The following are the main questions which have been asked by the economists from time to time.
It is worth remembering that all these fundamental questions arise because of the basic problem of scarcity confronting an economy.
1. What goods are produced and in what quantities by the productive resources which the economy possesses?
2. How are the different goods produced? That is, what production methods are employed for the production of various goods and services?
3. How is the total output of goods and services of a society distributed among its people?
4. Are the use of productive resources economically efficient?
5. Whether all available productive resources of a society are being fully utilized, or are some of them lying unemployed and unutilized?
6. Is the economy’s productive capacity increasing, declining or remaining static over time?
The six questions listed above have been the concern of economic theory from time to time. As said above, all of them arise from the fundamental problem of scarcity. All economies whether they are capitalist, socialist or mixed, must take decision about them. Economic theory studies how these decisions are arrived at in various societies.
It is worth mentioning that economic theory has been mainly evolved and developed in the framework of capitalist institutions where free market mechanism plays a dominant role in solving the above basic problems. Therefore, mainstream economic theory assumes free market system and explains how the above six problems are solved by it and with what degree of efficiency.
We shall explain below above six problems and questions in detail and see how they are related to the problem of scarcity.
1. The Problem of Allocation of Resources:
The first and foremost basic problem confronting an economy is “What to produce” so as to satisfy the wants of the people. The problem of what goods are to be produced and in what quantities arises directly from the scarcity of resources.
If the resources were unlimited, the problem of what goods are to be produced would not have arisen because in that case we should have been able to produce all goods we wanted and also in the desired quantities. But because resources are in fact scarce relative to human wants, an economy must choose among various goods and services. Wants for those goods which society decides not to produce will remain unsatisfied. Thus the question of selecting goods for production implies which wants should be satisfied and which ones to be left unsatisfied.
If the society decides to produce a particular good in a larger quantity, it will then have to withdraw some resources from the production of other goods and devote them to the production of the good which is to be produced more. The greater the quantity of a good which is desired to be produced, the greater the amount of resources allocated to that good. The question of what goods are produced and in what quantities is thus a question about the allocation of scarce resources among the alternative uses.
Thus, with the given scarce resources, if the society decides to produce one good more, the production of some other goods would have to be cut down. For instance, at times of war, when the society decides to produce more war goods like guns, jet planes and other armaments, some resources have to be withdrawn from the production of civilian goods and devoted to the production of war goods. Because of the scarcity of resources we cannot have more ‘guns’ and more ‘butter’; some ‘butter’ has to be scarified for the sake of more ‘guns’.
What determines the allocation of resources and what are the results of attempts made to change the allocation has occupied the minds of economists from the very beginning of our economic science. Whatever the type of economy, be it capitalist, socialist or mixed, a decision has to be made regarding allocation of resources.
In a capitalist economy, decisions about the allocation of resources or, in other words, about what goods are to be produced and in what quantities are made through the free-market price mechanism. A capitalist or free-market economy uses impersonal forces of demand and supply to decide what goods are to be produced and in what quantities and thereby determines the allocation of resources.
The producers in a free-market economy, motivated as they are by profit considerations, take decisions regarding what goods are to be produced and in what quantities by taking into account the relative prices of various goods. Therefore, the relative prices of goods, which are determined by free play of forces of demand and supply in a free market economy, ultimately determine the production of goods and the allocation of resources.
The branch of economic theory which explains how the relative prices of goods are determined is called Microeconomic Theory or Price Theory and has been the concern of economists from the earliest days of economics.
2. Choice of a Production Method:
There are various alternative methods of producing goods and a society has to choose among them. For example, cloth can be produced either with automatic looms or with power looms or with handlooms. Similarly, 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, it has to decide whether cloth is to be produced by handlooms or power looms or automatic looms. Similarly, it has to decide whether the irrigation has to be done by small irrigation works or by large canals. 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 relatively more labour and less capital. On the other hand, production with automatic looms uses relatively more capital and less labour. Therefore, production with handlooms is a labour-intensive technique while production with automatic looms is a capital-intensive technique of producing cloth. Thus, a society has to choose whether it wants to produce with labour- intensive methods or capital-intensive methods of production.
