Chapter 1

Basic Economic Problems

Chapter 1
BASIC ECONOMIC PROBLEMS

After reading this chapter, you will be able to

 Describe economics, microeconomics and macroeconomics
 Scarcity, choice and opportunity cost
 Production Possibility curve- Static and dynamic analysis
 Factors of production
 Stages of Production
 Division of labour and specialization
 The different allocative mechanisms (Economic systems)
 Planned, Free Market and Mixed Economies
 Problems regarding the transition from Planned to Market Economic
System
 Some important terms and definitions

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What is meant by the term economics?

Different economists define economics in their way. According to Adam Smith, economics is the
science of wealth. Economics is essentially a study of how humankind provides for its material well-
being. According to Robins, "it is a study of human behaviour as a relationship between ends and
scarce resources which have alternative uses”. So we can define economics as a science that, deals
with limited resources which have alternative uses and unlimited wants which might have different
preferences for the betterment of humanity.

Economics methodology

It is a system of methods used in a particular area of study or activity.

Or
It is a body of the method, rules, and postulates employed by a discipline: a particular procedure
or set of procedures

Economics Methodology

Observing consumers’
behaviour in the market
place

Formation of hypothesis to
New or amended
explain spending pattern
of consumers hypothesis

Developing predictions
from hypothesis

Using evidences to test

Further Tests
predictions

Rejected or need
Acceptance as
amendments, as
evidences support
evidences do not
the hypothesis
support

Economics as a social science

Economics analysis is based upon the procedures used in a scientific method. As in a scientific
method, at the first stage, identify the economic question or concepts and then define all related
variables to the concept or the economic question in such a way that these can be measured. For
example, to develop a relationship between price and demand, these terms must be defined in a
clearly understood manner.
The next step is to specify certain assumptions under which the economic model will be explained.
For example, in the ‘law of demand’, all other factors, like income, prices of related goods, taste

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etc. are kept constant to develop a relationship between the change in quantity demanded due to
the change in the price of the product.
After that, there is the formulation of a hypothesis which tentatively untested explanation that
how the given variables are related. The hypothesis becomes a prediction of what will happen in
the demand for the given product as its prices change. Therefore, the purpose of this hypothesis,
like that of any theory, is to help make predictions about cause and effect in the real world.
In the last stage, the hypothesis is tested. The predictions are compared with pieces of evidence to
test the viability and validity of the hypothesis. The test leads us to accept the hypothesis or reject it.
Economic theories always predict the average behaviour instead of the behaviour of a particular
consumer or firm. As the behaviour of an individual is unpredictable but the unpredictable behaviour
of numerous individuals may cancel out one another and so, the average behaviour of the large group
can be predicted accurately.
Now the question arises, of whether economics is a natural science or social science. Although
economics models are based upon procedures used in the scientific method, however, these theories
are not tested in laboratories. Therefore, it may not be taken as natural science. Economics is a social
science and it has diverse applications. It assesses and studies society and human behaviour. Unlike
pure sciences, an economic theory may be changed if there is a change in the behaviour of a group of
people or there is any change in the given assumptions (ceteris paribus factors)
Economists usually explain how the economy works and sometimes they are more concerned that
how should it works. For instance, look at the following statements

1 The economy is experiencing an inflation rate of 10%

2 The government needs to make policies to control the inflation rate, and it should be around
4%.
Based on such statements, economics can be classified as positive economics and normative
economics.

Positive economics
It is the study of economic propositions that can be proved right or wrong. It can be verified
at least in principle, by the observation of real-world events, and without using normative propositions
or value judgments. For example, the above-mentioned statement 1 can be proven false or true by
the observation of real-world events. However, in statement 2, there is an opinion and a debatable
issue. Therefore, it is not a positive statement but perhaps a normative statement.

Normative economics
It deals with subjective opinions. It tells us something about peoples’ views about the world,
rather than the world itself; they are about values, attitudes and tastes. These statements are usually
debatable, hence cannot be proven true or false. It involves value judgments. Usually, such statements
have words like ‘ought’, ‘should be’ or ‘deserve’. For example, inflation is more harmful than
unemployment or the government should concentrate more on the control of inflation than the
unemployment rate or another argument that might be developed in an economy on the protection
of trade unions i.e. whether trade unions deserve protection to maintain employment in an economy.

