Central Problems of an Economy (With Diagram)

In this article we will discuss about the central problems of an economy, also learn about their relative importance.

Every nation’s resources are insufficient to produce the quantities of goods and services that would be required to satisfy all the wants of its citizens. This is known as the problem of scarcity and this can be overcome by exercising choice.

This problem can be divided into a number of produc­tion questions, known as the central problems of every economic society. All economies, whether they be capitalist, socialist or mixed, have to face the following seven problems, as listed by R.G. Lipsey.

1. What to produce, i.e., what commodities are being produced and in what quantities?

This question directly springs from the scarcity of re­sources. It is largely concerned with the allocation of scarce resources among competing uses. Two basic questions which have created interest among economists for more than two centuries are: ‘What determines the allocation of resources in various societies?’ and ‘What are the consequences of con­scious attempts to change resource allocation?’ In free-market economies the most important decisions concerning the allocation of resources are made through the market system or the price system.

2. How to produce, i.e., by what methods are these commodities pro­duced?

This question arises because there are various technically possible ways in which goods and services can be produced. Agricultural commodi­ties like wheat can be produced by cultivating a small plot of land inten­sively, using large quantities of fertilizer, labour and machinery, or by cultivating a large quantity of land extensively, using only small quantities of fertilizer, labour and machinery.

Both methods can be used to produce the same quantity of some commodity; one method economises the use of land but uses large quantities of other resources and the other method economise the use of all resources except land, which is used in large quantity.

The same thing happens in case of manufactured goods; it is generally possible to produce the same output by several different tech­niques, ranging from ones using a large quantity of labour and only a few simple machines to ones using a large quantity of highly automated ma­chines and only a very small number of workers.

3. For whom to produce, i.e., how is society’s output of goods and services divided among its members?

Why can some individuals and groups con­sume a large share of a nation’s output while other individuals and groups can consume only a small share? The process is simple enough. The former earn large incomes while the later earn small incomes. But, this in turn, raises another question.

Why do some individual and groups earn large incomes while others earn only small incomes? This question is concerned with the division of the total national product among individuals and groups, i.e., why any particular division occurs in a free-market society and what forces including government intervention, can cause it to change.

4. How efficient is the society’s production and distribution?

This ques­tion is directly related to the first three questions. Having raised the first three questions— what, how and for whom — it is natural to ask whether the production and distribution decisions are efficient.

Production is said to be inefficient if it would be possible to produce more of at least one commodity —without simultaneously producing less of any other — just by reallocating existing resources. The commodities that are produced are said to be inefficiently distributed if it would be possible to redistribute them among the individuals in the society and make at least one individual better off without simultaneously making anyone worse off.

All the above are related—directly or indirectly—to the allocation of resources and the distribution of income and are intimately connected, in a market economy, to the way in which the price system works.

5. Are the country’s resources being fully utilised, or are some of them lying idle?

Any economic analysis starts with the proposition that the existing resources of any country are not sufficient to satisfy even the most urgent or pressing needs of all the consumers. So, this question may cause surprise to us. Surely if resources are so scarce that there are not enough of them to produce all of those commodities which are urgently required, there can be no question of leaving idle any of the resources that are available.

Yet one of the most disturbing characteristics of free-market economies is that some such resources go waste. If this happens the resources are said to be (involuntarily) unemployed. Unemployed workers would like to have jobs the factories in which they could work are still there, the managers and owners would like to be able to operate their factories, raw materials are available in plenty, and the goods that could be produced by these resources are urgently required by individuals in the community.

Yet for one reason or the other, nothing fruitful happens: the workers remain unemployed, the factories have idle capacity and the raw materials are wasted, or remain unused. The cost of such periods of unemployment is felt both in terms of the goods and services that could have been produced by the idle resources and in terms of involuntary idleness of manpower even for long periods of time.

6. Is the purchasing power (value) of money and savings constant or is it being eroded because of inflation?

The world’s economies have often experienced periods of prolonged and rapid changes in price levels. Over the long periods of recorded history, price levels have often risen and occasionally fallen. In recent past, however, the course of prices has almost always been moving upward.

Inflation reduces the purchasing power or value of money and savings. It is closely related to the stock of money in circulation. Money is one of the greatest inventions of mankind, and the stock of money in existence can be controlled by the central bank. Economists raise various questions about the causes and consequences of changes in the quantity of money and the effects of such changes on the price level. They also seek to identify other causes of inflation.

