inefficiency and Corruption: Planned economies can be prone to bureaucratic
inefficiency and corruption. Centralized decision-making processes may be slow and bureaucratic,
leading to delays, red tape, and inefficiencies. Moreover, the concentration of power and lack of
transparency in command economies can increase the risk of corruption and favoritism.
➢ Unbalanced amounts of goods would be experienced.
It is difficult for the government to obtain updated information about consumer needs, so rationing is a
way of life in most cases. After all, some items are mass produced, while others are simply not enough
to support economic needs.

Market Economies:
Market economies, also known as free-market economies or capitalism, In a market economy people
and firms act in their own best interests to answer the WHAT, HOW, and FOR WHOM questions. In economic
terms, a market is an arrangement that allows buyers and sellers to come together in order to exchange goods
and services.
In a market economy, people’s decisions act as votes. When consumers buy a particular product, they
are casting their “dollar votes” for that product. After the “votes” are counted, producers know what people
want. Because producers are always looking for goods and services that consumers will buy, the consumer
plays a key role in determining WHAT to produce.
Examples
Many of the largest and most prosperous economies in the world, such as the United States, Canada,
Japan, South Korea, Singapore, Germany, France, Great Britain, and other parts of Western

Europe, are based on the concept of a market economy. While there are also many significant
differences among these countries, the common thread of the market binds them together.

What Are the Advantages of a Market Economy:

1- Absence of Bureaucracy

Free markets reduce cost, lead to more innovation and research & development through the absence of red
tape. Entrepreneurs don’t have to wait for the government to tell them what to make. They study demand,
research trends and meet the customer’s needs through innovation. This also encourages competition
amongst firms to improve their product and service. It is a structure that provides profits for businesses of any
size while creating satisfied customers at the same time.

2- It creates competition.A market economy thrives because businesses are forced to continually
innovate to survive. Businesses that refuse to innovate will be left behind because there will always
be someone willing to look at things in a different way. This motivation is the foundation of a market
economy because it must be there to encourage better products and services to be offered over time.

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3. It reduces the need to store products.

Because the laws of supply and demand are enforced in a market economy, manufacturers produce goods
based on the demands that the society requires. This reduces the need to store surplus products because
anything that is extra will be sold at a deeply discounted price or simply destroyed. The goal is

to find a balance between society’s demands and the number of goods that are produced.

4. Market economies tend to provide more jobs.

With a market economy, the focus on innovation allows these small businesses to find a niche and provide
local jobs that can pay well. Although larger companies may outsource jobs to save money, local jobs come
from individuals and partnerships that exploit a good idea they may have.

5. Prices are usually kept down in a market economy.

Because competition is present within an industry, prices tend to stay lower because businesses are
attempting to obtain as many customers as possible. It is this element that is a core philosophy in the
Republican health care proposals that circulated in 2017. By introducing competition in the insurance markets
across state lines, the goal is to drop policy pricing for many consumers.

What Are the Disadvantages of a Market Economy

It’s difficult to find a system that is completely perfect. Even though we strive to achieve perfection as time goes
by and we learn from our failures and mistakes, there are still some areas that will always need adjustments.
Here are some of the disadvantages of a market economy:

1. Inequality: A market economy has always been referred to as a capitalist market. It favors the accumulation
of wealth by individuals who have the opportunity to do so. This creates a state of inequality between the haves
and the have-nots. Unequal distribution of wealth results in many social problems because those who are less
privileged or poor will try to use unlawful ways to gain access to wealth. People are not born equal and those
who had a better foundation will always have a head-start in such an economy. The more privileged in the
society may also use their positions to trample on the rights of the poor.

2.Market economies tend to produce inferior goods and services.

The goal of a market economy is to find balance between cost and profit. Businesses will minimize costs and
maximize profits. That usually means skilled workers who demand high wages will be replaced by low or
average-skill workers who can still produce a reasonably good product, but at a cheaper price. That means a
market economy rarely provides the best possible goods and services that could be produced.

3. It harms the environment.

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A market economy places an emphasis on the cost of good produced over any other factor. That means there
are fewer environmental concerns that are addressed during the production of goods. When it costs less to
dump waste in nature than it does to properly dispose of it, the lack of governmental interference or a central
authority would allow such an action to occur.

4. Commodity prices typically rise in a market economy.

Commodities are primary agricultural products or raw materials that are bought or sold. Coffee is a
commodity, as is copper. In a market economy, these are the items that are essential to the manufacturing
process. Without them, a business cannot create goods or services for sale. Because supply and demand
applies, and most businesses need commodities to function, the pricing of these goods is higher and that
increase gets put into the final consume price tag.

The Mixed Economy

In the real world there are no completely free market economics and there are no completely centrally
planned economies.
Mixed economics refers to an economic system that combines elements of both free market capitalism and
government intervention. In a mixed economy, certain sectors of the economy are left to operate through market
forces, while others are regulated or owned by the government. This blend allows for both private enterprise
and public control, aiming to balance the efficiency of the market with the need for government oversight to
ensure social welfare, stability, and equitable distribution of resources.
Pakistan is a mixed economy, where the Government has a variety of ways in which it influences what
is produced. It can simply pay firms to produce a particular good or service. For example, Electricity, Natural
gas, Railway.