Ceteris Paribus
It means other things being unchanged. Usually, in a theory, a certain relationship is created between
the given variable. However, at the same time, there are some simultaneous changes in other related
variables and as a result, the theory cannot be proved. Therefore, to prove that theory we keep all
other factors constant.

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Time Period in Economics

In economics analysis, the measurement of time is entirely different from daily life. These time periods
are based on several input factors that are fixed or variable in microeconomics, particularly in the
description of a production function. Therefore, on these grounds, the production function can be of
the following time periods.
Very short run: it is also called a momentary period. In the very short run, all input factors are fixed,
hence no change in the output.
Short runs: In the short run, there must be a minimum of one fixed factor of production and other
input factors are variable or one variable factor of production whereas, other input factors may be
fixed.
Long runs: In the long run, there is no fixed factor of production; all factors of production are variable
and that also changes the size of the firm.
Very long run: There are not only the change factors of production but also there is a change in
methods of production like technological change or change in government policies towards
production etc.

The Margin and the decision-making

In economics, the margin refers to change in a particular variable (dependent variable) due to
change in another variable (independent variable). According to the ‘Marginalist economists’, the
marginal analysis is a fundamental concept used to understand decision making processes and
economic behaviour. In marginal analysis, we focus on the effects of incremental adjustments to
existing conditions, rather than to analyze the entire situation at once.
Marginal analysis allows economist and other economics agents to evaluate trade-offs and make
decisions based on additional benefits and costs. For example, an exchequer assesses a change in
total tax receipts as the marginal rate of tax changes. Similarly, a firm’s decision whether to produce
additional output more or less depends on the marginal cost and marginal revenue of additional
production. Likewise, a consumer makes a decision of consumption by evaluation marginal utility of
a product and its price. An environmentalist also make an appraisal between marginal social cost
and marginal social benefits before planning of an economic activity as well.

MICRO AND MACROECONOMICS

Microeconomics is all about scarcity. It is the study of the economic behaviour of individual units
(markets) of an economy. It studies how resources are allocated in these units and deals with the
problems of a consumer, firm, industry and region. It observes, assesses and tends to give a solution
to an economic problem when any change occurs in the behaviour of economic actors. It also studies
which factor(s) influence the behaviour and what might be the consequence.
Macroeconomics is the study of the behaviour and functioning of the whole economy. It just targets
aggregate changes in the economy and deals with the problems of unemployment inflation, economic
growth, the balance of payment etc. Macroeconomics looks different from microeconomics but in
reality, macroeconomics behaviour is the sum of many microeconomics decisions. This is why when
macroeconomic objectives are formed or problems are addressed then microeconomic problems and
objectives are also taken into consideration.

Needs and wants.

Needs are necessities of life without which one cannot survive. Needs can be classified as primary
needs e.g. food, clothing, and shelter; secondary needs e.g. medical care and education. On the other
hand, wants are desires and may not be essential. Wants include all comforts and luxuries of life. For
instance, basic food is a necessity whereas, eating at a five-star restaurant might be comfortable or
luxurious. Another difference is that needs may be limited and wants are unlimited. Both needs and
wants have common features of emerging and re-emerging.

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When does an economic problem arise?

The economic problem arises at that point where economic resources are less than the wants. We call
it scarcity if there is no scarcity there is no economic problem. For instance, if a person has $10 and
can meet all of his wants within $9, there is no scarcity, but on the other hand, if a consumer has $100
and he needs $102 to meet all of his wants, there is scarcity. Hence, scarcity is a relative concept, its
occurrence is not on the available resources but depends on the available resources concerning needs
and wants.
However, since needs and wants have a feature to be arrayed according to preference and on the
other hand, resources have alternative uses. Therefore, economic problems can be sorted out by
making the right choice. This is the reason that the choice is inevitable in case of scarcity.

Opportunity Cost
It is the true cost that is paid for economic activity. It is the cost in terms of the best alternative
forgone. All economic agents e.g. a consumer, firm or even state incur opportunity cost due to their
decision making. In economics it is one of the most important concept, which helps economic agents
that how to allocate scarce resources.
It is important, because it helps us to make better decisions. This concept forces us to think about the
value of alternatives that we are giving up as we always think about the values of alternatives. This
concept also explains that why some resources are scarce. For instance, land is scarce because there
is a limited of it available. The opportunity cost of using land for one purpose is the value of next best
use of that land. This helps us to understand why land prices are high in areas where there is a lot of
demand for land for different purposes.
Similarly, it helps to make decisions regarding specialization. For example, regions or nations prefer to
specialize in those areas, where they incur low opportunity costs and therefore, they are able to utilize
their scarce resources in the best possible way.
Some examples of opportunity cost:
 A student who decides to attend his economics class instead of to watch movie; the movie will
be the opportunity cost for the economics class.
 A company that decides to produce for example, vacuum cleaners instead of washing machines;
then washing machines are opportunity costs for vacuum cleaners.
 A government decides to construct a flyover instead of to construct a hospital; then the hospital
will be the opportunity cost for the flyover.

