Chapter-2: Central problems of an eConomy

Objectives
After going through this chapter you shall be able to understand the following concepts
 Scarcity of Resources and Problem of Choice
 Central Problems of an Economy
Introduction
As we know, the need for economics stems from the basic problem of scarcity and choice. Similar to an
individual every economy also confronts these problems. It is because of this problem of scarce resources and
the problem of choice that an economy is pushed to face the central problems.
Before studying the central problems of an economy, let us understand the problem of scarcity and the problem
of choice carefully.
Scarcity of Resources and Problem of Choice
No matter, how well a particular economy is endowed with resources, these resources will be relatively scarce
to fulfil its unlimited wants. Moreover, these scarce resources have alternative uses and can be allocated to the
production of different goods and services. Allocation of resources to any particular use involves a cost in terms
of sacrifice of the other possible uses. To allocate the scarce resources in the best possible manner, an economy
needs to analyse the cost (i.e. the opportunity cost) of allocating the resources to one use while sacrificing the
other uses. For example, a piece of land can be used in a number of ways such as to grow crops, for building
houses, for putting up industries, etc. Therefore, the question here arises that to which particular use the piece of
land should be allocated. It depends on the economy to analyse what is presently more important (or need as per
the present scenario) and which use of land will be most beneficial for the economy as a whole.
Thus, it is due to the scarce availability of resources (having alternative uses) to fulfil the different and
competing unlimited wants that an economy faces the problem of choice. From this discussion, we can conclude
that the problem of choice is a consequence of the problem of scarcity of resources.
Hence, the following are the three main causes that give rise to the central problems in an economy.
1. Unlimited Human Wants- Human wants are never-ending and new wants keep arising.
2. Limited Economic Resources- In relation to the unlimited wants, the resources required to satisfy them are
relatively scare and limited in supply.
3. Alternative Use of Resources- Resources are not only scarce but also have alternative uses. This implies that
a choice has to be made among the various alternative uses of resources.
Central Problems of an Economy
Due to allocative problems of scarce resources to alternative uses and the problem of choice every economy
faces mainly three central problems. These are:
1. What to produce and in what quantities?
2. How to produce?
3. For whom to produce?

1. What to Produce and in What Quantities?

The first problem that an economy faces is to decide which goods and services are to be produced. Besides this,
the economy also needs to decide in what quantities these goods and services should be produced. Let
understand this problem with the help of the following example.
Let us suppose that an economy can produce only two types of goods viz. consumer goods (such as, rice, wheat,
Laptops, etc.) and capital goods (such as, machinery, guns, bridges, etc.). Now, with the amount of resources
available, the economy need to decide how much and which of the consumer goods should be produced and
how much and which of the capital goods should be produced. Thus the economy faces a choice as whether, it
wants more of capital goods and less of consumer goods or vice-versa.
2. How to Produce?

