CENTRAL
PROBLEMS OF AN ECONOMY
Scarcity
is the root cause of all economic problems. We know that resources are scarce
or short in supply in relation to demand; but wants or ends are unlimited. As a
consequence, we face the problem of choice among so many of our wants. This is
because scarce means have alternative uses. Thus, we have to choose among the
most urgent and less urgent wants. In fact, the basic problem of an economy is
the problem of choice. More precisely, problem before us is to take right
decisions in regard to the goals or ends to be attained and the way, the scarce
means to be utilized for this purpose. Every economy faces some fundamental
problems called as central problems of an economy. These are the following:
(1) What goods and services are to be produced?
The first major problem faced by an economy is what types of goods and services
to be produced. As resources are limited, we must choose between different
alternative collection of goods and services that may be produced. It may also
imply whether to produce capital/producer goods or consumer goods. Moreover, we
have to decide about the quantity of the goods to be produced in the economy.
(2) How to produce these goods and services?
The next problem we have to tackle is the problem of how to produce the desired
goods in the economy. Thus the question of techniques to be used in the
production comes in the mind. Whether we should use labour-intensive technique
or capital – intensive technique. Labour-intensive method of production implies
more use of labour per unit than capital whereas; capital-intensive technique
indicates more use of capital per unit than labour. The choice depends on the
availability of resources. A labour surplus economy can well use the
labour–intensive technology.
(3) For whom these goods and services are to be
produced? Once we have decided what goods to be produced and what techniques to
be used in the production of goods, we are encountered with another problem,
i.e., the problem of distribution of goods in the economy. This is the problem
of sharing of national income.
(4) Are the resources efficiently used? We have
also to see that scarce resources are efficiently utilized. This is the problem
of economic efficiency or welfare maximization.
(5) Are the
resources fully employed? An economy must also try to achieve full employment
of all its resources.
(6) How to
attain growth in the economy? An economy is to ensure that it is attaining
sufficient growth rate so that it is able to grow larger and larger and develop
at faster rate. It should be able not only to make a structural change from
agrarian to industrial sector but also to increase per capita and national
income of the country. An economy must not remain static. Its productive
capacity must increase continuously.
It is clear that the basic problem of an economy is the
economizing of resources. The economizing problem arises in every type of
economic society owing to the fact that resources are scarce in relation to
multiple wants/ends.
PRODUCTION POSSIBILITY CURVE
The production possibility Curve is a graph that depicts
the trade-off between any two items produced. It is also known as
Transformation Curve or Production Frontier, which shows the maximum feasible
quantities of two or more goods that, can be produced with the resources
available. In other words, it indicates the opportunity cost of increasing one
item’s production in terms of the units of the other forgone. Prof. Samuelson
analyzed the economizing problem by the use of production possibility curve.
Thus, a PPC shows the maximum obtainable amount of one
commodity for any given amount of another commodity, given the availability of
factors of production and the society’s technology and management skills. The
concept is used in macroeconomics to show the production possibilities
available to a nation or economy, and also in microeconomics to show the
options open to an individual firm. All points on a production possibilities
curve are points of maximum productive efficiency or minimum productive
inefficiency: resources are allocated such that it is impossible to increase
the output of one commodity without reducing the output of the other. That is,
there must be a sacrifice—an opportunity cost—for increasing the production of
any good. All resources are used as completely as possible (without the
situation becoming unsustainable) and appropriately. The production possibility
curve does not remain stationary. It moves outward overtime with growth of
resources and improvement in technology. This is because we get more output
from the same quantities of resources. The table below illustrates production
possibilities of a simple economy producing two commodities—cars and computers.
Two production possibilities–E and F are shown. When the economy decides to put
more resources for the production of computers, it must sacrifice some
resources from the production of cars. Thus, when 10000 computers are decided
to be produced, 5000 cars cannot be produced as the resources are now diverted
to the production of computers.
|
Production
|
Computers (in
|
Cars (in
|
|
possibilities
|
000’s)
|
000’s)
|
|
|
|
|
|
E
|
5
|
15
|
|
F
|
10
|
10
|
|
|
|
|
The below diagram derived from the
table above, shows the production possibility curve. If all resources in the
economy are utilized in the production of cars, OA units of cars can be
produced.