Production possibility curve (PPC/PPF)

The PPC shows different combinations

of two different goods, which can be Consumer goods
produced by an economy by using all C
of its resources in the best possible
ways under the given circumstances.
According to Paul A. Samuelson PPC is
combinations of given goods that can
be produced by an economy under the
given level of resources and the given
state of technology. The PPC is drawn O
under the following assumptions K Capital goods
a) The economy produces just
two goods
b) Resources are limited and given, that is, there is no change in economic resources
c) There are no technological changes
d) Resources are fully employed

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e) The average cost of production is minimum all over the economy

The PPC shows, that if the economy allocates all of its resources to produce consumer goods, then the
maximum output is OC of consumer goods and zero units of capital goods. Similarly, if the economy
prefers to produce just capital goods then the maximum output is OK for capital goods and no
production of consumer goods. However, the economy can produce any combination of both goods
at the given PPC.

Static Analysis
Let’s take a scenario of an economy Consumer goods
that is producing two types of goods 150
i.e. consumer goods and capital goods. A E
120
The maximum possible production of
consumer goods is 150 units whereas,
B
75
the economy can produce a maximum D
of 125 units of capital goods.
For instance, in the diagram, the
economy is producing at point A, i.e. O
70 100 125 Capital goods
120 units of consumer goods and 70
units of capital goods. Now there is a change in the production pattern of the economy to produce
more capital goods and fewer consumer goods. This change may occur due to the change in market
forces (market economy) or maybe the recent survey suggested (planned economy) i.e. an increase in
the demand for capital goods. Therefore, the economy prefers to produce at point B. Now it can
produce 75 units of consumer goods and 100 units of capital goods. The economy will have to forgo
45 units of consumer goods to produce 30 additional units of capital goods, hence, the opportunity
cost of producing 30 additional units of capital goods is 45 units of consumer goods.
The PPC model can be used to explain different micro and macroeconomic concepts. For
instance, PPC can be drawn only whenever there are scarce resources (limited) and any decision could
cause an opportunity cost. Here, scarcity, choice and opportunity cost are microeconomics concepts.
Similarly, the performance of an economy can also be explained with PPC. For example in the above
diagram, if the economy produces either at point ‘A' or ‘B', there is an efficient use of resources i.e.
the economy is producing at its potential. However, point 'D' determines economic inefficiencies,
which is also a microeconomics concept. On the other hand, production at point ‘D’ may also show
unemployment of resources, which is a macroeconomic concept. Similarly, if the economy moves from
‘D’ to any of the combinations on the PPC, let’s assume at ‘A’ or ‘B’, the economy is experiencing actual
economic growth and an outwards shift in the PPC shows potential economic growth. That is also a
macroeconomic concept. In fig., point ‘E’ is unattainable under the given conditions. However, it is
achievable if the economy grows or it is also possible if the economy participates in international
trade.
Another important concept that can be driven, is if the economy is producing at ‘A', i.e. more
consumer goods and fewer capital goods. Since consumer goods just used up resources and may not
contribute to production, hence, there is a possibility of an inward shift in the PPC in the long run
because of the depletion of resources. However, at point ‘B' more capital goods are produced, which
are produced for the sake of further production, so, there is a possibility of an outwards shift in PPC
in the long run

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Shifts in PPC (Dynamic Analysis)

There is a complete rightward shift in PPC if Consumer goods
there is an increase in the quantity and quality of
natural resources. It also shifts outwards if there is an
increase in the quality and quantity of capital or any
improvement in health, education, motivation and skill
of the labour force. Factors like research and
development and even international specialization or
trade, shift PPC outward. In the above diagram, point
‘E' is attainable if PPC shifts outwards.
PPC may shift inwards if there is a depletion in
resources or the economy faces some natural Capital goods
calamities, wars and even civil war etc. Consumer goods
PPC may have pivotal shifts like the following, if the
economy finds out better techniques of production to
produce capital goods only, it will have an outwards pivotal
shift, and similarly if there is a depletion of resources or due
to any other negative reason for the product, there is a
leftwards pivotal shift in PPC.
There is another possible shift in the PPC. For
instance, if there is an exhaustion of an important resource Capital goods
which is required for the production of consumer goods. At
the same time, new technology is introduced in the
production of capital goods, and then under the given
circumstances, the y-intercept falls, the x-intercept
increases and the PPC will become flattered as is shown in
the diagram.

