Chapter 2: Central Problems of an Economy

1. Economic Problem
The problem concerning the allocation of scarce resources to different uses is called an eco-
nomic problem. It is essentially the problem of choice or the problem of economical use of
scarce resources.
Core Components:

• Unlimited Human Wants

• Scarce Resources

• Alternative Uses

Causes of Economic Problem:

1. Unlimited Wants: Human wants are unlimited. No man can satisfy all his wants. Wants
of all members of the society cannot be satisfied at a given time.

2. Limited or Scarce Means: Most of the goods that satisfy human wants are limited or
scarce. These goods are scarce because their demand is greater than their supply.

3. Alternative Uses: Limited resources have alternative uses. For example, land is a scarce
resource. It can be used for residential construction, farming, factories, etc.

2. Central Problems of an Economy

Every economy faces three central problems:

I. What to Produce?
The first and foremost problem of every economy is what goods and services should be
produced so as to satisfy the maximum wants of the people. It is concerned with the problem
of resource allocation.

• What to Produce: The economy has to decide what goods to produce (e.g., choice be-
tween consumer goods and capital goods, or war-time goods and peace-time goods).

• How much to Produce: The economy has to decide the quantity. More production of
consumer goods implies less production of capital goods because resources are scarce.

II. How to Produce?

This problem is concerned with the choice of technique of production. It aims at the efficient
use of resources (more production at less cost).

• Labour Intensive Technique: Labour is used more than capital. This leads to higher
employment.

• Capital Intensive Technique: Capital is used more than labour. This leads to higher effi-
ciency.

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III. For Whom to Produce?
Due to limited resources, an economy cannot produce for all sections of society. Every econ-
omy has two sections: the rich and the poor.

• Rich Section → GDP Growth: Producing for the rich yields high profits, leading to more
investment and GDP growth.

• Poor Section → Social Justice: Producing for the poor promotes social justice and reduces
inequality, but profits remain low, meaning less investment and economic slowdown.

Conclusion: There is a problem of choice between social justice and GDP growth.

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3. Solutions of Central Problems in Different Economies
A. Market Economy (Capitalist/Free Economy)
Producers are free to decide what, how, and for whom to produce. Aim: Profit Maximisation.

• What to produce? Goods with high prices (luxuries) to maximize profits.

• How to produce? Adopt techniques or inputs whose prices are relatively low to minimize
the cost of production.

• For whom? For the rich section of society who are willing to offer a high price.

B. Centrally Planned Economy (Controlled/Socialist Economy)

Decisions are taken by a central authority of the government. Aim: Maximizing Social Wel-
fare.

• What to produce? Goods most useful for the society (items of necessity).

• How to produce? Socially useful techniques (e.g., Labour intensive technique to reduce
unemployment).

• For whom? For the weaker section of the society suffering from hunger or starvation,
even if it leads to losses.

C. Mixed Economy (e.g., India)

Decisions are taken based on market forces as well as social considerations. Aim: Profit
Maximisation + Social Welfare.

• What to produce? Private sector produces high-priced goods (luxuries); Government pro-
duces items of necessity.

• How to produce? Both techniques are used. Capital intensive for efficiency, Labour in-
tensive to combat mass unemployment.

• For whom? Private producers produce for the rich; Government produces for the weaker
sections to maximize social welfare.

4. Production Possibility Curve (PPC)

PPC is a curve showing different combinations of two goods which can be produced with the
available resources.
Alternative Names: Production Boundary, Production Frontier, Transformation Line, Transfor-
mation Curve.
Assumptions:

1. Resources are given.

2. Given resources are fully and efficiently utilized.

3. Technology remains constant.

Example Schedule:

Two Basic Properties of PPC:

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 Combinations Burger (Y) Pizza (X)
A 100 0
B 90 1
C 70 2
D 40 3
E 0 4

1. PPC slopes downward: With fuller utilization of given resources, production of both goods
cannot be increased simultaneously. More of Good X can only be produced with less of
Good Y.

2. PPC is Concave to the origin: To produce each additional unit of Good X, more and more
units of Good Y must be sacrificed. The opportunity cost tends to increase (Increasing
Marginal Opportunity Cost).

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Points on and around the PPC:

• Attainable Point: All points ON or INSIDE the PPC.

• Unattainable Point: Any point OUTSIDE the PPC.

• Efficient Point: All points ON the PPC (fuller utilization).

• Inefficient Point: All points INSIDE the PPC (underutilization).

5. Shifting and Rotation of PPC

Change in Resources:

• Increase in Resources: PPC shifts to the right.

• Decrease in Resources: PPC shifts to the left.

Change in Technology:

• Efficient Technology for Good-X: PPC will rotate outward on the X-axis.

• Efficient Technology for Good-Y: PPC will rotate outward on the Y-axis.

• Efficient Technology for both: PPC will shift to the right.

6. PPC and Central Problems

1. What to Produce: PPC shows different combinations. If production of one increases, the
other must decrease.

2. How to Produce: Relates to the choice of technique. Efficient tech = more production.
Inefficient tech = less production.

3. For Whom to Produce: Skewed (unequal) distribution in favour of the rich generates more
surplus/savings for investment, shifting PPC rightward (though it may lead to social un-
rest).

4. Fuller Utilisation of Resources: Points ON the PPC show potential/maximum output with
given resources and technology.

5. Growth of Resources: Supply of skilled labour or increased resources shifts PPC to the
right.

7. Opportunity Cost & Marginal Opportunity Cost

Opportunity Cost:
Opportunity cost is the value of a factor in its next best alternative use.

• Example: Use 1 (Wheat) = Rs 10,000; Use 2 (Rice) = Rs 8,000; Use 3 (Maize) = Rs 7,000; Use
4 (Sugarcane) = Rs 12,000.

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 • If resources are employed in Use 4, the Opportunity Cost is the loss of output in Use 1 (Rs
10,000).

Marginal Opportunity Cost (MOC):

The rate at which output in Use-1 is lost for every additional unit of output in Use-2. It is the
slope of the PPC.
∆Y (loss of output) ∆Q1
MOC = or
∆X (gain of output) ∆Q2

Why does MOC rise? Resources are use-specific. As resources are shifted from Use-1 to Use-2,
their existing specialized use is increasingly disturbed, causing the loss of output to increase.

Calculation Example (Wheat and Cloth):

Wheat (kg) [Y] Cloth (meters) [X] Marginal Opportunity Cost (MOC)
100 0 -
10
90 25 25 = 0.4
20
70 50 25 = 0.8
30
40 75 25 = 1.2
30
10 85 10 = 3.0
10
0 87 2 = 5.0