7. Is the economy’s capacity to produce goods and services growing from year to year or is it remaining static?

Some economies grow faster than others. This is largely attributable to differences in the rate of saving or capital formation. Economic growth implies an expansion of society’s pro­duction capacity. So, it is interesting to know why the capacity to produce grows rapidly in some economies, slowly in others, and not at all in yet others.

The reason is simple enough:

Different societies take different deci­sions regarding consumption and capital formation. A high-investment nation usually grows faster than a low-investment nation.

The decisions on these questions are made in free-market societies through the price system, and the government sometimes intervenes in an attempt to alter the decisions.

Diagrammatic illustration of the problems:

Four of the above questions can be illustrated diagrammatically. Consider the choice that faces all economies today, between producing armaments and producing goods for civilian use. This is a problem of allocation of resources; how many resources to devote to producing ‘guns for defence’ and how many to devote to producing goods for all other purposes.

We illustrate this choice in Fig. 1. On one axis we measure the quantity of military goods (like gun) produced and on the other axis the quantity of all other goods, which we call civilian goods (like butter). Next we plot all possible combinations of gun and butter that can be produced if all re­sources are fully employed. By joining up these points we get a line called a production-possibility frontier or boundary.

Points inside the boundary such as c show the combi­nations of military and ci­vilian goods such as gun and butter that can be ob­tained given the society’s present supplies of re­sources. Points outside the boundary such as d show combinations that cannot be obtained because of scarcity of resources. Points on the boundary such as a and b are just attainable; they are the combinations that can just be produced using all the existing resources.

The boundary is concave to the origin because of increasing opportunity costs or diminishing returns. Society must give up more and more unit of a commodity to get one more of the other. The slope of the boundary shows gun-butter transformation ratio.

Thus, a movement from point a to point b implies reallocation of resources out of civilian (butter) production and into military (gun) produc­tion. The amount of gun produced increases from q to s, while the quantity of butter produced falls from p to r. Thus, the opportunity cost of getting s—q more guns produced is p—r butter sacrificed.

If the economy could be at point b, then it could also be at point c producing less of both gun and better than at b, or indeed at any point inside the boundary. When the economy is inside the boundary, production of both types of commodity is less than it would be if some points on the boundary could be attained.

So, if society is inside the boundary its actual output will be less than its potential output. An economy can be producing at some point, such as c, inside its production-possibility boundary, either because some of its resources are lying idle, or because its resources are being used inefficiently in the production procedure.

Since the PPC is a frontier (boundary) and cannot be shifted in the short-run, more guns can be obtained only at the cost of producing less civilian goods (e.g., by moving from point a to point b). If however, the economy is inside the boundary as at point c, more of both goods can be produced at the same time.

If the economy is inside the boundary because there is unemployment or idle capacity, the measure which helps to reduce unemployment will allow the economy to produce more of both goods. If on the other hand, the economy is inside the boundary because, although existing resources are fully employed, they are being used inefficiently, then measures, which increase the efficiency of resource utilisation, will permit more of both goods to be produced.

If the economy’s capacity to produce goods is growing through time, then the production-possibility boundary is pushed outwards over time as illustrated in Fig. 2. If the economy then remains on the boundary, more of all goods can be produced moving the economy, for example, from point a to point d.

Thus, there are two alternative ways of increasing the production of all goods at the same time. If production is at a point inside the production-possibility boundary as in Fig.2 then it may be moved to a point closer to, or actually on, the boundary, from c to b in Fig. 2.

If the economy is already on the bound­ary then it is necessary to move the boundary outwards so that produc­tion can expand, for example, from a to d in Fig. 2. As R.G. Lipsey has put it:

“It is very important to dis­tinguish between two sorts of movements – (i) a movement from a point within, to a point on the boundary, and (ii) a movement of the actual boundary. A policy that would succeed in increasing total output if the object were to move from a point within the boundary to a point on the boundary, would be a failure if what was necessary was to increase output by moving the actual boundary.”

Relative Importance:

Obviously, the first three problems are more important than the other four. Among the first three, the first one is the most important of all. The other two are ranked second and third in order of importance. The basic point to note is that these problems are no doubt different, but interrelated and one of our objectives of study of the central problems of every economic society is to discover the nature of this interrelationship.