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Introduction
Master Plan

Basic economic problem of Choice

Central problems of an economy
1. Allocation of resources
a) What to produce and in what quantities?
b) How to produce?
c) For whom to produce?
2. Efficient use of resources
3. Fuller utilisation of resources
4. Growth of resources
Production possibility Frontier – meaning, schedule and curve
Depiction of central problems in a Production Possibility Curve
Opportunity cost and Marginal Opportunity Cost
Reason for the concavity of Production Possibility Curve
Positive Economics and Normative Economics
Solution to the central problems in different economic organizations – Capitalistic, Socialist
and Mixed Economies
Meanings of Micro economics and Macro Economics

An economic problem arises, only due to scarcity of resources in relation to the demand for
them.
Human wants are unlimited and recurring in nature. But, the resources (land, labour, capital
and entrepreneurship) that satisfy our wants are limited in supply. Also, these resources can
be put to alternative uses. Now, the basic economic problem is to choose between
alternative uses, i.e., to choose those wants that should be satisfies now and those that can
be satisfied later. In short, the basic economic problem is the problem of choice.
For example, there are wants such as rice, wheat and houses. But, the land available to
produce all these goods is scarce. If the economy decides to produce rice, then no land will
be available for the production of wheat and houses. Now, a choice has to be made as to
which goods should be produced with the given amount of land. Thus, the economic problem
is the problem of choice.

Central problems of an economy

The scarcity of resources in relation to their demand gives rise to the problem of choice. Had
the resources been unlimited or had the wants been limited or had the resources not been
able to be used to alternatively, the basic problem of choice will not rise in an economy.
Thus, due to scarcity of resources and the subsequent problem of choice, every economy
faces the following central problems. They are:
1. Allocation of resources: The first central problem is that the economy has to allocate its
scarce resources to produce a variety of commodities it needs.
a) What to produce and in what quantities? The economy has to decide what all different
commodities should be produced and in what quantities each commodity should be
produced. If it produces more of consumer goods, it can produce only less of capital goods
and vice versa.
b) How to produce? Since the resources are scarce, the economy has to produce at the least
cost. In other words, the economy has to decide what technique of production is to be used
in production. If it uses labour-intensive technique of production, production will be slow and
less as well but it can solve the problem of unemployment. On the other hand, if it uses
capital-intensive technique of production, it can produce more and fast but it creates
unemployment.
c) For whom to produce? The economy has to decide whether goods should be produced for
all or for the rich class in the society. It is basically a question of how the national income of
the country is distributed among the four factors of production. If it produces luxury goods for
rich class, the interests of the poor section of the society are neglected.
2. Efficient use of resources: The economy should see that there is efficiency in production
and distribution.
If production cannot increase even by one unit with different allocation of resources, then
there is said to be efficiency in the existing production.
Similarly, if, by a redistribution of income, even one person cannot be made better-off without
making others better-off, then the existing distribution is said to be efficient.

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3. Fuller utilisation of resources: Since the resources are scarce in relation to their demand,
the economy cannot afford to waste them. Hence, the economy must make sure that there is
fuller utilisation of resources.
4. Growth of resources: If the resources in the economy do not grow, it cannot produce more
and it cannot develop. Therefore, the economy has to provide for the growth of resources,
too. Also, the national income should increase faster than the increase in population.

Production Possibility Curve

Production possibility curve is a diagrammatic representation of all those combinations of two
commodities that can be produced in an economy during a given time period, with the given
resources and the available state of technology.

The central problems of an economy can be depicted in a production possibility curve. Let us
suppose that the economy, with all its resources, can produce two goods – consumer goods
and capital goods – in the following combinations.
Production Possibility Schedule
Possibilities Consumer goods Capital goods
A 20 0
B 18 1
C 15 2
D 11 3
E 6 4
F 0 5

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The different combinations of the two commodities – A, B, C, D, E and F are plotted in the
diagram and they are joined by a curve. This curve is called Production Possibility Curve
or Production Possibility Frontier.

The economy can produce any one combination of the two goods measured on the
production possibility curve. It can choose any point lying on the curve.

While any point on the curve depicts the central problem of allocation of resources and
efficient use of resources, fuller utilisation of resources, any point inside the production
possibility curve means inefficient use of resources and under utilisation of resources.
A given production possibility curve shows that if the production of one good goes up, the
maximum production of the other good should fall. However, it is not that an economy can
never produce more of both goods. Over time, if the technology progresses or if the
resources available in an economy (such as fertility of soil and skilled labour) grow, then the
economy can produce more of both goods. In such case, the production possibility curve can
shift upwards. Thus, the dotted upward movement of the curve means that the economy is in
a position to produce more of both goods than before. Thus, the upward curve shows growth
of resources of the economy.

