Unit 1

FUNDAMENTAL PROBLEMS OF ECONOMIC SYSTEMS

AN ECONOMIC SYSTEM

Concept of Scarcity
“Scarcity” lies at the root of all economic activity. The concept of
scarcity finds an expression in two basic facts of economic life,
A. Unlimited wants or ends,
B. Scarce resources or means.

A. UNLIMITED WANTS OR ENDS

Every person has some wants. If they are not satisfied, the
person concerned feels a ‘pain' which may be physical or
psychological or both.
These two characteristics of wants, namely
i) recurrence of wants satisfied earlier,
ii) ii) emergence of new wants, mean that human wants are
unlimited and keep increasing.
B SCARCE MEANS OR RESOURCES
Fulfillment of wants requires resources ‘
Availability of resources is limited in relation to requirements. This
basic fact is common to all individuals, all groups and all societies
Scarcity is a situation in which the available resources fall short of
requirements.
Satisfaction of wants of an increasing scale requires
two-fold strategy:
1) Means provided by nature are insufficient for
satisfying all wants of the members of the society.
Therefore, their availability must be increased in
possible ways
2) all wants of all people cannot be satisfied.
Therefore, some system has to be devised whereby
more important and more urgent wants are identified
out of the total and are given priority.
 It implies that the use of resources has to be
'Economised'—which means that the resources
cannot be wasted or put to less important uses.
An Economic System or Economy
An economic system is the structured mechanism
through which a society organizes its production,
distribution, and consumption of goods and
services.
Every society is faced with an unending problem
of scarcity of means in comparison with their
need to satisfy the ever-increasing and unlimited
wants.
So, every society tries to increase the availability
of the means on one hand and to economies
their use on the other
For this purpose, various institutions, methods
and arrangements are devised, and they, in their
totality, are called an ‘economy' or an economic
system'. The precise nature of an economic
system differs from society to society.
Economic Entities
Economic entities are the decision-making units of an
economic system. such economic units as individuals,
households, business firms and companies, institutions,
and various organs of State.
They undertake a variety of decisions while acting in
different capacities, such as consumers, savers,
investors, buyers of inputs, suppliers of goods and
services, borrowers, lenders and so on.
It is the decisions and activities of economic entities
which comprise the working of an economy and
determine its health and efficiency.

Factors of production or production

resources
Production' implies the transformation of various
inputs into outputs
Items which are so transformed are called inputs
output is nothing but the transformed form of inputs.
A particular transformation is production if the want-
satisfying capacity of the output (also called 'product')
is more than that of its inputs.
production is nothing but the creation of utility.
utility means the expected satisfaction which the
consumer . Utility will be different from One person
two another

Factors of production are the essential inputs used to create goods and services. In
economics, these are categorized into four core resources:

land (natural resources),

labour (human effort),

capital (machinery and tools),

entrepreneurship or organisation (the drive to combine the other three for profit).
Land

The term ‘Land’ does not represent just the area available for
cultivation, factories, houses, roads, etc
land includes not only the land used for agricultural or industrial
purposes, but also all the natural resources taken from above or
below the soil.
land represents the sum total of natural resources available to the
economy
.supply of land is fixed.
It is predetermined by nature,
man cannot add to it through his own efforts..
Land has no mobility.
Land cannot be transferred from one place to another. But its use
can be transferred; a plot of land can be used either for paddy or for
jute.
land is a free gift of nature, an individual may not get the land free
of cost. He has to pay some money and buy it. Market price to land
comes into existence as a result of economic arrangements like
private ownership and inheritance. Being scarce in supply, its
ownership and possible use generate a price, which is normally called
‘rent’.

labour
In economics, the term labour is used to denote any
manual or mental activity undertaken in exchange for
a payment.
This concept of labour, however, is confined to only
human effort and the work performed by animals and
machines is not considered as labour.
labour cannot be separated from the person of the
labourer and used as an input.
its performance cannot be postponed.
If a labourer does not work during one month, then the
labour of that period cannot be performed in future.
Labour not performed is labour lost forever