Merits of Mixed Economy:

(i) Encouragement to Private Sector:
The most important advantage of mixed economy is that it provides encouragement to private sector and it gets
proper opportunity to grow. It leads to increase in capital formation within the country.

(ii) Freedom:
In a mixed economy, there is both economic and occupational freedom as found in capitalist system. Every
individual has a liberty to choose any occupation of his choice. Similarly, every producer can take decisions
regarding production and consumption.

(iii) Optimum Use of Resources:

Under this system, both private and public sectors work for the efficient use of resources. Public sector works
for social benefit while private sector makes the optimum use of these resources for maximisation of profit.

(iv) Advantages of Economic Planning:

In the mixed economy, there are all advantages of economic planning. Government takes measures to control
economic fluctuations and to meet other economic evils.

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(v) Lesser Economic Inequalities:

Capitalism enhances economic inequalities but under mixed economy, inequalities can easily controlled by the
efforts of government.

(vi) Competition and Efficient Production:

Due to competition between both private and public sectors, the level of efficiency remains, high. All factors of
production work efficiently in the hope of profit.

(vii) Social Welfare:

Under this system, the main priority is given to social welfare through effective economic, planning. The private
sector is controlled by the government. Production and price policies of private sector are determined to achieve
maximum social welfare.

(viii) Economic Development:

Under this system, both government and private sector join their hands for the development of socio-economic
infrastructures, Moreover, government enacts many legislative measures to safe guard the interests of the poor
and weaker section of the society. Hence, for any underdeveloped country, mixed economy is a right choice.

Demerits of Mixed Economy:

The main demerits of mixed economy are as follows:
(i) Un-stability:
Some economists claim that mixed economy is most unstable in nature. The public sector gets maximum
benefits whereas private sector remains controlled.

(ii) Ineffectiveness of Sectors:

Under this system, both the sectors are ineffective in nature. The private sector does not get full freedom, hence
it becomes ineffective. This leads to ineffectiveness among the public sector. In true sense, both sectors are
not only competitive but also complementary in nature.

(iii) Inefficient Planning:

There are no such comprehensive planning in mixed economy. As a result, a large sector of the economy
remains outside the control of the government.

(iv) Lack of Efficiency:

In this system, both sectors suffer due to lack of efficiency. In public sector it is so because government
employees do not perform their duty with responsibility, while in private sector, efficiency goes down because
the government imposes too many restrictions in the form of control, permits and licenses, etc.

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(v) Delay in Economic Decisions:

In a mixed economy, there is always delay in making certain decisions, especially in case of public sector. This
type of delay always leads to a great hindrance in the path of smooth functioning of the economy.

(vi) More Wastages:

Another problem of the mixed economic system is the wastages of resources. A part of funds allocated to
different projects in public sector goes into the pocket of intermediaries. Thus, resources are misused.

(vii) Corruption and Black Marketing:

There is always corruption and black marketing in this system. Political parties and self- interested people take
undue advantages from public sector. Hence, this leads to emergence of several evils like black money, bribe,
tax evasion and other illegal activities. All these ultimately bring red-tapism within the system.

(viii) Threat of Nationalism:

Under mixed economy, there is a constant fear of nationalism of private sector. For this reason private sector
does not put into use their resources for the common benefits.

Role of government in a mixed economy

In a mixed economy, which combines elements of both market-based allocation of resources and government
intervention, the role of the government is multifaceted. Its primary functions include:

Regulation and Oversight: The government establishes and enforces regulations to ensure fair competition,
consumer protection, and the proper functioning of markets. This includes regulations related to product safety,
environmental protection, labor standards, and financial markets.

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Provision of Public Goods and Services: The government is responsible for providing essential public
goods and services that may not be efficiently provided by the private sector due to market failures or
insufficient demand. These include infrastructure (roads, bridges, utilities), education, healthcare, public
safety, and national defense.

Redistribution of Income and Wealth: Governments often implement policies to address income inequality
and poverty through progressive taxation, social welfare programs, and wealth redistribution measures. These
policies aim to ensure a more equitable distribution of resources and opportunities within society.

Stabilization of the Economy: Governments use monetary and fiscal policies to stabilize the economy and
mitigate economic fluctuations such as recessions, inflation, and unemployment. This may involve actions
such as adjusting interest rates, managing government spending and taxation, and implementing counter-
cyclical measures during economic downturns.

Promotion of Economic Growth and Development: Governments play a crucial role in fostering long-term
economic growth and development through investments in infrastructure, education, research and
development, and innovation. They may also provide incentives for private sector investment and
entrepreneurship to stimulate economic activity and job creation.

Protection of Property Rights and Enforcement of Contracts: Governments establish and enforce laws to
protect property rights and ensure the enforcement of contracts, which are essential for the functioning of
markets and the smooth operation of business transactions.

Correction of Market Failures: When markets fail to allocate resources efficiently or produce socially
undesirable outcomes, such as monopolies, externalities, or public goods undersupply, governments
intervene to correct these failures through regulatory measures, subsidies, taxes, or direct provision of goods
and services.

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