Functions of an Economic System!

Functions of an Economic System

No economy is free from economic problems. Even the richest nation of the world experiences alternating crises. Why? The answer is that the resources to satisfy growing needs of the people are limited in nature. In brief, the answer is ‘scarcity’. That is why an economy has to make a large number of choices. In fact, scarcity and choice go hand in hand.

Scarcity and choice are at the heart of economic activity. One observes interaction between scarce resources and unlimited human wants. Scarcity arises when resources for producing goods and services that people desire are insufficient to meet all our wants. Scarcity is not to be confused with poverty.

Scarcity occurs both among the rich and the poor. “Scarcity is a fact of life, just as is gravity. And just as physicists did not invent gravity, economists did not invent scarcity.” Faced with scarcity, an economy has to make a large number of choices among the available alternatives.


All economic choices can be presented in terms of five basic economic questions.

In other words, every economic system, irrespective of its nature, must carry out the following five functions:

1. What goods and services are to be produced? This is called ‘allocation problem’.

2. How are these goods and services produced? This is called ‘production problem’.


3. For whom are these goods and services produced? This is called ‘distribution problem’.

In short, these three problems are called the ‘What’, ‘How’, and ‘For whom’ questions.

These problems can be presented in the form of a table:

Three Basic Economic Problems

In addition to this trio, we face two other problems that require to be addressed here:


4. Are the country’s scarce resources being fully utilized or are some of them lying idle? This is the problem of ‘resource utilization’.

5. Is the productive capacity of an eco­nomy growing or remaining static over time? This is known as the ‘problem of economic growth’.

The first question is concerned with the allocation of scarce resources among alternative uses. We need variety of goods. Because of resource scarcity, we cannot produce all of them at a time. We must take decisions in accordance with the targets and priorities of needs.

For example, if a country decides to produce more nuclear bombs, given the problem of scarcity of resources, it must give up the production of another commodity, say, and wheat. Hence, a “trade-off” is involved.

It may be pointed out here that this allocation problem or the decision of ‘what to produce’ is examined in ‘microeconomics’.

The second question is related with the technique of production. There are a variety of methods to produce goods and services. Usually, there are two techniques of production to produce a commodity in certain amount—they are labour-intensive technique, and capital-intensive technique.

Normally, production of simple, unsophisticated consu­mer goods requires labour-intensive technique of production, while production of iron and steel, etc., demands capital-intensive method of production. But, strict adherence to these rules is neither possible nor desirable.

Therefore, the choice of a right technique of production is crucial since the output has to be maximized or the cost of production has to be minimized. It is suggested that a country must choose that technique of production that can produce goods and service in a ‘least possible cost’ manner.


The third problem is connected with the problem of distribution of goods and services among the various members of the society. Given the resource constraint, an economy cannot produce enough goods for all members of a society. Thus, distribution is of great importance.

The economy must specify the mechanism by which goods and services already produced is distributed. Clearly, the distribution of the given output is settled by the purchasing power of the demanders. People with high (low) income have the largest (poorest) purchasing power. Thus, we are interested in determining the incomes or prices of different input services.

People having larger efficiency, skill and knowledge or enjoying a greater amount of properties (or resources) earn more incomes and thus enjoy larger amount of goods and services. Simply, it is said that higher ‘money’ votes enable people to consume more goods. In fact, an economy produces more goods and services for people with ‘more money’ than people with ‘less money’.

The fourth problem is connected with the utilization of resources. We know that a society does not have adequate resources to produce every kind of goods that a people want, even if these resources are efficiently utilized. But a free enterprise capitalistic economy may exhibit unemployment or underemployment of resources—men and machines may remain idle.


This means wastage of resources. A capitalist economy can never utilize its resources fully. Resources remain involuntarily unemployed there. This causes national output to decline. In other words, actual production falls short of target or anticipated output.

This is really a problem of macroeconomics. John Maynard Keynes (1883-1946), in the 1930s, searched the causes for unemployment of resources and gave suggestions to control unemployment, mainly through government action.

The fifth problem is associated with the problem of economic growth.

An economy must grow over time. It remains static if national income, investment, employment, price level, etc., grow at the same rate year after year. No economy is a static one. Every economy tries to achieve a higher growth rate hitherto not attained through technological improvement and other means such as increases in the quantity and quality of inputs.