Shapes of Production Possibility Curve

PPC shapes depend upon the opportunity cost and
opportunity cost depends upon the gradient i.e. marginal
rate of transformation (MRT) of the curve. MRT can be
defined as how many units of a product will have to forgo
to produce one additional unit of another product under
the given resources and state of technology. The slope of the PPC determines how the reallocation of
production can end with different combinations of given products provided that there is no change in
predefined conditions and assumptions.
∆𝒀
MRT=
∆𝑿

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A concaved shape or outwards

bowed PPC shows an increasing
Increasing Opportunity Cost
opportunity cost due to the
increase in MRT (as is shown in Good Y MRT1
the above diagram where MRT2
𝚫Y
is more than MRT1). So as an
economy produces additional 𝚫X
units of good-X, it will have to MRT2
forgo more and more units of
MRT2 > MRT1 𝚫Y
good-Y. It might be due to a
diminishing marginal rate of
return or due to a lack of
𝚫X
adaptability or varying abilities
of resources to produce
different goods.
Good X
In the real world, most
production possibilities curves
are bowed outward. In other
words, for most goods, the
opportunity costs increase as
more of a good is produced.
This is referred to as the ‘law of
increasing opportunity cost’.
For example, some people are
good at the construction of Good Y Decreasing Opportunity Cost
houses whereas another group
of individuals are good at
cultivation. As there is an
increase in the demand for MRT1
houses, at the early stage, the 𝚫Y
MRT2 < MRT1
construction company will take
the services of trained and
skilled workers and therefore,
the opportunity cost of 𝚫X 𝚫Y MRT2
construction is low. However,
as the demand for houses
increases and the most skilled 𝚫X Good X
labourers have already been
employed by the construction company, now the company will employ workers with fewer skills and
as a result opportunity cost increases.

PPC will be convex-shaped i.e. bending towards the origin if MRT decreases as opportunity cost
decreases (as is shown in the diagram where MRT2 is less than MRT1). This can happen when less and
less of one product will have to be forgone to produce additional units of another product. Perhaps it
is due to the increasing marginal rate of return.

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Good Y Constant Opportunity Cost

PPC will be linear if the marginal rate of
transformation remains the same
throughout as is shown in the figure where
the same number of units of good-Y has to MRT1
forgo for additional production of good-X. It 𝚫 Y1
is possible when there is a constant marginal MRT2 = MRT1
rate of return. 𝚫 X1
𝚫 Y2
𝚫 X2 MRT2

Good X
FACTORS OF PRODUCTION
Land
It includes all-natural resources, which are part of the production process. Sea, forests, mines, rain,
and sunlight are examples of land. The land is also considered a natural resource. Some of these
resources are renewable, which means can be reproduced. Some of the natural resources are non-
renewable for example oil, and natural gas. According to economists the supply of land is strictly
limited; however, it applies to the total supply of land in the world, although reclamation and other
techniques can be used to increase the surface area of land. The reward for the land is rent.

Labour
It is an important part of human resources. It includes all human mental and physical efforts which
involve in a production process. Labour earns wages that are paid according to the productivity of
labourers. Productivity is the ability to convert other input factors into output and it can be enhanced
through education and training. It must be borne in mind that only services of labour are bought not
the labourer itself.
The size of the labour force not only depends on the size of the population but also on the
demographic structure. For example, many of the European economies are facing issues of aging /
declining the size of population. Therefore, the influx of immigrant workforce has a considerable
contribution. For instance, in 2018, the share of immigrants in EU labour force was 11.2%.
Another important factor is the quality of the labour force that determines it importance as a resource.
For instance, Americans usually prefer to spend on human capital (labour force) to make them more
productive as compare to physical capital.

