CA Foundation Business Economics Study Material – Basic Problems of an Economy and Role of Price Mechanism

CA Foundation Business Economics Study Material Chapter 1 Nature and Scope of Business Economics – Basic Problems of an Economy and Role of Price Mechanism

Basic Problems of an Economy

• We know that human wants are unlimited and resources are scarce.
• The problem of scarcity of resources is not only faced by individuals but also by the society at large.
• This gives rise to the problem of how to use scare resources so as to serve best the needs of the society.
• This economic problem is to be dealt with in all the economic systems whether capitalist or socialist or mixed.
• The central problems relating to allocation of resources are:
  • What to produce and how much to produce?
  • How to produce?
  • For whom to produce?
  • What provision should be made for economic growth?

What to produce and how much to produce?

• An economy has millions commodities to produce.
• It has to decide what commodities are to be produced and how much.
• E.g. – To produce luxury goods or consumer goods, etc.
• Here, the guiding principle is to allocate the resources in the production of goods in such a way that maximizes aggregate utility.

How to produce ?

• There are many alternative techniques to produce a commodity. ‘
• Choice has to be made between capital intensive technique or labour intensive technique of production.
• The choice of technique will depend upon —
  • availability of various factors of production, &
  • the prices of factors of production.
• Such techniques of production has to be adopted that makes best use of available resources.

For whom to produce?

• Who will consume the goods and services that are produced in the economy?
• Whether a few rich or many poor will consume?
• Goods and services are produced for those people who can purchase them or pay for them.
• Paying capacity depends upon income or purchasing power.

What provisions should be made for economic growth?

• A society cannot afford to use all its scarce resources for current consumption only.
• It has to provide for the future as well so that high economic growth can be achieved.

Therefore, an economy has to take decisions about rate of savings, investment, capital formation, etc.

Meaning of Economic System

An economic system comprises the totality of forms through which the day to day economic process is at work. It refers to the mode of production, exchange, distributions and the role which government play in economic activity. There are three types of economic systems Capitalism, Socialism and Mixed Economy ‘

CAPITALIST ECONOMY

• Capitalistic economic systems is one in which all the means of production are privately owned.
• The owners of property, wealth and capital are free to use them as they like in order to earn profits.
• The central problems about what, how and for whom to produce are solved by the free play of market forces.

Characteristics of Capitalist Economy:

• There is right to own and keep private property by individuals. People have a right to acquire, use, control, enjoy or dispose off it as they like.
• There is right of inheritance ie. transfer of property of a person to his legal heirs after his death.
• There is freedom of enterprise ie. everybody is free to engage in any type of economic activity he likes.
• There is freedom of choice by consumers ie. consumer is free to spend his income on whatever goods or services he wants to buy and consume.
• Entrepreneurs or producers in their productive activity are guided by their profit motive. Thus profit motive is the guiding force behind all the productive activity.
• There is stiff competition among sellers or producers of similar goods. There is competition among all the participants in the market.
• Price mechanism is an important feature of capitalist economy were the price is determined through the interaction of market forces of demand and supply.

Merits of Capitalist Economy:

• Capitalism works through price mechanism and hence self regulating
• In capitalism there is greater efficiency and incentive to work due to two motivating force namely private property and profit motive.
• Faster economic growth is possible.
• There is optimum allocation of productive resources of the economy.
• There is high degree of operative efficiency.
• Cost effective methods are employed in order to maximise profits.
• Consumers are benefited as large range of quality goods at reasonable prices are available from which they makes the choice. This also results in higher standard of living.
• In capitalism there is more innovations and technological progress and country benefits from research and development, growth of business talent, etc.
• Fundamental rights like right to private property and right to freedom are preserved.
• It leads to emergence of new entrepreneurial class who is willing to take risks.

Demerits of Capitalist Economy:

• In capitalism there is vast economic inequality and social injustice which reduces the welfare of the society.
• There is precedence of property rights over human rights.
• Cut-throat competition and profit motive work against consumer welfare leading to exploitation of consumers.
• There are wastage of resources due to duplication of work and cut-throat competition.
• Income inequalities lead to differences in economic opportunities. This lead to rich becoming richer and poor becoming poorer.
• There is exploitation of labour.
• More of luxury goods and less of wage goods are produced leading to misallocation of resources. .
• Unplanned production, economic instability in terms of over production, depression, unemployment, etc. are common in a capitalist economy.
• Leads to creation of monopolies.
• Ignores human welfare because main aim is profit.