Every economy, irrespective of its nature, must face these problems. There is no escape route to avoid all these problems since scar­city and choice are at the heart of any eco­nomic activity. All the economies—primitive economy, feudal economy, customary economy, capitalist economy, socialist economy, or mixed economy—address these problems.

Note that the first three questions are concerned with the allocation of scarce re­sources, production and distribution of goods and services or income among the members of the society.

Since we are basically con­cerned with the market economy these basic questions are solved by price mechanism. These questions are handled under the head­ing “price theory”, popularly known as “microeconomics”. The last two questions are addressed in “macroeconomics”.

Illustrating Economic Problems: The Production Possibility Curve (PPC):

Now we will illustrate these central economic problems in terms of a diagram. A curve— called the production possibility frontier (PPF)—will be used here to show how choice is made among scarce economic alternatives.

Every society has to decide WHAT goods and services are to be produced, HOW to produce, and FOR WHOM to produce—given the stock of resources. Let us consider a hypothetical economy where all resources— land, labour, capital, and organization—are used to produce two goods: food and clothing. Various possible combinations of output of these two goods can be represented by the production possibility curve (PPC).

A PPC (or a PPF) shows all the possible combinations of two goods which a country can produce if available resources are fully and efficiently employed. Thus, the PPC has meaning for a full employment, maximum efficiency economy in terms of both the prevailing state of technology and quantity and quality of available resources. This is illustrated in (Fig. 1.1).


The Production Possibility Frontier

The production of food is measured on the vertical axis and the production of cloth is measured on the horizontal axis. OA amount of food can be produced with all its resources fully employed if no cloth is produced. On the other hand, if the country decides to produce cloth only using all available resources fully, it can produce maximum OB amount of cloth; no food will be produced.

But with the existing stock of resources and the level of technology, a country produces combinations of both the goods. If all the different output combinations of two goods—food and cloth— are joined together, we get the curve AB. AB is the PPC or PPF.

The PPC or PPF itself describes the production or the supply side of an economy. All points on the PPC represent combinations of food and cloth that a country can produce given the full employment of the country’s productive resources and technology. If a country should decide to raise cloth output (from OC1 to OC2) then the curve AB shows that this could be achieved only by reducing food output (from OF1 to OF2).

The reduced food output is the opportunity cost of producing more cloth output. The quantity of food that is sacrificed is called the opportunity cost of producing more cloth. The PPC, thus, shows that each increase in the output of one good involves a sacrifice or a decrease in the production of another good, given the full employment situation.

As scarcity involves choices, economists say that ‘there cannot be free lunch’. One may indeed get ‘lunch’ without paying any price! Your office, after remarkable performance, may provide today’s ‘lunch’ to all staff. Even then, there is a ‘cost’ to someone—ultimately to the society in which we live. An economy unarguably faces resource scarcity that can be used for producing other commodities.


In other words, in making the ‘lunch’ available, either we sacrifice production of food for more cloth output, or we sacrifice cloth output for additional unit of food output. This sacrifice is called ‘opportunity cost’ by economists. To get more of one commodity, we sacrifice the opportunity of getting another commodity.

Now, we can say that the PPC illustrates scarcity and choice. It can explain the WHAT, HOW, and FOR WHOM problems that an economy faces.

The PPC shows the maximum production of two goods with given resources. If the society decides to have more cloth output, it will lie close to point B. If the society plans to produce more food-grains, it will be nearer to point A.

How much food and cloth output will be produced using the available resources greatly depends on the demand for these two items. Production will be made in accordance with the demands for the products. Any production combination below or inside the curve AB is attainable, but it represents an inefficient use of resources.

Point N suggests that as the resources are not fully and efficiently utilized, society enjoys fewer outputs. Consider point M that lies outside the PPC. This is an impossible combination as the nation does not have enough resources to produce those quantities of food and cloth. Thus, the PPC describes what goods and services are to be produced and in what quantities.

All points on the PPC describe that society’s resources are optimally utilized. As these points on the curve represent maximum amount that can be produced with full employment of resources, these points describe efficient combinations.


