From the study of the essential processes of an economy, it would appear that some fundamental problems arise whatever the type of the economy.
An economy exists because of two basic facts: Firstly human wants for goods and services are unlimited; and secondly, productive resources with which to produce goods and services are scarce.
Wants being unlimited and our resources being limited, we cannot satisfy all out wants. That being so, an economy has to decide how to use its scarce resources to give the maximum possible satisfaction to the members of the society.
In doing so, an economy has to solve some basic problems called Central Problems of an economy, which are:
(i) WHAT to Produce.
(ii) HOW to Produce.
(iii) FOR WHOM to Produce.
Whatever the type of the economy or economic system, these problems have to be solved somehow. Whether it is a capitalist economy of the U.S.A. or a socialist economy of the U.S.S.R. or a mixed economy of India, every economy has to make decisions in regard to what, how and for whom to produce. These problems are basic and fundamental for all economies.
However, different economies may solve these problems differently. For instance, the socialist economy of Soviet Russia tackles these problems in a different way from that of capitalist America. We shall now explain each of the above three problems in some detail.
(i) WHAT to Produce:
The problem ‘what to produce’ can be divided into two related questions. First, which goods are to be produced and which not; and second, in what quantities those goods, which the economy has decided to produce, are to be produced. If productive resources were unlimited we could produce as many numbers of goods as we liked and, therefore, the question “What goods to be produced and what not” would not have arisen. But because resources are in fact scarce relative to human wants, an economy must choose among different alternative collections of goods and services that it should produce.
If the Society decides to produce particular goods in a larger quantity, it will have to withdraw resources from the production of some other goods. Further, an economy has to decide how much resources should be allocated for the production of consumer goods and how much for capital goods. In other words, an economy has to decide the respective quantities of consumer goods and capital goods to be produced.
The choice between consumer goods and capital goods involves the choice between the present and the future. If the society decides to produce more capital goods, some resources will have to be taken away from the production of consumer goods and. therefore, the production of consumer goods would have to be cut down. But greater amount of capital goods would make possible the production of larger quantities of consumer goods in the future. Thus, we see that some current consumption has to be sacrificed for the sake of more consumption in the future.
(ii) HOW to Produce:
The problem of ‘how to produce’ means which combination of resources is to be used for the production-of goods and which technology is to be made use of in production. Once the society has decided what goods and services are to be produced and in what quantities, it must then decide how these goods shall be produced. There are various alternative methods of producing a good and the economy has to choose among them.
For example, cloth can be produced either with automatic looms or with power looms or with handlooms. Fields can be irrigated (and hence wheat can be produced) by building small irrigation works like tube-wells and tanks or by building large canals and dams. Therefore, the economy has to decide whether cloth is to be produced by handlooms or power looms or automatic looms. Similarly, it has to decide if the irrigation has to be done by minor irrigation works or by major works. Obviously, it is a problem of the choice of production techniques.
Different methods or techniques of production would use different quantities of various resources. For instance, the production of cloth with handloom would make use of more labbur and less capital. Production by handloom is, therefore, called labour-intensive technique of production. Production of cloth with power loom or automatic loom would utilise less labour and more capital. Production with power looms is, therefore, called capital-intensive technique of producing cloth. Thus, the economy has to choose whether it wants to use for production labour-intensive methods or capital-intensive methods of production.
Obviously, the choice between different methods would depend on the factor-supply situation and the prices of the factors of production. The criterion, it is obvious, must be the cost of production- It is well known that the resources are scarce. But some resources are more scarce than others. It is in society’s interest that those methods of production are employed that make the greatest use of the relatively plentiful resources or, conversely, economies are much as possible on the relatively scarce resources.
(iii) For Whom to Produce:
Once the problems of ‘what’ and ‘how’ to produce are solved, the goods are then produced. Because the resources and the resulting output of goods are limited, the third basic economic decision, which must be taken, is ‘for whom to produce’. ‘For whom to produce’ means how the national product is to be distributed among the members of the society. In other words, for whom to produce means that should get how much of the total amount of goods and services produced in the economy.
Thus, the third problem is the problem of sharing of the national product. Distribution of the national product depends on the distribution of national income. Those people who have larger incomes would have larger capacity to “buy goods and hence will get greater share of goods and services.
Those, who have low incomes, would have less purchasing power to buy things. The more equal is the distribution of income, the more equal will be the distribution of the national product. But the question now arises: how is the national income to be distributed, that is, how is it to be determined as to who should get how much of the national income?
Should the people get equal incomes and hence equal shares from the national product, or whether the distribution of national income should be done on the basis of the Marxian principle ‘from each according to his ability, to each according to his needs’, or should the distribution of national income be in accordance with the contribution made to the total production, that is, should everybody get income exactly equal to what he produces?
The main difficulty in the question of distribution of national product or income is how to reconcile the equity and justice aspect of distribution with the incentive aspect. From the point of view of equity, distribution of national product or income on the basis of equality seems to be the best.
But the problem is that equality in the distribution of national product or income may adversely affect the incentive to produce more. If this incentive is destroyed or greatly diminished as a result of promoting equality, the total national output available for sharing may be so much smaller that the living standards of all may go, down.
Problems of Efficiency and Growth:
Besides the three fundamental problems explained above, there are two other problems of an economy to which economists of today attach considerable importance. They are the problems of efficiency and growth of the economy. Now a word about each of them.
Efficiency of Resource-use:
A very important question that can be asked about the working of an economy is: Are the resources being used efficiently? Since resources are scarce, it is obviously desirable that they should be most efficiently used, i.e., the production and distribution of the national product should be efficient. Production is said to be efficient, if it is not possible to produce more of one good without reducing the output of any other goods in the economy. Similarly the distribution is efficient if it is not possible to make any one person/persons better off without making any other person/persons worse off through any redistribution.
Growth of Productive Capacity:
It is also important to know whether the productive capacity, of an economy is increasing, static or declining. The increase in productive capacity of an economy over time is called economic growth. Obviously, for under-developed economies, their basic problem is how to accelerate the pace of their economic growth.
Even developed countries would not like to rest on their oars. In fact, it has been observed that they are able to achieve higher annual rate of growth than the under-developed ones. The problem of growth is thus not peculiar to the under-developed countries, but is of importance to all countries, whether developed or undeveloped, whether free-market or centrally planned.
Solution of the Fundamental Economic Problems in a Capitalist Economy:
It is the price mechanism that helps in the solution of the fundamental problems of the economy. Price mechanism means a set of equilibrium price of individual commodities and factors of production determined through the forces of demand and supply in the various markets.
The main problems, are what to produce, how to produce and for whom to produce. In all these cases, price is the indicator of the direction of profitable investment. Those commodities will be produced for which demand prices are high and are therefore profitable to produce; those techniques or factors of production will be employed which cost less as indicated by the prices of factors and the commodities will be produced for those sections of the people who have good incomes and are in a position to pay their price.
Hence, in a free capitalist economy, it is the price mechanism which solves the central problems of the economy. Price-mechanism establishes an equilibrium price ‘both in the commodity market and in the factor market. Equilibrium prices in the commodity markets and fact markets are determined through the forces of demand and supply in the various markets.