Capital
Capital is a manmade resource. It does not mean money but all those goods and services which
produce with the help of other factors of production and are also involved in a production process.
Machinery, raw material, technology, and road canal are examples of capital. Interest is the reward
for capital.
Capital is usually divided into two broad categories. The fixed capital is not used up in a production
process like machinery, and, the working capital, is used up in a production process, for example,
processed raw material, printers’ ink etc.

Human capital vs. Physical capital

Human capital implies the knowledge that a worker brings to produce goods and services in the form
of education, skills, talent, abilities, knowledge etc. that he or she learns or gains over time. The
entrepreneur or the firm takes it as an asset for the business as this asset contributes towards
production. The value of this asset can be enhanced like any other asset by the provision of learning

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opportunities. Human capital is an intangible asset; therefore, it is not listed on the balance sheet.
However, it influences the goodwill value of the business and increases the market value when any
company acquire or purchases it.
Physical assets indicate all man-made resources that involve in a production process like machinery,
buildings, equipment, roads etc. The firm or business can use these assets to convert raw materials
into finished or semi-finished goods. Physical assets are tangible assets and an accountant records
them in the balance sheet.

The entrepreneur
This factor of production is involved in decision-making and risk bearing. An entrepreneur decides
what to produce, how to produce and how to distribute. The entrepreneur arranges other input
factors to produce goods. It produces goods and services by undertaking anticipation of demand to
make a profit. The entrepreneur is the main risk bearer of all decisions and takes in a production
process. In small-scale businesses, the owner itself performs both of the functions i.e. decision-making
and risk bearing. However, in large organizations, these functions are divided between managers and
shareholders. Managers are involved in organizing other factors of production, whereas, shareholders
who are the actual owners of the business bear the risk. The return for the enterprise is profit.
Entrepreneurial skills are very important in any economy to carry out economic activities efficiently
and profitably. Most developing countries have an abundance of natural resources and labour, but
there is a lack of capital and enterprise, therefore, they are unable to produce a sufficient amount of
goods and services to satisfy human wants. Another example that can elaborate on this scenario is the
situation faced by eastern European countries during their transition period from a planned economic
system to a free market economy. Since in planned economies, all decisions are taken by the state
and entrepreneurship is not encouraged, therefore, they found it difficult to develop.
On the other hand, developed countries of Western Europe have adequate and high-quality resources
along with exceptional entrepreneurial skills that enable them to produce a large number of goods
and services to satisfy the needs and wants of their people. Even during the transition period, the
developed countries made foreign investments in eastern European countries. It benefited all the
economies as foreign firms were able to make good use of skilled labour and domestic producers
learned entrepreneurial skills.

The importance of any factor of production depends upon the relative availability of the factor of
production, the nature of production and the comparative advantage of the product. For instance,
usually, economies specialize in the production of such goods which they can produce conveniently
due to an abundance of ‘any' factor of production. So, that factor is more important for producers.
Another important determinant is the nature of the industry e.g. in capital-intensive industries (e.g.
manufacturing) capital is more important as compared to other factors, similarly land is more
important in land-intensive industries (e.g. extractive) and labour is most important in labour-
intensive (service sector) industries. Lastly, comparative advantage is the reason for international
specialization that can determine the importance of any factor of production. A factor of production
may be most important for an economy which results in a comparative advantage for the product in
international trade.

STAGES OF PRODUCTION
Primary production:
It is also called an extractive industry. At this stage, natural resources are extracted from the land.
Mining, fishing, farming and production of raw materials are included in this sector. Developing
economies mostly rely on the primary stage of production.

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Secondary production:
It is also called the manufacturing industry. At this stage, the raw material is converted into finished
and semi-finished goods. For example, extracted crude oil is converted into petrol, diesel and kerosene
at this stage.
Tertiary production:
It is also called the service industry. At this stage, produced goods and services are distributed. It
includes commercial services; which involve the distribution of goods, like retailing, transportation,
banking, insurance etc. In personal services; services of teachers, doctors, engineers, musicians etc.
are involved.
Quaternary Production:
It was considered part of tertiary production however now it is the fourth stage or type of industry.
This industry is based on skills; knowledge and information hence including intellectual activities,
information technology, research and development centers, media etc.

