Basic Problems of an Economy

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Explain Briefly the Basic Economic Problem of an Economy

The fundamental problem in economics is the issue with the scarcity of resources but unlimited wants. Economics has also pointed out that a man's need cannot be fulfilled. The more our needs are fulfilled, the more wants we develop with time. By definition, scarcity implies a limited quantity of resources. As a result of scarcity, there is constant opportunity cost. Opportunity cost means that if you use your resources to consume a particular good, you cannot consume any other good with the given resource. Therefore, economists are concerned with dealing with the optimum allocation of resources in society to make the usage of these resources efficient as well as practical. 

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Introduction to Basic Problems of an Economy

1. What to Produce? 

No country can produce all the goods because there are limited resources available to them. Therefore, a choice has to be made between the different types of commodities that a country can produce with its available resources. For instance, a farmer who has a piece of land can produce either wheat or rice. Similarly, the government of a country needs to decide where to allocate its resources whether in consumer goods or defence goods or both, if both, then what will be the proportion of allocation of resources in the two categories of goods.

2. How to Produce?

This economic problem is concerned with the technique of producing a commodity. This problem arises only when there is more than one way of manufacturing goods. The techniques of production can be classified into two broad categories:

  • Labour Intensive techniques (extensive use of labour)

  • Capital Intensive techniques (extensive use of machinery)

Labour intensive technique is known to promote employment, whereas capital intensive techniques promote growth and efficiency in manufacturing.

3. For whom to Produce?

All wants of people in a society can not be satisfied. So, a decision has to be made on who should get the amount of total output of goods and services produced. Society decides on the amount of luxury and standard goods that have to be produced. The further distribution of these goods directly relates to the purchasing power of the economy. 

How market mechanisms solve the basic problems of an Economy?

All the three kind of economies, Capitalistic economy, Socialistic economy and Mixed economy, solve the basic problems of an economy in two methods:

  • Free price mechanism 

  • Controlled price system which is also called State intervention

The Basic Problem of an Economy and Free Price Mechanism

A system of guiding the decisions of individuals within an economy through the price which is determined with the help of market forces of demand and supply is called price mechanism. This system is free of any government intervention. When the market equilibrium is reached by market forces of demand and supply, i.e. the quantity supplied becomes equal to the quantity demanded, then the price of a commodity is determined. Price mechanism also facilitates the determination of resource allocation, consumption and production as well as determining the level of savings and factor income. This method mostly takes place in a capitalistic economy.

The Basic Problem of an Economy and State Intervention System

This system is defined by administering the fixed prices of every commodity. In a socialist economy, the government plays a vital role in determining the price of commodities. Ceiling price or floor price may be introduced by the government to regulate the prices of certain commodities.

Explain Briefly the Basic Economic Problem of an Economy in India

In India, the basic economic problems are

  • What to produce?

  • For whom to produce?

  • How to produce?

Starting in the early 1950s, India adopted a system of a mixed economy. The basic problem of economics is solved with the help of a mixed economy in India. A Mixed economy is a system where the private and public sectors co-exist. In other words, a mixed economy is a blend of a capitalist and socialist economy. In mixed economies, all the economic problems are solved with the help of free as well as controlled price mechanisms. 

Did you know?

  1. Singapore is the most unique economy. Singapore’s economic success can’t be explained by one single economic theory. It is the greatest example of combining extreme features of capitalism and socialism for a successful economy. 

  2. Economics was called “political economy” before the beginning of the 20th century.

FAQ (Frequently Asked Questions)

Q1. Explain briefly the basic economic problem of an economy in terms of Microeconomics.

Ans: In Microeconomics, the economic problems are:

  • The problem of Externalities: Some economic decisions have external effects on other people who are not involved in that transaction. These are called externalities. Externalities usually are solved through government interventions. For instance, taxes on negative externalities, e.g. sugar tax and subsidies on positive externalities, e.g. free public education.

  • Environmental Issues: Economics is concerned with utility (satisfaction) maximisation and therefore ignores long term environmental sustainability. 

  • Inequality and Poverty: Inequality is an unfair distribution of resources which is also one of the factors causing poverty.

  • Monopoly in the Market: Adam Smith, in his book "Wealth of Nation", talks about Monopoly. Some firms gain enough power to charge high prices from consumers because of the lack of alternatives available to consumers. This is called Monopoly.

Q2.  Explain briefly the basic economic problem of an economy in terms of Macroeconomics.

Ans: In Macroeconomics, the economic problems are:

  • Recession: A period of negative growth is called a recession. Recession highlights the already existing problem of inequality and unemployment in an economy.

  • Inflation: If prices rise faster than wages and interest rates, it causes a serious problem. The purchasing power of people declines when inflation rises. 

  • Balance of Payment (BOP) or Current Account Deficit: When the economy imports more commodities than it exports, the current account deficit on balance of payment arises. 

  • Exchange Rate Volatility: Since the exchange rate or forex changes with time, it becomes difficult to decide due to the volatility of the exchange rates.