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 Chapter-2: Central problems of an eConomy
The next problem that an economy faces is to decide which production technique is to be employed in the
production of the decided goods and services. The following are the two techniques of production.
(a) Labour Intensive Production Technique
This production technique uses comparatively more of labour units than that of capital or machine. For
example, agricultural activities in India use labour intensive production technique.
b) Capital Intensive Production Technique
This production technique uses comparatively more of capital or machine units than that of labour units. For
example, production of durable goods such as, T.V, refrigerator, vehicles, etc. needs capital intensive
production technique.
The economy needs to decide which particular production technique should be adopted in order to utilise its
available resources in the best possible efficient and optimal manner. India, for instance, is a labour abundant
country. Thus, it will be more beneficial for India to opt for labour intensive techniques, as this will not only
minimise the cost of production (due to cheap availability of labour) but will also help in reducing
unemployment.
3. For Whom to Produce? Or the Problem of Distribution of National Product.
This economic problem basically focuses on the distribution mix of the final goods and services produced. The
distribution of the final goods and services is equivalent to the distribution of National Income (or National
Product) among the factors of production such as land, labour, capital and entrepreneur.
The economy needs to decide a mechanism of distributing the final goods and services among the different
segments of population, so as to reduce the inequality of income. This problem is concerned about who gets
more or who gets less? Which goods should be made available free or at low (nominal) price and to which
segment?
Objectives
After going through this chapter you shall be able to understand the following concepts
 Economy and Economic Activity
 Types of Economic System- Market Economy, Centrally Planned Economy and Mixed Economy
 Difference between Market Economy, Centrally Planned Economy and Mixed Economy
Introduction
Economy- An economy is defined as a framework that consists of an economic system which allocates the
scarce resources to the consumption, production, investment and saving activities. In economics, a country is
generally referred to as an economy. This is because we are concerned with the economic aspect of above
mentioned activities of a country as a whole.
Economic Activity- An activity that involves the use of scarce resources for the production of goods and
services for the fulfilment of the human wants is regarded as an economic activity. Consumption, investment,
production, saving, etc. are some of the examples of economic activities.
Types of Economic System
The economic system can be broadly classified into the following three types.
1. Market Economy
2. Centrally Planned Economy
3. Mixed Economy
Market Economy/Capitalist Economy
In this type of economy, the capitalist or the private entrepreneurs control the economic activities. They
organise and undertake production with the sole motive of profit making. In this economic system, the
government does not interfere in the economic activities. The role of the government is limited only to defence
and maintaining law order, and government do not interfere in the economic activities. This system is also
known as Free Market Economy or Laissez-Faire System. For example, Britain during the industrial revolution
period.
Features of Market Economy/ Laissez-Faire System/Free Market Economy
The following are the important features of a Market Economy.
1. The production activities are fully controlled, organised and managed by the private entrepreneurs. They
hire the different factors of production such as, land, labour and capital to undertake the process of production.
2. The sole motive of undertaking the production process is to earn and maximise profits.
3. A market economy is not controlled, regulated and planned by the government. The role of government is
limited only to defence and maintaining law and order in the economy.
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 Chapter-2: Central problems of an eConomy
4. There exists a very high degree of competition among different capitalist to earn maximum possible profits
and capture the maximum market share.
5. The central problems of a market economy are solved by the price mechanism. That is, in other words, the
capitalist decides what to produce, how to produce and for whom to produce as per the price signals.
Solutions to the Central Problems in a Market Economy
In a market economy, the solution to the three central problems is provided by the Price Mechanism. This
mechanism plays an important role in determining what to produce, how to produce and for whom to produce.
Price of a good or service reflects the valuation and need of the society for that particular good or service. Price
is determined by the demand for and supply of the goods and services. It acts as a signal for the capitalist to take
decision. Suppose, if the society demands more of a particular good or service, then its price will be high and a
profit-motive capitalist will produce more of that good to earn profit.
Central Problems
Faced by a Market Solutions to Central Problems
Economy
What to Produce? Those goods will be produced for which the demand is high
Those production techniques will be employed which minimise the cost of
How to Produce?
production.
For Whom to Produce? Only for those who have the capacity to pay
Centrally Planned Economy
In this type of economy, central authority or state (government) plans, organises and regulates all the important
economic activities. All the factors of production such as, land, labour, capital and entrepreneur are controlled
and governed by the state. The state designs the plans (for the whole economy) and accordingly controls the
production units to achieve the planned targets. The main motive of the state is to render service and to enhance
the welfare. The state controls the distribution of goods and services (i.e. the final product) among the different
segments of population. The final product is distributed in a pattern that the state feels desirable, which is in
tune with the accomplishment of the long-term planned targets. Unlike market economy, in a centrally planned
economy the private entrepreneurs have no role to play as all the economic activities are solely governed by the
state. For example, Soviet Union was a centrally planned economy for the major part of the twentieth century.
Features of Centrally Planned Economy
The following are the major features of a centrally planned economy
1. The production activities are planned, organised and controlled by the government.
2. Unlike market economy where self interest (or profit) is focused, in a centrally planned economy social
welfare is focused. The state undertakes the production activities with the sole motive of social welfare and to
render services.
3. Besides production, the state also manages and controls the distribution of goods and services among
different segments of the population.
4. In a centrally planned economy, the role of the private entrepreneurs is minimal.
5. A centrally planned economy solves the central problems through economic or central planning. In other
words, the state with the help of central planning tries to solve the three central problems of what to produce,
how to produce, and for whom to produce as per the needs and requirements of the society.
Solutions to the Central Problems in a Centrally Planned Economy
In a centrally planned economy, the solution to the three central problems is provided by the economic (or state)
planning. The plans designed by the state helps in determining what to produce, how to produce and for whom
to produce. The economic activities are controlled to achieve the planned targets and simultaneously to enhance
the social welfare. The state will produce those goods and services which will maximise the welfare of the
society.

