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 needs 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.
Introduction to Basic Problems of an Economy
1. What to Produce?
Ans: 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?
Ans: 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?
Ans: 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.
4. How Market Mechanisms Solve the Basic Problems of an Economy?
Ans: 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?
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.
Economics was called “political economy” before the beginning of the 20th century
FAQs on Basic Problems of an Economy
1. Explain briefly the basic economic problem of an economy in terms of Microeconomics.
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.
2. Explain briefly the basic economic problem of an economy in terms of Macroeconomics.
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.
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4. What is Economics?
Economics has become one of the most grown fields around the world in the coming years because of the rise of people’s interest in the stock market. Economics is a study in the field of social science. It is to understand and explain the various aspects related to the production and distribution of goods, supply and demand of products, and the creation, consumption and transfer of wealth. The origin of Economics as a subject can be traced back to Adam Smith, referred to as the Father of Modern Economics.
5. What are the two categories of Economics?
Modern Economics is essentially broken down into two distinct types.
The study of economics which focuses on understanding the behaviour of an individual and the consumption that happens on an individual level is called Microeconomics. Macroeconomists attempt to understand and scrutinize the changes that take place on a household and individual level, and their impact on the economic prosperity of a Nation as a whole. Consumer behaviour is given the most importance in Microeconomics. Microeconomics is also considered an important area of study and research to tackle the world problems of poverty and unemployment.
The study of economics that focuses on understanding the behaviour and performance of an economy as a whole is called Macroeconomics. It takes into account the total amount of goods and services produced within an economy, the level of unemployment in the country and the general behaviour of prices rate. Macroeconomics is an important aspect of world politics. Macroeconomists use various aggregates and markers to study the effect and changes that take place. Some of the aggregates include Gross Domestic Product (GDP), Consumer Price Index (CPI) etc.
6. Explain the important types of Economic Systems?
Economic System refers to the system by which a country conducts its trade and business on domestic and international levels. There are four important types of Economic Systems. They are -
Traditional Economic System: It is the most basic form of economic system where goods are sold and bought on a barter system.
Capitalism: As propounded by Adam Smith, it is characterized by an absence of governmental interference and regulation, the existence of private enterprises, and price determination by the forces of the supply and demand curve.
Socialism: It is the complete opposite of Capitalism. It is characterised by governmental intervention, public enterprises, and determination of prices is being state-controlled. Five Year Plans are a commonly used monetary and fiscal policy in Socialist Economic System.
Mixed Economy: Mixed Economy refers to a system that is an amalgamation of Capitalism and Socialism System. It is characterised by the existence of both private and public enterprise, minimal government intervention, and both the government and private sector influence supply and demand policies.
7. Explain the following terms
GDP
CPI
GNP
Poverty Line
GDP: Gross Domestic Product (GDP) refers to the market values of the finished goods and services produced within the geographical boundary of a country. It is an important indicator of the progress of an economy.
GNP: Gross National Product (GNP) refers to the value of all finished goods and services produced by the citizen’s of a country, irrespective of the geographical location.
CPI: Consumer Price Index (CPI) examines the prices of consumer goods and services, such as food, clothing, transportation etc. It is used to measure the cost of living and inflation.
Poverty Line: The poverty Line is used to measure the level of an individual or family income. People belonging below a certain level are considered to be poor according to the Government and require monetary assistance.