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In this unit you will get acquainted with the fundamental problems of the economy. The
understanding of the concept will help you bring closer to the basic idea of the economy¶s
problems as well as remedies of such problems. In this unit you will get detailed description
of what is an economic system, problems of economic system, factors of production, concept
of production possibility curve, and the fundamental of allocation of resources in different
types of economies.

 
 


Before we further move on we have to know about the sources of economic problems and a
brief about the economic system.

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Want is Want is an effective desire for a thing, which can be satisfied by making an effort for
obtaining it. We have unlimited wants and as one want gets satisfied another arises. For
instance, one may have the desire to buy a car or a flat. Once the car or the flat is purchased,
the person wishes to buy a more spacious and designable car and the list of his wants does not
stop here but goes on one after another. !"#"$ we have to make a
choice between the most urgent want and less urgent wants. Thus the problem of choice
arises.

Means also known as resources are limited. Means are the ways to derive the satisfaction of
the various wants. For instance, money is an important means to satisfy many of our wants.
As stated, means are scarce and as such these are to be used optimally. In other words scarce
or limited means are to be judicially used and economized to get the maximum satisfaction.
Another problem which is to be viewed is that resources have alternative uses i.e. the same
resource can be used for more than one purpose. For example, money can be used either
buying a laptop or a play station, all depends on how you perceive the urge of the desire or
want you want to satisfy.


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The term economic system can be defined as a set of techniques by which a society decides
and create balance between resources and unlimited human wants. It therefore clearly
signifies that being a part of social system not only natural resources but also man made
resources also get included in the economic system. The economic system thus comprises of
people and institutions like banks, markets etc.

The set of parameters thus used to determine the components of economic system is very
dynamic and depends upon various factors like social, political, geographical and climatic
etc. This shows that we can distinguish the two economies, no economy in the world will be
same.
The difference can be judged on the basis of control of the economy For Example: The
economic system of the country can also be based on the basis of involvement of society,
more involvement of society in the economy and the decision are taken with a view of society
and equitable distribution of wealth is characteristic of Socialist Economy. Contrarily if the
economy is decentralized and the power lies in the hands of private enterprises then the said
economy is capitalist economy.

Primarily the difference is done on the basis of the control but other things like growth,
production of the economy can also be used to judge the economic scenario of the two
economies, the production done in a fiscal year, purchasing power of the people and
employment are primarily the factors considered.

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Economic agents are the key units of the economic system, the whole economy revolves
around them. Producers, consumers, institutions and various other bodies come under this
category. The agents are considered to be the most critical part of the economy as they guide
and drive the economy by their actions.

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1. What is an economic system?
Ans. Economic system or economy is known a set of principles by which problems of
economics are addressed, such as the economic problem of scarcity through allocation of
finite productive resources. The economic system thus comprises of people and institutions
like banks, markets etc.

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Production process is an end to end activity which means that there is a relational pedagogy
between input and output. Factors of production also known as productive inputs are the
resources employed to produce goods and services, thus it constitutes the input part of the
production process. Factors of production involve in the production process and improves the
working of the process but do not form the ultimate part of the product. Factors of production
can be broadly classified as:
1. ›and
2. ›abour
3. Capital
4. Entrepreneurship

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In economics, land includes all natural resources which are free gift of nature. Thus, by land
economists do not mean only agricultural soil, but also other natural resources such as
minerals, water, climate and forests. Payment for use of land per period is called 

›and as factor of production implies the ground used to built and start the production
moreover it serves as a pool of various minerals and valuable natural resources which
facilitates the human mankind. ›and is a fixed factor of production and thus it is not possible
to increase. ›and helps to facilitate the production only if the efficient workforce is used to
generate the maximum output out of the limited resource. This means optimum utilisation of
resources.

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›abour represents all physical and mental abilities which people can make available for
production of goods and services. ›abour is usually measured by the time spent in working
during a period. Reward made per period of labour is called (

›abour is a non homogeneous factor of production. There are set of people in the underlying
category which can be distinguished as skilled and unskilled worker. The workers that are
skilled and educated are used in the operations of a more complex job requiring special skills
and training and the other category belongs to the lower level working operations. The two
factors which highlight the labour are efforts put in and performance which correlates the
efficiency. The efforts put in by a labour can be modified with the motivational analysis that
can help the person to make the worker work produce more.