The importance of these types of production varies from economy to economy. For example, in low-
income developing economies, most of the labour force is unemployed and semi-skilled or with low
skills and therefore, can be absorbed by the primary sector of the economy and allowed to earn
income at a subsistence level. This sector also provides staple food which is important for the survival
and self-sufficiency of a large proportion of the population. However, it also provides the raw material
needed by the secondary sector of the same country or in other countries for their operations.
In middle-income developing countries, people have a comparatively better living standard, and
therefore, to improve living standards further, they enhance their skills, are mostly involved in
manufacturing, and partially in trade but still, a considerable part of the population is engaged in
primary production. The secondary sector allows economies to grow at a relatively high rate as
compared to those economies which rely on the primary sector.
In emerging economies, however, a large part of economic activities is taken place in secondary and
tertiary sectors. Most of the people in these economies have far better living standards as compared
to other developing countries.
In developed countries, to maintain living standards they need to earn large incomes,
therefore, they prefer to adopt tertiary and quaternary sectors. In developed economies, the
workforce is highly skilled and productive which enables them to employ them in highly paid jobs.
Another reason is globalization and free trade which have enabled developed economies to import
more manufactured goods. Therefore, an increasing proportion of the economy can be devoted to
the higher-value service sector. This sector also provides more leisure hours for workers. For example
in the UK, in 1917 the average working hours are almost 52 whereas in 2017 the average working
hours are just 36.5.

Division of labour
It is a process where a task is split into a large number of small production processes and a specialized
worker performs each production process. Hence specialization is inevitable in the process of division
of labour. Specialization means where an economic agent prefers to perform that task at which it
considers itself the best.

Advantages of the division of labour

1. When there is a repetition of a specific task, it increases proficiency at that particular

operation. It makes the work simple and as a result output increases.
2. Division of labour saves time due to no movement from one job to another or by putting down
one set of tools and picking up another set of tools.
3. Division of labour creates occupations. When work is split into many operations, for each
operation a specialized worker is required who suits that job, as a result, employment will rise.

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4. Division of labour encourages mechanization. When a complex process has been broken down
into a series of separate, simple processes, it is possible to devise machinery to carry out each
operation. Due to the use of machinery, once again productivity increases, waste decreases
as a result output increases and average cost falls.
5. It encourages inventions and innovations in the production process. When a worker performs
a task, again and again, he may find out better techniques and methods to produce goods
efficiently and economically.
6. In the division of labour, there is the best use of one's ability, because one prefers to perform
that task at which it is the best. It raises productivity and output.

Due to the above-mentioned reasons, not only there is an increase in several goods and services
which leads to an increase in the wealth of the nation i.e. the GDP, but also increases the income of
workers who can spend more to buy more goods and services to improve their living standards.

Disadvantages of the division of labour

1. Repetition of a task creates monotony and boredom among workers. There is no opportunity
for the workers to exercise initiative, judgment, manual skills and responsibilities. Sometimes
workers commit some careless mistakes due to which the average cost of production
increases.
2. Specialization leads to an increase in the use of machinery, due to which most of the work
becomes automatic. Hence, basic skills are transferred from the hands of workers to
machines. Now machines control the designs, the quality and the quantity of the product, and
not the person.
3. It also increases the risk of unemployment. Firstly, workers specialize in a certain field. If there
is no vacancy is vacant of that particular skill, they remain unemployed. Secondly, in the
division of labour, a business becomes more capital-intensive; hence, lesser workers are
required, which creates unemployment.
4. Interdependency increases due to the division of labour. As if there is a breakdown at one
stage whole of the working process will be halted, as a result, there is no production. Similarly,
specialization leads to increase interdependency in an economy. It is not simply a question of
workers specializing, factories, firms and even whole industry specializes. Therefore, if a unit
suffers, the whole of the economy suffers.
5. Another disadvantage is the lack of variety. In the division of labour, there is large-scale
production; hence, it is not possible to produce goods in different designs and most
importantly in different sizes.

From the above-mentioned reasons, it can be assessed that an increase in the division of
labour may not be good all of the time. It may cause a reduction in productivity and the choice of
consumers, but also affects living standards due to a lack of job satisfaction and variety.
However, history tells us that most inventions and developments are more and less based on
specialization and division of labour. So, if its limitations are rectified or reduced still it is very much
beneficial for the economy.

Specialization, exchange and Globalization

Specialization occurs when one focuses on the production of a limited scope of goods and services
intending to gain a greater degree of efficiency.
Specialization can be at the microeconomic level and also at the macroeconomic level. For example,
an individual's specialization, a firm's specialization and regional specialisation are examples at
microeconomic levels, whereas international specialization is an example at the macroeconomic level.