SIZE OF LABOUR
Labour is not a homogeneous factor of production.
There are a large variety of workers, both skilled and
unskilled. Depending upon their health, general
intelligence, age, social background, the extent of
education etc.
Different workers have different productive capacities
for a given job. Similarly, each worker is not equally
productive in different jobs. His capacity to work
changes when he shifts from one kind of work to
another. This difference is more among skilled labour. A
skilled worker is educated and trained for a specific job.
Each kind of skilled job requires specific education and
training.
For this reason, labourers require additional training
and education when they are shifted from one type of
skilled work to another. If we ignore migration of
workers from one country to another, the population of
a country becomes the only source of its total labour
force. But its size of labour force is influenced by other
causes also, such as the proportion of persons in
different age groups, social customs, attitudes, etc.
Size of labour force refers to the number of persons
who are able and willing to work.
Work force is that part of labour force which gets
employed.
QUALITY OF LABOUR
This concept denotes two aspects:
i) the intensity with which a worker works,
ii) ii) the maximum efficiency which that worker
can achieve.
 Capital: Includes human-made goods used to produce
other goods, such as machinery, computers, tools, and
factories . Its income is earned as interest
Money raise to operate and expand the business.
Financial capital is the money that is used to generate
income or invest in a business.
Borrowed capital (LOAN) – Money borrowed from
friends, family or the bank. This money needs to be
paid back, with interest.
Own capital – The owners own money that the owner
has saved up or inherited and that the owner invested
in the business.
Other forms of capital: Capital also refers to machines,
factories, roads, infrastructure, schools or office
buildings which people have made in order to
produce better goods and services, more efficiently.
Capital goods have the following features: They can
be used in the productions of other goods. They are
human made. They are not used up immediately in
the process of production, unlike raw materials. They
are stock items and their value can be calculated at
the point of time.
ENTREPRENEURSHIP
An entrepreneur is someone in the community that
identifies needs and wants and finds a way of using
the other factors of production (natural resources,
labour and capital) to provide for those needs and
wants. Entrepreneurs take calculated risks and absorb
the profits or the losses of their enterprises.
Entrepreneurship is the human effort that takes on
the risk of bringing labour, capital and natural
resources together to produce goods and services.
Qualities of entrepreneurs:
- Hardworking
- Prepared to take risks
- Innovative –
Prepared to persevere
- Good with people
- Motivated –
Able to work on their own

FUNDAMENTAL OR CENTRAL PROBLEMS OF AN

ECONOMY
The four basic economic problems arise from scarcity.
Every society must decide: what to produce (which
goods), how to produce (what methods to use), for
whom to produce (how to distribute output), and how
to manage economic growth to balance current
consumption with future needs.
1. What to produce?
Since resources are limited, societies cannot produce
every desired good or service. An economy must
prioritize and choose which goods and services to
create, and in exactly what quantities, to best satisfy
collective wants

2. How to produce?
This involves choosing the optimal combination of
resources and technology to minimize costs and
maximize efficiency. Producers must decide whether to
use a labour-intensive method (employing more
workers) or a capital-intensive method (using more
advanced machinery and automation).
3. For whom to produce?
This addresses the distribution of the produced goods
and services among the members of society. Because
not everyone can satisfy all of their wants, an economy
must establish mechanisms (such as income
distribution based on purchasing power or state
welfare systems) to determine who gets to consume
the output
[Link] of growth
Societies must decide how much of their resources to
allocate for current consumption versus how much to
save and invest for the future. This involves planning
for capital accumulation, technological advancement,
and resource development to raise future standards of
living.

Public goods and private goods

Public goods are non-excludable and non-rivalrous,
meaning anyone can use them without diminishing
their availability to others (e.g., national defense,
streetlights). Private goods are excludable and
rivalrous, meaning they must be purchased, and one
person’s consumption prevents anyone else from using
them (e.g., groceries, smartphones).
Economists classify goods based on two core traits:
excludability (whether non-paying individuals can be
prevented from using the good) and rivalrousness
(whether one person's use reduces the good's
availability to others)
Private Goods
 Traits: Excludable and Rivalrous.
 Characteristics: Because they are rivalrous, if you
consume or use a private good, nobody else can
use it. Because they are excludable, producers can
 prevent people who do not pay from obtaining
them.
 Market Dynamics: Typically allocated efficiently
through competitive free markets to generate
profit.
 Examples: Personal electronics, clothing,
restaurant meals, and cars.