As land is the natural or passive factor in all production, so labour is the human or active
factor. All the production results with the action of labour thus it can be said that labour is
producer of all wealth. In economics the labour and capital is said to be the primary factors of
production and from their union all of the production comes.

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Capital, which is not in itself a distinguishable element, but which it must always be kept in
mind consists of wealth applied to the aid of labour in further production, is not a primary
factor. There can be production without it, and there must have been production without it, or
it could not in the first place have appeared. It is a secondary and compound factor, coming
after and resulting from the union of labour and land in the production of wealth.

Capital refers to man made resources of production. ›abour plays an integral role in the
capital formation, here too state of labour effects and relates with the capital formation an
efficient worker will generate additional capital with additional production. Here the term
investment arise which is the amount of capital formation in a year.

The capital formation with a viewpoint of economy will include the accumulated part of the
production process. The production is a continuous process and hence a halt can hamper the
production in a big way, thus there is always some production in progress and some products
add to the production of other products appreciating the value of the products will lead to the
capital formation.

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Entrepreneur represents a special human resource which provides his entrepreneurial abilities
to the enterprise. Entrepreneur plays a crucial role in a free market economy it integrates all
the factors of production land, labour and capital to produce the output with a view of
anticipating all the losses if the output fails in the free market.

Entrepreneur always is in the risky situation as he is the one who bears all d cost of inducing
the other factors of production into the production process and the profits are the rewards of
the entrepreneur at the end of everything. Nowadays Venture Capitalists and other financer
are willing to diversify the risk of the new entrepreneur. The existence of the
entrepreneurship as a part of factor of production is still debatable.
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1. ›ist the major factors of production?
Ans. Major Factors of production are as follows:
a. ›and
b. ›abour
c. Capital
d. Entrepreneurship

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Every economy has to face some problems as scarcity of resources having alternative uses in
relation to demand give rise to the choice problem. The allocation of resources is the
fundamental problem of the economy.

These Fundamental problems are:

1. What to produce?
2. How to produce?
3. For whom to produce?
4. The choice between current consumption and growth through saving and investment.

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This question arises from the fact of limited resources in the society now apparently society
has to decide which goods have to be produced and in which quantities, now it is clear that
some of the goods have to be produced and some have to be foregone. This lead us to take an
intermediate solution of what we must produce and what we must not as the goods that are
foregone also have some wants associated with it which leads some of the customers
dissatisfied.

Another problem attached with the production is allocation of resources like for example if
we have to produce product A and product B, both of them will require the exhaustion of the
resources, here the problem of allocation of resources comes into picture as to how much
resources we must allocate to which product. This is necessarily not an issue of the
developing countries as developed countries can also face the problem of allocation of
resources.

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This is the problem of choosing method or technique of production which means that what
combinations of factors a society decides to produce goods. For example if the economy
decides to produce product A then how the production will take place and allocation of
resources has to be decided. A combination of factors in appropriate amount for the
production is known as the technique of production.

The things that come into consideration while taking the decision of how to allocate the
factors and which factors to be used can be decided with the current economic scenario. For
example in developing countries where there is abundance of labour and relatively lesser
amount of capital there we can use ›abour Intensive Technique for the production and
similarly in developed countries where labour is relatively less and capital is more, then
Capital Intensive Technique can be adopted for the production purposes. The basic criteria of
choosing the different types of technique in the different kind of scenario would be based on
1. Availability of the supplies of resources
2. Prices of the different resources which must lead to most cost effective way of production.

The problem here is that the scarcity of resources which requires that the available resources
must be used judicially and efficiently, if not economy has to face the inefficiency and thus
productivity will hamper.

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This is the problem related with the issue of the distribution of the national product among
the society. Society is a very vast term and includes a lot of components and consumers
which include the ultimate consumers of the national produce thus it is very critical to state
an effective distribution strategy, society thus itself decides how much is to distributed in
what quantities. In a free market economy it is the income of the individual which is the
deciding factor that how much he can purchase out of the available resources, Higher the
income higher is the power to utilise the resource in his favour.