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At the individual level, specialization comes in the form of a particular career or it can be seen when
the division of labour is applied. Firm specialization can be seen in the form of different industries like
the textile industry, automobile industry, banking industry and tourism etc.
At regional specialization, it can be observed that some regions of a country are more suited
for the production of a specific good and particularly in the agricultural sector.
Economies specialize based on comparative advantage in the production of goods and
services. Comparative advantage is based on opportunity cost i.e. the opportunity cost of the
produced product is less than the opportunity cost of all other goods.
All types of modern economies are characterized by specialization based on resources and
factors of production and by the exchange of goods and services. These exchanges not only occur at
the microeconomics level but also the macroeconomic level. Domestic trade and individual exchanges
are good examples of microeconomics level whereas international trade is an example of exchange at
the macroeconomic level so exchange and specialization are inevitable.
International trade leads to globalization where all markets and economies are
interconnected and integrated to a very extent. Usually, this can be seen not only in the commodity
market but also exists in financial markets, labour markets, sports and even in the entertainment
markets.

Economic questions
All societies face three fundamental questions and how these are answered depends on the type of
economic system that is operated.
The first question is what to produce. The community wants to produce all kinds of varieties
of goods and services but due to limited resources, it has to decide, which goods should be produced
and in what quantities. If they require more consumer goods, then consumer goods should be
produced in larger quantities. But if they desire more capital goods, society will have to act
accordingly.
The second question is how to produce. Due to scarcity, resources should be used efficiently.
Economists use the terms labour intensive and capital intensive to describe alternative methods. In
labour-intensive methods, more labour is used and less capital. Such methods are used in those
economies where labour is in an abundant form and capital is in a scarce form or is relatively
expensive. This method is usually applied in developing economies that mostly rely on primary
production. In capital-intensive methods, a vast amount of capital and little labour is used. These
methods are used in developed economies that produce goods like machinery, electrical appliances
etc. The total output of the community depends not only on the availability of resources but on how
to use those resources too.
The third question is how to distribute goods and services. It is once again the economic
system that has to determine the relative sizes of the shares going to each household. For example in
primitive societies goods were distributed among those who produced. In planned economies, goods
are distributed among all citizens, whereas in market economies usually goods are given to those who
can pay for them.

Planned Economic System

In such systems, all resources are owned and controlled by the state. There is no concept of
private ownership. All land, housing, factories, power stations, transport systems etc. are owned by
the government.
The logic of public ownership in these societies is based upon the desire for a more equitable
distribution of income and wealth.
In these societies, all of the decisions, what to produce, how to produce and how to distribute
are taken by the state. Production decisions are very complex in planned economies. In the first stage,
a survey is carried out which looks at the resources of labourers, machines, factories etc., to produce
goods and services and then find out which quantities of goods and services should be produced.

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Usually, planned economies adopt those methods of production which employ more workers to
maintain a certain level of employment.
Ideally, the complete planning of production is accompanied by the complete planning of distribution.
What has been produced could then be allocated to consumers by some kind of physical rationing
scheme.
In planned economies, only those goods are produced which require the whole society but
not according to the buying power of some of the consumers. Therefore, most necessities of life and
basic comforts are produced. The provision of health and education facilities is also the responsibility
of the state which is available to all irrespective of their buying power.
The government prefers to make such policies or projects which absorb more people to
maintain employment in the economy. This is why in such economies the unemployment rate is
usually low.
Another advantage of this system is to avoid undue duplications and competition, which cause
the wastage of scarce resources.
Planners make their decisions based on a conducted survey. In the event of sampling errors,
there is a possibility of over or under-production. So, in any case, either resource is wasted or there is
a possibility of a shortage of goods and services in the economy.
In this system, not only does the government monitor but also manages demand and supply
to control the price of a product and even the general price level, which brings stability to the
economy.
The planned economic system has certain flaws this system is bureaucratic by nature, hence;
changing decisions is very complex and time-consuming. So, due to this inflexibility, there are
possibilities of wasting scarce resources.
Usually, workers are paid equally without considering their ability and productivity; therefore,
there is a low incentive to work hard. It is said that in this system the unemployment rate is low but
in reality, the underemployment rate is very high.
Another drawback of this system is a lack of profit motive; hence, there is no incentive to
innovate. As a result, firms operate inefficiently. In such economies usually, goods are of poor quality
as well as no variety is available to consumers, as a result, they do not enjoy a high living standard.
Historical opinion portrays these economies may not enjoy a high living standard. Though such
economies have low inequalities, the overall per capita income is low.