More generally, 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 for their production. Scarcity of resources demands that goods should be produced with the most efficient method. If the economy uses its resources inefficiently, the output will be less and there will be unnecessary loss of goods which otherwise would have been available.
The choice between different methods of production by a society depends on the available supplies and the prices of the factors of production. The criterion for the choice of a method of production should therefore be the cost of production per unit of output involved in various methods. We have noted above that economic resources are scarce relative to demand. But economic resources are unequally scarce; some are more scarce than others. Therefore, it is in society’s interest that those methods of production be employed that make the greatest use of the relatively plentiful resources and economizes as much as possible on the relatively scarce resources.
Why one method of production is used rather than another and consequences of the method used are dealt with in the Theory of Production. In the theory of production we study the physical relationship between inputs and outputs. This physical relationship between inputs and outputs along with prices of factors goes to determine the cost of production. Cost of production governs the supply of goods which together with demand for them determines their prices.The theory of production thus becomes a part of microeconomic theory (i.e. theory of price) and will be explained in detail in the present work.
It is worth noting here that the choice of technique of production is dealt with not only in microeconomic theory but is also an important issue in the theory of economic growth. This is because the choice of a production technique determines not only the cost of production of a commodity but also the surplus which can become a source for further investment. The greater the surplus, the higher the rate of investment and therefore the higher the rate of growth of output and employment. An eminent economist. Prof. Amartya Sen, currently of Harvard University, has analysed the choice of technique as an important issue in economics of growth of the developing countries.
3. The Problem of the Distribution of National Product:
This is the problem of sharing of the national product among the various individuals and classes in the society. The question of distribution of national product has occupied the attention of economists since the days of Adam Smith and David Ricardo who explained the distribution of national product between different social groups such as workers and capitalists in a free market society. Who should get how much from the total output of goods and services is a question concerning social justice or equity.
Economists’ interest in this subject has increased very much’ in recent years. It is important to note that the distribution of national product depends upon the distribution of money income. Those people who have larger incomes would have larger capacity to buy goods or to use Prof. Amartya Sen’s phrase, would have larger entitlement for goods and hence will get greater share of output. Those who have low incomes would have less purchasing power to buy things and will therefore be able to obtain a small share of output. More equal is the distribution of income, more equal will be the distribution of national product.
Now, the incomes can be earned either by doing some work or by lending the services of one’s property such as land, capital. Labour, land and capital are factors of production and all of them contribute to the production of national product and get prices or rewards for their contribution. The question as to how the prices or rewards of factors of production are determined is the subject-matter of the Theory of Distribution.
After the marginalist revolution in economic theory, theory of distribution has been boiled down to the theory of factor pricing which is an important part of the price theory or what is now popularly called microeconomic theory. The old division of factors into land, labour and capital is retained in modern economic theory but their old association with ‘social classes’, such as capitalist and working classes as was made by classical economists has been given up.
The theory of distribution viewed as the theory of pricing of factors of production is merely an extension of the theory of price or value. Prof. A. K. Dassgupta rightly remarks “Distribution appears an extension of the theory of value, being just a problem of pricing of factors of production. The two aspects of the economic problem are then integrated into a unified and logically self-consistent system.
Value of commodities is derived in the ultimate analysis from utility, and value of factors derived from productivity imputed by the commodities which they help in producing. The old tripartite division of factors into land, labour and capital is retained but their old association with social ‘classes’ is lost. Factors are conceived as just productive agents independently of the institutional framework within which they operate.”
The theory of distribution viewed as the theory of factor pricing deals with the functional distribution of income rather than the personal distribution of income, since it explains only how the prices of factors, that is, wages of labour, rent of land, interest on capital and profits of entrepreneur are determined. But the question which we raised, namely, “how the national product is distributed among the various individuals that comprise a society” is not fully answered by the theory of functional distribution.
It is the personal distribution of income that determines who would get how much from the national product. Now, the income of a person depends not only on the price of a factor he owns and the amount of work he does but also on how much property or assets in the form of factors of production such as land and capital he owns. Private ownership of the means of production is a sine qua non of the capitalist system.