The distribution strategy is also not free to operate in the economy on the basic principles of
demand and supply there are certain factors which governs the marketing mechanism like
from socialist perspective focus is on the providing basic necessities to all and generate
motivation in the people to generate additional income by doing additional work, Similarly
there has to be different strategies to be adopted in case of different economic structure. The
problem of distribution does not have an easy way out it implies that there is always conflict
of ideologies in setting up of the distribution strategy.

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Economic growth suggests that there is an increase in the production of goods and services
on a continuous basis. Growth thus implies that the economy must move on with increase in
the substantial amount of the investment. Capital formation is thus necessary and for the
expansion of the stock there has to be a sacrifice in the present level of consumption. If all the
stock is used up and nothing is there for the future use, there will be no capital formation and
thus no growth.

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1. Public Goods: It is those types of goods that can not be restricted and bounded by the
use of an individual. The basic characteristic of these types of goods are:
a) Consumption of the good by one person does not lead to the reduction in the
availability for the consumption of others.
b) No body can not get excluded from using the good.
Free to air television channels are the examples of these types of goods. These are the
goods available to all and anybody can see without getting obstruction in a way these
goods comes as a right to a person. These goods satisfy a collective want of the
society.
 2. Private Goods: These types of goods are the just opposite of what we have just read
Public Goods. The main characteristics or the Private Goods are:
a) Consumptions by one consumer prevent simultaneous consumption by other
consumers.
b) It is reasonably possible to prevent a class of consumers from consuming the
good.
Private goods are produced and marketed with a perspective of profit and it just
satisfies an individual want. Bread can be one of the examples of Private Goods.



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The merit goods are those goods which follow the concept of need, rather than ability and
willingness to pay. For example: Health Services it helps the society on the whole and caters
the need at individual level, but since it is a costly merit service the same has to be privatised
which results in the acquisition of services only by those whom have the power to pay the
more money. Thus Merit Goods merit remains effective till it helps the individual as well
society on a holistic level.

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1. What is capital formation?
Ans. Capital formation is the term used to coin the additional things added into the
economy on account of growth. Capital stock added in the financial year counts on
account of capital formation when it comes to real and tangible products and in case of
services the additional value generated by rendering services that appreciates the value of
Gross National Product.

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Production possibility curve is also known as Production Possibility Frontier or
Transformation Curve. Production Possibility curve is a curve which depicts
Graphical representation of the alternative combinations of the amounts of two goods or
services that an economy can produce by transferring resources from one good or service to
the other. As the total productive resources of the economy are limited, the economy has to
choose between different goods. The resources can be put into different types of goods it is
therefore necessary to decide which product to be produced more and which has to be less.

Assumptions underlying:
1. Given or fixed amount of resources available in the economy.
2. Given resources are being used fully and with utmost efficiency.
3. Technology does not undergo any change.

Production possibility curve can be drawn with the help of a schedule that can be depicted
between the two goods which can be produced with the full utilisation and efficient
employment of given resources. This can be drawn on the basis of schedule for example we
take Cloth and Tanks.
Production Possibilities Cloth Tanks
A 0 15
B 1 14
 C 2 12
D 3 9
E 4 5
F 5 0

This schedule when depicted on a graphical format takes a convex shape and depicts the
optimum number of combinations of the two products with the given level of resources in
hand.

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Capitalism, broadly speaking, is the economic system in which financial considerations
dominate. It is a system in which the quest for financial reward is the driving force shaping
what is done, by whom, how, where and when.
This concept basically works on two dimensions: freedom of economic choice and freedom
of enterprise. Freedom of choice means that in a world of scarce resources the individual is
free to make his own decisions.
Freedom of enterprise is usually more narrowly defined as the freedom to own and operate a
business.