On
the other hand, if all resources are put in the production of computers, OB
units of computers would be produced in the economy. Joining points A and B, we
get production possibility curve AB. In case, the economy decides to produce
both the commodities by using the available resources, it can produce various
combinations of cars and computers by staying on the curve AB, such as at E or
F. At point E, it can produce OS units of cars and OT units of computers.
Similarly, at F, ON units of cars and OM units of computers can be produced.
Thus, the points E, F or any other point on curve AB show maximum feasible
combinations of cars and computers which can be produced with the resources
available. Point C in the figure is not attainable or feasible for the economy
as it is above the production possibility curve AB, i.e., beyond the capacity
of the economy. Again, it will not produce at point D which is though
attainable but not desirable, because in that case the economy’s resources will
not be used most effectively.
It
is, thus, seen that to produce more computers, some units of cars are to be
sacrificed, i.e., cars can be transformed to computers. The rate at which one
product is transformed into another is called marginal rate of transformation (MRT). Thus, MRT between cars and
computers is the units of cars (in our case, 5000), which has to be sacrificed
for the production of computers. MRT increases, as more of one commodity is
produced and less of another. This makes Production Possibility curve concave
to the origin.
Uses of
Production Possibility Curve
The production possibility curve has
a number of uses. It helps in finding the solution of the basic problems of
production—what and how to produce and for whom to produce goods in the
economy. Besides, whenever government decides to divert its resources, say,
from necessaries to luxuries, it may utilize the concept of production
possibility curve. It can also help in guiding the diversion of resources from
current consumption goods to capital goods and increase productive capacity to
attain higher levels of production.
OPPORTUNITY COST
Opportunity
cost is a term which means the cost of something in terms of an opportunity
foregone (and the benefits that could be received from that opportunity), or
the most valuable foregone alternative. In other words, the opportunity cost of
a given commodity is the next best alternative cost or transfer costs. As we
know that productive resources are scarce, therefore, the production of one
commodity means not producing another commodity. The commodity that is
sacrificed is the real cost of the commodity that is produced. This is the
opportunity cost. Let us explain this with an example. Suppose a producer can produce
a car or a computer with the money at his disposal. If the producer decides to
produce car and not computer, then the real cost of the car is equal to the
cost of computer, i.e., the alternative foregone. Let us take another example
to explain the concept. For example, if a company decides to build hotels on
vacant land that it owns, the opportunity cost is some other thing that might
have been done with the land and construction funds instead. In building the
hotels, the company has forgone the opportunity to build, say, a sporting
center on that land, or a parking lot, or a housing complex, and so on. In
simpler terms, the opportunity cost of spending a day for picnic with your
friends could be the amount of money you could have earned if you had devoted
that time to working overtime.
Opportunity
cost need not be assessed in monetary terms, but rather, is assessed in terms
of anything that is of value to the person or persons doing the assessing. The
consideration of opportunity costs is one of the key differences between the
concepts of economic cost and accounting cost. Assessing opportunity costs is
fundamental to assessing the true cost of any course of action. The simplest
way to estimate the opportunity cost of any single economic decision is to
consider, “What is the next best alternative choice that could be made?” The
opportunity cost of paying for college fee could be the ability to buy some
clothes. The opportunity cost of a vacation in the Goa could be the payment for
buying a motorbike.
It
is to be noted that opportunity cost is not the sum of the available
alternatives, but rather of benefit of the best alternative of them.
The
concept of opportunity cost can be explained with a diagram that depicts
opportunity cost between any two given items produced by a given economy. It is
known in economics as the production possibility curve, as shown in Fig. 2.1
above. In the imaginary economy discussed above which produces only cars and
computers, the economy will be operating on the PPC if all resources (inputs)
are fully utilized and used most appropriately (efficiently). The exact
combination of cars and computers produced depends on the mechanisms used to
decide the allocation of resources (i.e., some combination of markets,
government, tradition, and community democracy).
The
concept of opportunity cost has become very popular in the recent years. The
modern analysis of cost-benefit analysis is based on the theory of opportunity
cost only. The cost-benefit analysis is a guiding tool for entrepreneurial
decisions in the modern economy. Although opportunity cost can be hard to
quantify, its effect is universal and very real on the individual level. The
principle behind the economic concept of opportunity cost applies to all
decisions, not just economic ones.