Therefore, the personal distribution of income is greatly affected by the distribution of the ownership of property. A person who owns a large amount of property will be enjoying a higher income. In the free market capitalist economies because of the large inequalities in the ownership of the property there are glaring inequalities of income. As a result, the distribution of national product is very much unequal in capitalist economies.
In recent years, the governments of the capitalist countries, like U.S.A., Great Britain have taken various steps to reduce inequalities of income and property and have accordingly tried to influence the distribution of national product. Since the distribution of the ownership of property is an institutional factor. We shall, therefore, confine ourselves to the analysis of the theory of functional distribution which is an integral part of the microeconomic theory.
4. The Problem of Economic Efficiency:
Resources being scarce, it is desirable that they should be most efficiently used. It is therefore important to know whether a particular economy works efficiently. In other words, whether the production and distribution of national product decided by an economy is efficient. Having asked what and how goods are being produced and how the total national product is distributed, it is but proper to ask further whether the production and distribution decisions of an economy are efficient ones.
The production is said to be efficient if the productive resources are allocated among production of various goods in such a way that through any reallocation it is impossible to produce more of one good without reducing the output of any other good. The production would be economically inefficient if it is possible by rearranging the allocation of resources to increase the production of one good without reducing the output of any other. Likewise, the distribution of the national product among individuals of a society is efficient if it is not possible to make, through any redistribution of goods, some individuals or any one person better off without making any other person worse off.
It is not enough to allocate resources efficiently for production among goods and distribute then efficiently among individuals for consumption. The achievement of these production and distribution efficiencies will not ensure maximum well-being if the economy is producing goods which do not correspond to the preferences of the people.
For attaining economic efficiency, product-mix, that is, allocation of resources among production of various goods should be in accordance with the preferences of people, given their incomes. If the economy is producing wrong-mix of goods, then through reallocation of resources among them it will be possible to make some people better off without any one worse off.
Economic Efficiency Vs. Technological Efficiency:
It is important to note here the difference between technological efficiency and economic efficiency. Technological efficiency prevails when a firm, industry or an entire economy utilises its available resources fully and most effectively and thereby produces maximum possible output of goods and services with the given amount of resources. That is, a firm or industry or an economy is said to have achieved technological efficiency when it is having greatest possible rates of physical output from available inputs, given the existing technology.
It is worth noting that a society that has achieved technological efficiency, that is, making full and most effective use of its available resources may not have attained economic efficiency. Economic efficiency is achieved by a society only when there prevail efficient allocation of resources between products and also efficient distribution of products between any pair of individuals in a society so that through any re-organisation of production and exchange it is not possible to make some people better off without making any one worse off.
Besides the economy may have achieved technological efficiency in the use of its resources for the production of goods but its pattern of production may not conform to the consumers’ preferences so that there are long queues outside the markets or stores selling commodities whose level of production has been quite insufficient or inadequate as compared to the wants of the consumers for them.
Such was the case in erstwhile USSR before the collapse of communism in late nineteen eighties. In our opinion, it is the failure to achieve economic or allocative efficiency which was the chief economic cause of the downfall of communism in erstwhile USSR and East European countries.
It may however be noted that attainment of economic efficiency also involves the achievement of technological efficiency. This is because if technical efficiency in the use of resources is not achieved, it would then be possible to make some people better off by increasing production through fuller and better utilisation of resources without making others worse off.
Thus with the achievement of economic efficiency a society not only produces the largest possible output with the available resources but also allocates its resources for the production of goods in such a way that conforms to consumers’ preferences. It may be noted that the concept of economic efficiency explained above was put forward by the Italian economist Vilfredo Pareto (1848-1923) and is therefore also called Pareto Optimality.
5. The Problem of Full Employment of Resources:
Whether all available resources of a society are fully utilized is a highly significant question because answer to it would determine whether or not there will exist involuntary unemployment of labour as well as of capital stock. In view of the scarcity of resources to satisfy all wants of the people, it may look strange to ask a question whether or not all available resources of a community are being fully utilized.
This is because resources being scarce, a community will try to use all the available resources to achieve maximum possible satisfaction of the people. Thus a community will not consciously allow the resources to lie idle. But in a capitalist free market society it so happens that at times of depression available resources are not fully utilised.
