Fundamental problems of an economy

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An economy is a complex system. It involves production, consumption, and exchange activities for allocating resources among people. Basically, production, consumption, and distribution of goods and services combine for fulfilling the needs of the population. 

An economy may represent a nation or probably a particular region. Sometimes it can represent even a single industry or family. 

Market-based economies: They are also called free market economies. They are self-regulated. In such economies, goods are produced and distributed in response to demand from consumers.

Command-based economies: Such economies are regulated by the government. They make a final call on what goods to be produced, their quantities, and also get to decide the prices. 

In the modern world, there are hardly any economies which are purely market-based or command-based. 

Fundamentally, an economy survives because of two basic facts. Firstly, the demand for goods and services is unlimited. Secondly, because of the scarcity of resources. 

Now with our wants being unlimited and resources being limited, it is impossible to satisfy all our wants. An economy functions by allocating resources carefully, ensuring the welfare of its population. 

Basic problems of an economy

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What to produce, how to produce, and for whom to produce are the key problems faced by an economy. It doesn’t matter whether it’s a capitalist economy, socialist economy or a mixed economy. All of them will have to deal with similar issues. 

What to produce?

In an economy, we have to decide on what goods to be produced and what not be produced. Secondly, we have to decide on the quantities these goods should be produced. All human wants can’t be necessarily satisfied because our resources are limited. This leaves the economy to choose between various goods and services.

If a society focuses on the production of particular goods in large quantities, it will end up affecting the production of some other goods. The ‘economy’ has to take the final call regarding the quantities of consumer goods and capital goods to be produced. 

Choosing between consumer goods and capital goods is basically choosing between the present and the future. If more capital goods are produced, the production of consumer goods will come down and vice versa. In short, we have to realize that current consumption has to be sacrificed for the sake of better consumption in the future.

How to produce?

It is necessary to find the right combination of resources for production of goods. The  technology to be used for production has to be decided as well. 

A society, after finalizing the goods and services to be produced, and their quantities, has to decide on how those goods should be produced. There are alternate methods to choose from. 

Let’s take the example of manufacturing clothes. They can either be produced with automatic looms, powerlooms or handlooms. Similarly a field can be irrigated for production of crops using tube wells and tanks or by constructing huge canals or dams. So, here you can see that it is for the economy to decide whether to use automatic looms or hand looms for production of clothes. Similarly they have to choose between minor irrigation works and major irrigation works for cultivation. Every economy has its own choices for production techniques. 

Different methods of production use up various quantities of resources. For example, production of cloth using handlooms involves more labor and less capital. Hence it is a labor-intensive technique of production. On the other hand, the production of cloth using an automatic loom or powerloom will require more capital and less labor. It is an example of capital intensive technique for production of clothes.

Hence cost of production is crucial. We all know that resources are scarce. The onus is on the society/economy to decide the methods of production. It has to decide whether to make maximum use of relatively scarce resources or vice versa.

For whom to produce?

It is basically about how the national product should be distributed among its people. It is important to have an idea about how much goods and services should be produced. 

Distribution of ‘final product’ heavily relies on distribution of national income. In an economy, those with higher incomes will have larger purchasing capacity and hence will tend to accumulate a major share of the goods and services. 

The government should interfere and provide several incentives to the poor, for ensuring fair distribution of goods and services among its people. 

Efficiency and growth


Problems of efficiency and growth are two other major problems faced by economies worldwide. Since resources are scarce, it is vital to ensure efficiency in the production and distribution of goods and services. 

Economic growth can be defined as the increase in productive capacity of an economy over time. Understandably, under-developed countries have to accelerate their productive capacity, so as to improve the living standards of its people. 

Price mechanism

In an economy, the forces of demand and supply end up determining the prices of commodities in the market. In short it is the buyers and sellers who actually decide the price of a commodity. 

Rationing, signaling and incentive functions are the three separate functions of ‘prices’. It controls the buying and selling decisions in the market, thereby ensuring that resources are allocated appropriately. 

Check your knowledge

 Answer) An economy is a complex system. It involves production, consumption, and exchange activities for allocating resources among people. 

 Answer) Market-based economies are also called free market economies. They are self-regulated. In such economies, goods are produced and distributed in response to demand from consumers.

  Answer) What to produce? How to produce?, and for Whom to produce? are the three basic problems faced by an economy.

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