Price Mechanism plays an important role in the role of determining the process of buying and
selling. Market forces determine the price and quantity to be produced in the economy with
the interaction demand and supply. In such economy the goods and services produced in the
society with the aim of generating profit and thus the resources are allocated to the goods
which provide better results on account of profit. The biggest concern seen and faced in this
type of economy is of income inequality, due to the price mechanism and profit motive the
goods are not supplied to the poor and the philosophy rich is become richer and poor
becomes poorer prevails.

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Socialist economy is a structure of the economy which aims at providing greater equality and
giving the working class greater ownership over the means of production. In a socialist
economy or a socialist state believes that socialism is the most equitable and socially
serviceable form of an economic arrangement designed to achieve human potentialities.
Socialist economies are characterized by the means of production owned by the state or by
the workers collectively called socialism.

The authorities decide in a planned economy how the resource must allocate in a profitable
manner which benefits the society at large, market forces are not allowed to influence the
decision at all. It is the government who takes control of all the resources and decides what to
produce and in what quantities. They produce with the perspective of the society at large and
not with the view of the earning profit.

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A Mixed Economy is an economy in which the decisions are taken in the combined manner
some is taken by the market forces and some are taken under government regulation.
The mixed economy as an economic ideal is supported by social democrats as a compromise
between classic socialism. The production process is governed in a semi segregated manner,
Critical sectors which are important with respect to the country as a whole is kept in hands of
the government and rest consumer goods are kept open in the economy to kept work
accordingly to the market mechanism.

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1. What is production possibility curve?
Ans. Production Possibility curve also known as Production Possibility Frontier is a curve
which shows the combination of two or more goods or services that can be produced
while using all the available factor resources efficiently For Example: We can allocate
the resources in the production of the cloths and tank.

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Knowledge has many branches and economics is an important and useful branch of
knowledge because problems of poverty, unemployment, lack of growth, inflation which face
all economies are best explained and explored and being solved with the help of Economics.
An economic system can be defined as a ³set of methods and standards by which a society
decides and organizes the allocation of limited economic resource to satisfy unlimited human
wants. The precise nature of economic system varies from society to society. Because
, Economic system is the economics category that includes the study of respective systems.

Means of production are the inputs used for production. The key term production is likely to
be explained as the creation of an item or a production that gives maximum satisfaction to the
people. Means of production can be classified into groups of homogenous (products having
same features and can be substituted) and heterogeneous (products having different features
from one another) units. There are various types of productive resources which are also
generally called factors of production. Economists traditionally classify productive resources
into four types: (a) ›and - Includes all natural resources which are free gift of nature.
Payment for use of land per period is called rent. (b) ›abour ± Represents all physical and
mental abilities which people can make available for production of goods and services.
Reward made per period for labour services is called wages. (c) Capital ± Refers to sum total
of all man ± made resources of production. Its formation in a year is called investment. (d)
Entrepreneur ± represents special human resource which initiates and organises the
production process by combining other resources such as labour, capital and land.

In every economy, scarcity of resources gives rise to four fundamental problems of economy.
These are: (i) what to produce ± means which goods and in what quantity are to be produced,
(ii) how to produce ± means which methods of production are to be used for the production of
goods and services, whether, labour or capital intensive, (iii) for whom to produce ± means
how the goods produced are to be distributed among the people, (iv) how much to grow ±
means how much to be saved and invested for increasing the productive capacity of the
economy.
The problem of what to produce is generally illustrated with the help of Production
Possibility Curve (PPC) which is based on some simple assumptions. It gives an idea to the
economy about what to produce and in how much quantity with full utilisation of its
resources with given techniques of production and thus simultaneous increase in production
cannot take place without reducing any one product. With economic growth only, it is
possible to move PPC outwards and make simulataneous increase in production of all goods.

Allocation of resources is different in every economic system. In capitalist economy, it takes

place through relation between supply, demand and price forces wherein the means of
production are owned by private sectors. Accordingly, it is the demand pattern in the
economy which finally determines the resource allocation. In a socialist economy, the means
of production are owned by government which tries to reduce income and wealth inequalities.
Individual economic units are restricted in their decisions on the basis of economic
rationality. In a mixed economy, both individual economic units and authorities take part in
decision making process where even private sectors sometimes work under the government
regulations such as price controls, subsidies and so on.