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 Chapter-2: Central problems of an eConomy
Central Problems Faced by
Solutions to Central Problems
a Mixed Economy
Those goods will be produced which will enhance the welfare of the society
What to Produce?
as a whole.
The production technique which suits the economic conditions in the best
How to Produce? manner. If labour (or capital) is abundant, then labour intensive technique
(or capital intensive technique) will be employed.
For the society as a whole. This will be as per the requirements of the
For Whom to Produce? elimination of the major economic problem such as, poverty, inequality,
employment, etc.
Mixed Economy
Mixed Economy consists of both the features of state economy and market economy. In a mixed economy, both
private as well as public sectors works side-by-side. The private sector is free to choose their production line but
is simultaneously governed by the public sector. The state interferes in the private sector activities in order to
safeguard the interests of workers and consumers. The interference by the state also ensures social justice along
with accomplishing higher economic growth rate. While on one hand, the state owns the core and the base
industries such as, iron and steel, energy, etc. on the other hand, the comparatively lesser important industries
are owned by the private sector. The state also keep a keen watch and tries to curtail the formation of
monopolies, price rigging and manipulation, unfair trade practices. India, Sweden, Israel, Norway is an example
of a mixed economy.
Features of a Mixed Economy
The following are the features of mixed economy.
1. In a mixed economy, both private sectors and public sectors coexists simultaneously.
2. The basic and core industries are owned by the public sectors, whereas, comparatively lesser important
industries are owned by the private sectors.
3. The state keenly interfere in the working of the private sectors to safeguards the interest of the weaker and
vulnerable sections of the society.
4. The factors of production are owned by both public as well as by the private sectors.
5. While on one hand, the public sector aims at social welfare and economic growth with social justice, whereas,
on the other hand, the private sectors are profit-driven.
6. The interference by the state in the private sector operations tries to curtail the formation of monopolies and
unfair trade practices.
Solutions to the Central Problems in a Mixed Economy
In a mixed economy, the solution to the three central problems is provided simultaneously throughprice
mechanism and through economic (or state) planning. The economic plans and price mechanism together
helps in determining what to produce, how to produce and for whom to produce.
Central Problems Faced by a
Solutions to Central Problems
Mixed Economy
This problem is solved through price mechanism (for private sector) and
What to Produce?
also through central planning (for public sector).
Private sector decides to employ those production techniques which
reduces the cost of production, thereby maximises the profits. Public
How to Produce?
sector use those production techniques which enhance the social
welfare.
The final product produced by the private sector is distributed as per the
For Whom to Produce? price mechanism. The final product produced by the public sector is
distributed through the public distribution system.

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 Chapter-2: Central problems of an eConomy
Difference among Market Economy, Centrally Planned Economy and Mixed Economy
Centrally Planned
Points of Difference Market Economy Mixed Economy
Economy
1. Ownership of factors The factors of production are The factors of The factors of
of production privately owned. production are production are jointly
publically owned i.e. owned by the state as
by the state. well as by the private
sector.
2. Solutions to the The central problems are The central problems The central problems
Central Problems solved by the price are solved by the are solved jointly by
mechanism, i.e. by the market planning mechanism. the price mechanism
forces- demand and supply and planning
mechanism.
3. Production motive The main motive is profit The motive of Coexistence of profit
making. production is social motive and social
welfare. welfare.
4.Governing of The production is governed by The production is The production by
Production the price mechanism, i.e. by governed by the the private sector is
the demand and supply forces. planning mechanism, governed by price
i.e. according to the mechanism and the
government plans. production by the
public sector is
governed by planning
and welfare motive.
5. Income distribution There exists very high The degree of There exists
inequality of distribution of inequality of income is significant inequality
income. comparatively lesser. of income. As in
India, there is a wide
gap between the rich
and poor.
6. Government’s role The prime role is played by the The main role is played The core and base
private players. They decide by the government- industries are
what to produce, while the role from production to governed by the state.
of a government is very distribution. The lesser important
minimal and is limited only to industries are owned
maintain law and order in the by the private
nation. players. The degree
of government role in
a mixed economy is
lesser than that of in a
centrally planned
economy but is
higher than that of in
a market economy.
7. Competition among There exists a cut-throat There is absolutely no There exists a high
the Producers competition among the competition as the state degree of competition
capitalists. is the only player. among the private
entrepreneurs, while
there is no
competition in the
public sector.

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 Chapter-2: Central problems of an eConomy
8. Degree of Freedom There exists very degree of There exists absolutely Although there exists
available to the freedom for the entrepreneurs no degree of freedom considerable degree
entrepreneurs to operate. for the entrepreneurs to of freedom to the
operate. entrepreneurs to
operate but
government keeps a
keen watch on the
operations of the
private sector.

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