At times of depression, many workers are rendered unemployed; they want to be employed but no jobs are there for them. At such times, factories which can employ people are there, but they are not working. Thus, at times of depression in capitalist economies, even the scarce available resources are not fully employed.
This question assumed great importance in economic theory during the depression of nineteen thirties when, on the one hand, about 25 per cent of labour force in the USA, Britain and other industrialised countries was rendered unemployed and, on the other, a number of factories representing a lot of capital stock remained idle and unused. How did it come about became a controversial question at that time.
An eminent British economist, J.M. Keynes put forward a different explanation from the then popularly held view advocated by neo-classical economists led by A. C. Pigou. Thanks to J.M. Keynes who in his book “General Theory of Employment, Interest and Money “published in 1936, explained what caused such involuntary unemployment of resources. Keynes’ explanation was that unemployment of labour at that time was found not because money wages were fixed at higher levels by the activities of strong labour unions and intervention of the Government but because of the fall in aggregate effective demand for goods and services.
His theory of deficiency of effective demand causing recession and resulting in involuntary unemployment of labour and underutilisation of capital stock has played an important role in the formulation of economic policies to control fluctuations in economic activity. Keynesian analysis has greatly widened the scope of economic theory and improved our understanding of the working of the capitalist economic system which suffers from large fluctuations in economic activity.
This branch of economic theory which deals with the problem of employment of resources (and thus with the determination of national income) is called Macroeconomic Theory. This macroeconomic theory has been greatly developed beyond the Keynesian perception in recent years and several alternative models of macroeconomics have been put forward.
6. The Problem of Economic Growth:
It is very important to know whether the productive capacity of an economy is increasing. If the productive capacity of the economy is growing, it will be able to produce progressively more and more goods and services with the result that the living standards of its people will rise. The increase in the capacity to produce goods over time is called economic growth. Now, the analysis of the factors on which the rate of economic growth depends has interested economists since the days of Adam Smith who in his book.
“An Enquiry into the Nature and Causes of the Wealth of Nations “threw light on the subject. But after the classical economists and with the advent of marginalism the economists’ interest in the problem of economic growth almost disappeared and the marginalist theory of relative prices and resource allocation with its emphasis on scarcity and choice occupied the central position in economic theory for a long time. In the thirties and forties, with the publication of Keynes’ General Theory of Employment, Interest and Money, the problem of depression and business cycles occupied the minds of the economists.
But the need for balanced equilibrium growth rate in the developed capitalist countries on the one hand and the urge to remove mass poverty, hunger and chronic unemployment in the developing countries after their achievement of political independence have once again aroused the interests of economists in the problems of economic growth and numerous growth and development models have been put forward.
Some of these growth models such as Harrod- Domar model. Neo-classical growth models of Solow and Swan, Cambridge growth models of Kaldor and Joan Robinson etc. have been propounded to explain and analyse the growth problem of the industrialised developed countries. Likewise, to initiate and accelerate the process of growth in developing countries, the various theories and models of growth and development have been offered.
However, it is worth noting that till 1980s the concept of economic development generally implied the active intervention of the government and the public sector in the field of production. And, with the fall of communism in the USSR and East European countries and dismal experience of the working of public sector in the developing countries, the trend all over the world today is to adopt market friendly approach to development. To what extent free-market economy approach would generate greater economic growth and ensure economic efficiency in the developing countries, only the future will tell.
Two Views about Development Economics:
However, it is worth mentioning that in the scope of development economics today we are not only concerned with the promotion of growth of GNP (gross national product) and raising standards of material living of the people at the present but also with bringing out the adverse and disastrous consequences of depletion of natural resources.
Besides, economists are also interested in preventing environmental pollution which occurs through reckless industrialisation and economic growth. If the interests of the future generation are to be promoted, the resources, especially energy resources, have to be conserved and also if quality of life has to be improved, the environment has to be protected and saved from pollution.
It is with this regard that the concept of sustainable growth or sustainable development has been put forward which implies that if severe damage is done to the environment and resources and if because of reckless industrialisation resources are not conserved for future, economic growth in the future will be limited.