The PPC highlights the second problem— the problem of choosing appropriate technique of production. All kinds of technique do not produce the same level of output. Some techniques are more efficient than others in the sense that the former produces larger quantities at lower costs.

If the technique of production is deemed to be inefficient, resources will not be fully or optimally utilized. Inefficient techniques result in lower output. Point N on the PPC describes inefficient outcome, given the resources available in the economy. If the technique of production is an efficient one, the society will then stay on the curve AB.

However, the choice of a certain technique of production crucially depends on the availability of resources.

In a labour-abundant country, labour-intensive technology may be chosen while, in a capital-rich country, capital- intensive technology may be recommended. However, such clear-cut decisions may not be advisable at face value. Other relevant factors must be taken into account while selecting a right technique of production.

However, the PPC cannot describe the ‘FOR WHOM TO PRODUCE’ problem directly.

Let us talk about the fourth problem. Whether an economy’s resources are fully utilized or not can be read from the PPF. Any point inside the AB curve indicates lower volume of outputs of both food and cloth compared to points on the curve AB. Point N indicates inefficient use of resources or a failure to use all the resources that are available.


In other words, lesser outputs are available inside the PP curve because of underutilization of resources.

Resources may not be fully employed. Some people may remain unemployed, or some lands may remain uncultivated, or some production facilities may not be optimally used. Further, resources may be used inefficiently. If wrong input combinations are chosen, an economy may produce less than the full employment output.

The fifth problem can also be explained in terms of PPF. If a country stays on the curve AB drawn in Fig. 1.1, then the productive capacity of the society becomes static. As a result, the problem of scarcity- gets magnified more and more as time progresses. Thus, it cannot move to point M of (Fig. 1.1).

What is required is the increase in production and productivity so that the scarcity problem can be lessened. This means the shifting of the PPC outwards. There are three main ways through which an economy’s capacity to produce can be raised.

These are:

(i) Growth of capital stock

(ii) Improvement in technology

(iii) Population

With given stock of resources, an economy has the production potential represented by the curve AB in (Fig. 1.2). Suppose, capital accumulation takes place. As a result, the AB curve will shift out to A1B1 indicating larger output of food and cloth.

Shifting of the PPF

Similarly, improvement in technology as well as a rise in labour force consequent upon the population growth will shift the entire curve to the rightward direction. However, there is no reason to believe that the PPC will shift parallelly in the upward direction.

The PPC may also shift downward. Suppose, an earthquake or flood has taken place. As a result of such natural disaster, the economy will experience fewer resources, such as breakdown in transport and communication system. All these will shift PPC downward indicating lower outputs of both the goods.

Shape of the PPC:

The PPF is a bowed out curve or concave from above. This shape is due to the operation of the law of diminishing returns or the law of increasing opportunity cost, that is, the sacrifice of a next best alternative. A small increase in food output indicates a reduction in the output of cloth or a fall in food output is the opportunity cost of a larger cloth output.

However, a society’s food output increases because inputs required for the cloth production are transferred to food production. Now, more and more employment of a resource in food output will result in a decline in its marginal productivity. This means an increase in cost. Hence another name of law of diminishing returns is the law of increasing opportunity cost.

Consider point A on the curve AB of (Fig. 1.1). If a nation decides to produce OC1 of cloth, it should sacrifice AF1 amount of food output. Production of more cloth demands an additional F1F2 amount of food output to be sacrificed, and so on.

As the society decides to produce more cloth, it will have to sacrifice food output. It is clear from the figure that gradually marginal product of input needed for food production declines. This indicates F3F4> F2F3> F1F2. In other words, the rate of substitution between food and cloth is diminishing and, hence, the PPC is concave to the origin.

If the PPC becomes a straight line, it will reflect a fixed rate of substitution between food and cloth. In other words, for a straight line PPC, opportunity cost remains unchanged. This is said to be the case of constant opportunity cost.

The slope of the PPF drawn in (Fig. 1.1) is OA/OB. It measures the opportunity cost in terms of food of producing 1 extra meter of cloth. The slope of the PPC is often called marginal rate of transformation (MRT) of food into cloth or of cloth into food. For a straight line PPC, MRT is unchanged, and for a convex PPC, the slope i.e., MRT increases and, hence, opportunity cost increases.