SOCIALIST ECONOMY

The concept of socialism was given by Karl Marx and Frederic Engels in their work ‘The Communist Manifesto’ published is 1848. A socialist economy is also called as “Command Economy” or a “Centrally Planned Economy.”

• In a socialist economy, all the property, wealth and capital is owned by State. There is no private property.
• State organises all economic activities. It owns, controls and manages the production units; it distributes the goods among the consumers; it decides the size and direction of investment.
• The state works for the welfare of the people and not for profit.

Characteristics of Socialist Economy:

• There is collective ownership of means of production Le. all the important means of production are state owned.
• It is a centrally planned economy. All the basic decisions relating to the working and the regulation of the economy are taken by central authority called planning commission.
  • Production and distribution of goods is ensured through planning on preferences deter-mined by the state. So freedom from hunger is guaranteed but, consumer’s sovereignty is restricted.
• There is social welfare in place of profit motive. Those goods and services are given top priority which is in the interest of largest number of people.
  • Price policy is guided by the aims of social welfare than profit motive.
• There is lack of competition because it avoid duplication of efforts and wastage of resources. Hence, competition is done away.
• Socialism tries to ensure equitable distribution of income through equality of opportunities. Thus, right to work is guaranteed but choice of occupation is restricted.

Merits of Socialist Economy:

• Social justice is maintained by equitable distribution of income and wealth and by providing equal opportunities to all.
• Balanced economic development is possible. Central planning authority allocate resources according to the plans and priorities.
• There are no class conflict and community develops a co-operative mentality.
• Unemployment is minimized, business fluctuations are eliminated resulting in stability.
• Right to work is ensured and minimum standard of living is maintained.
• There is no exploitation of consumers and workers.
• Wastage of resources are avoided due to planning resulting in better utilization of resources and maximum production.
• Citizens feel secure as there is social security cover for them.
• Demerits of Socialist Economy:
• There is predominance of bureaucracy resulting in inefficiency and delays.
• There is no freedom of individuals as it takes away basic rights also like right of private property.
• Workers are not paid according to their personal efficiency and productivity. This acts as disincentive to work hard.
• Prices are administered by the state.
• State monopolies may be created and may become uncontrollable. This will be more dan¬gerous than monopolies under capitalism.
• The consumers have no freedom of choice.

MIXED ECONOMY

Mixed economy combines the features of both capitalism and socialism. The concept is designed to incorporate best of both. The main characteristics/features are:—

• There is co-existence of both private and public sector ie. economic resources are owned by individuals and state.
  • State open those enterprises which are in the interest of the’society as a whole.
  • Private sector moves to those enterprises which produce higher profit.
• There is co-existence of free price mechanism and economic planning.
  • Price mechanism is however curtailed through measures like price control, administered prices etc.
  • Planning is done through incentives like concessions, subsidies, etc. and disincentives like high rate of taxes, strict licensing etc.
• In mixed economy social welfare motive gets due importance particularly in case of poor and backward classes.
  Eg. Subsidised hospital, food articles, education etc.; social security schemes like old age pension, reservation of jobs, laws in the interest of workers, consumers, human, children etc.
• There is freedom to joint any occupation, trade or service according to the education, training, skills and ability.
• There is freedom of consumption. People are free to consume goods and services of their choice and in the quantity they can afford.

Merits of Mixed Economy:

• Merits of capitalist economy and socialist economy are found in mixed economy.
• There is right of private property and economic freedom. This results in incentive to work hard and capital formation.
• Price mechanism and competition induces the private sector in efficient decision making and better resource allocation.
• There is freedom of occupation and consumption.
• Encourages enterprise and risk taking.
• Leads to development of technologies through research and development.
• Economic and social equality is more.

However, mixed economy suffers from uncertainties, excess control by state, poor implementation of plans, high taxes, corruption, wastage of resources, slow growth, lack of efficiency, etc. There are possibilities of private sector growing, disproportionately if state does not maintain a proper balance between public and private sectors.