Public Goods
 Traits: Non-excludable and Non-rivalrous.
 Characteristics: They are open to all of society, and
one person's use does not limit another person's
access. Furthermore, non-payers cannot be
realistically prevented from using them.
 Market Dynamics: Because anyone can consume
them regardless of payment, they often suffer
from the free-rider problem, where people benefit
without paying. Because of this, public goods are
generally funded through taxes and provided by
the government.
 Examples: National defense, public parks,
lighthouses, and official statistics.
Merit goods
These are commodities and services—like education,
healthcare, and vaccinations—that the government or
society judges everyone should have, regardless of
individual ability to pay. Because they generate
significant societal benefits (positive externalities), they
are chronically under-consumed and under-produced
in a completely free market
The production possibility curve
(PPC) illustrates the maximum combinations of two
goods an economy can produce using fixed resources
and technology, highlighting trade-offs, opportunity
costs, and efficiency.
Definition and Purpose

The production possibility curve (PPC), also called

the production possibility frontier (PPF), product
transformation curve.
 Opportunity Cost: Moving along the PPC shows
the cost of producing more of one good in terms of
the other good forgone
  Productive Efficiency: Any point on the curve uses
all resources efficiently, maximizing
 Pareto Efficiency: Increasing production of one
good results in a decrease in the other, reflecting
optimal allocation of resources
 Allocative Efficiency: Occurs when production
aligns with consumer preferences, maximizing
societal welfare
Assumptions of the PPC
1. Fixed Resources: Quantity and quality of resources
remain constant
2. Constant Technology: Production methods do not
change
3. Full Employment: All resources are used efficiently
with no waste
4. Two-Good Model: Analysis is simplified to two
goods at a time
Shape and Interpretation
The PPC is typically concave to the origin, reflecting
the law of increasing opportunity cost, meaning that
producing more of one good requires increasingly
larger sacrifices of the oth
A straight-line PPC assumes resources are perfectly
adaptable, resulting in constant opportunity
Shifts in the PPC
The curve can shift due to changes in:
 Resource availability (e.g., labour, capital, land)
 Technological advancements
 Education and skill improvements
A shift outward indicates economic growth, while a
shift inward signals a reduction in production
capacity
Example
Consider an economy producing cars and computers. If
all resources are devoted to cars, no computers are
produced, and vice versa. Intermediate points on the
PPC show trade-offs, such as producing some cars and
some computers efficiently. Moving along the curve
illustrates the opportunity cost of reallocating
resources between the two goods
The PPC is a fundamental tool in economics for
understanding scarcity, efficiency, and the limits of
production, helping policymakers and businesses make
informed decisions about resource allocation and
economic planning

Shift in ppc
Resources allocation

Allocation of resources is different from one economic

system to the other.
In a market-or capitalist economy, the allocation takes
place with the help of market mechanism, that is,
through the interaction between demand, supply and
prices. In this economy, the means of production are
owned by private economic units and they take
decisions in different capacities (such as consumers,
producers, and so on) in response to changes in prices
caused by market mechanism. The response of each
unit is dictated by considerations of economic
rationality. The employment of means of production is
decided by employers by comparing the productivity of
an input with its price. The employer tries to ensure
that for each rupee spent on inputs, he gets the
maximum possible return. Accordingly, it is the demand
pattern in the economy which finally determines the
resource allocation. Since, a market economy is
characterized by large scale inequalities of income and
wealth distribution, the demand pattern is not able to
reflect the true needs of the society. It becomes
profitable to produce and sell luxuries than necessities.
Consequently, the resource allocation also does not
reflect the true needs of the society.
In a socialist economy, the means of production are not
owned privately. Instead, they are owned by the
government or cooperatives. A socialist economy tries
to reduce income and wealth inequalities. It tries to
ensure that the production of goods and services (and,
therefore, resource allocation) conforms to the actual
needs of the society. For this reason, market
mechanism is not allowed to work freely. Prices of
most goods and services are decided administratively
without reference to their demand and supply position.
Individual economic units are restricted in their
decisions on the basis of economic rationality.
In a mixed economy, decision-making is shared
between individual economic units and the authorities.