Opportunity cost
Opportunity cost is defined as the value sacrificed of the next best activity.
In our example of production possibility curve schedule, if the economy chooses to produce
one unit of capital good, it has to sacrifice the production of two units of consumer goods.
Therefore, the opportunity cost of the capital good is two units of consumer goods.

Marginal Opportunity Cost

It is defined as the additional value sacrificed of the next best activity. It is also called
Marginal Rate of Technical Substitution or Marginal Rate of Transformation.

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 Production Possibility Schedule
Possibilities Consumer Capital Opportunity cost Marginal opportunity
goods goods of capital goods cost of capital goods
A 20 0 - -
B 18 1 2 2
C 15 2 5 3
D 11 3 9 4
E 6 4 14 5
F 0 5 20 6

If the economy chooses to produce one unit of capital goods, it has to sacrifice the
production of two units of consumer goods. Therefore, the marginal opportunity cost of the
first capital goods is (20 – 18 =) 2 units of consumer goods. Similarly, the marginal
opportunity cost of the second unit of capital good is (18 – 15 =) 3 units of consumer goods.
The marginal opportunity cost means that the economy has to sacrifice the production of
more of a good in order to produce one more unit of other good. That is why the production
possibility curve is concave to its origin.

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If marginal opportunity cost were constant, the production possibility curve would be a
straight line as follows.

And if the marginal opportunity cost were decreasing, then the economy would be able to
produce more of one good by sacrificing less of other good. In such case, the production
possibility curve would be convex to the origin.

Therefore, production possibility curve is concave to its origin because of increasing marginal
opportunity cost. Increasing marginal opportunity cost is because of the law in engineering.

Shifts and Rotation of Production Possibility Curve

When the entire PPC moves up (because of growth of resources) or moves down (due to
decrease in resources, it is known as Shift of PPC.

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On the other hand, when the resources that can produce the good shown along the X-axis
increases, the economy can produce more of that good, , the PPC rotates outward (fans out)
along the X-axis. However, production of good shown along Y-axis will remain the same.

When the resources for the production of the good shown along the X-axis decreases, the
economy can produce less of that good, the PPC rotates inward (fans in) along the X-axis.
However, production of good shown along Y-axis will remain the same.

Similarly, when the resources that can produce the good shown along the Y-axis increases,
the economy can produce more of that good, the PPC rotates outward (fans out) along the Y-
axis. However, production of good shown along X-axis will remain the same.

When the resources for the production of the good shown along the Y-axis decreases, the
economy can produce less of that good, the PPC rotates inward (fans in) along the Y-axis.
However, production of good shown along X-axis will remain the same.

In the above cases, rotation of PPC takes place.

Solution to the central problems

1. In a Capitalistic economy
A capitalistic economy is featured by private enterprise and consumer sovereignty. It
produces goods and services to earn profit. Therefore, it produces those goods and services
that are demanded in the market. And they will be produced in that quantity as demanded by
the consumers. They will be produced using that technology which gives the producer the
least cost and maximum product.
2. In a Socialistic economy
A socialistic economy is characterized by government ownership of all resources and
absence of private enterprise. It produces goods and services for the welfare of all the people
in the country. The government will decide the types and the quantity of goods and services
to be produced on the basis of the needs of the entire society. It will use that technology that
keeps the unemployment level low.
3. In a Mixed economy
A mixed economy is characterized by the presence of both public sector and private sector.
While private sector produces goods and services on the basis of the demand for them,
public sector produces those goods and services that are needed by the entire society. Fiscal
instruments of tax and subsidies are used to reallocate the resources in such a way as to
maximize public welfare.

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Positive Economics and Normative Economics
When economics analyses what is or what was, it is known positive economics. Such
analysis is based on facts that can be proved. For example, “Inflation affects the poor
sections of the society as their standard of living goes down” is a positive statement.

On the other hand, when economics analyses what ought to be, it is known as normative
economics. It passes value judgments on economic phenomena. For example, “Inflation is
worse than unemployment” is a normative statement.

However, the distinction between positive and normative economics is not a very sharp one.

Branches of Economics
1. Micro Economics: It is that branch of economics that studies the individual units of the
economy such as demand for a commodity, supply of a commodity, price of a
commodity and wages of labour. The central problem of allocation of resources is
studies in Micro Economics. Micro Economics is also called the Theory of Pricing.
2. Macro Economics: It is that branch of economics that studies the aggregates of an
economy such as aggregate demand, aggregate supply, general price level and
national income. It deals with the central problem of fuller utilisation of resources.
It is also called the Theory of Income and Employment determination.
While Welfare Economics studies the central problem of efficient use of resources,
Development Economics studies the central problem of growth of resources.

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