Free Market Economic System

This system is based on laissez-faire, which means ‘let people do’. Like purely planned economies this
system in pure form does not exist. In this system, resources are allocated based on the price
mechanism. Market forces, that is, demand and supply (invisible hands) are allowed to move freely in
an allocation of resources. As a result of this, decisions are made easily and quickly by seeing the
changes in demand and supply forces. Government plays a very limited role in this system. Private
ownership of resources is an important feature of this system. Private property not only confers the
right to own and dispose of real assets but it also provides the right to generate income from assets.
In this system, there is freedom of choice and enterprise. Consumers are free to spend their income
in any way they wish. On the other hand, entrepreneurs may use their resources as they see fit.
Consumers are considered sovereign in this system because goods and services are produced
according to their desires.
Profit is the main motive in this system; this is why there is an incentive to innovate. Similarly,
factors of production are also paid according to their contribution toward production. So, workers also
excel in their abilities to produce, which makes them more productive and efficient.
Another important feature is the competition. Competition leads to increase efficiency in
businesses. Competition increases choice and variety for the consumer and also enables them to buy
at competitive prices.

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On the other hand, there are many flaws in this system. In this system, only those goods and services
are produced which bring profit for the business. There is no concept of the production of public goods
like parks, roads etc. Similarly, merit goods like education and health are under-produced. On the
other hand, demerit goods like weapons, drugs, and cigarettes are produced more to generate a
healthy profit.
In market economies, to gain a higher profit, firms reduce their cost of production by neglecting
negative externalities. It is the cost which incurs by the whole society due to a production process.
Firms only employ those factors of production which bring profit for the firm; as a result, many of the
factors of production remain unemployed.
It is said that consumers are sovereign in the market economy but there is a producers’ sovereignty,
who produce goods and force consumers to buy them. In free market economies, monopolies can be
established due to the weak control of the state and therefore, consumers can be exploited.
Another big drawback of this system is inequalities in the distribution of income and wealth.
This system creates a wide gulf between the rich and the poor.

Mixed Economies
There is no existence of purely planned economies as well as pure market economies. Usually,
we have mixed economies. However, in some mixed economies, government plays a major role and
in some of the economies, individuals are stronger.
In mixed economies, there are usually two sectors; the private sector, which is controlled by
individuals. It possesses most of the features of market economies like private ownership, economic
freedom for producers and consumers, profit as the main motive, competition etc. this sector also
possesses some of the evils of market economies like under provision of merit goods or no provision
of public goods, similarly, self-interest as the dominating motive which may exploit interest of the
society.
Another sector is the public sector, which is controlled by the state. In many of the developed and
emerging economies, this sector has a very limited role to play. However, in developing countries still,
this sector is more important. The public sector not only produces those goods and services which are
not produced or under-produced by the private sector but also controls the activities of the private
sector. It makes laws that protect consumers and society from the evils of the market economy. It
forms competition policies that control monopolies but also control the quality, quantity and to a
certain extent prices of products. It makes laws against pollution, redundancies and unfair trade
practices. The public sector also contributes to maintaining a certain level of employment in the
country.
It is considered that a mixed economic system creates an ideal balance between the two opposite
economic systems i.e. free-market economy and planned economy and promotes social welfare.
Under this system, both the public and private sectors work for the betterment of society.
However, this system also has some limitations. For example, since the private sector is regulated by
the public sector, firms may incur more production costs and also they cannot operate freely and may
not enjoy many of the benefits.
There is an element of uncertainty in the private sector because there are continuous changes in rules
and regulations by the public sector which prevents the private sector from making long-term policies.
Even in some cases, firms also feel a threat of nationalization in mixed economies.
Similarly, firms which operate in the public sector can be inefficient and incur heavy losses and
ultimately these losses are borne by the private sector in terms of more taxes.
Although there are certain flaws in this system, still it is quite popular and operates effectively.

Problems faced by economies during their transition period from planned economies to
market economies.
The first problem which was faced by these economies was inflation. Command economies
usually kept prices below that charged by non-government producers. When the private sector

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replaced the public sector since their objective was to make a profit, therefore, they increased prices
and as a result, the general price level increased. In 1994 the rate of inflation in Russia was above
400%.
The second biggest problem was industrial unrest. Workers pressed firms to raise their wages
which enabled them to meet high prices. They were also likely to try to maintain their job security. In
the early ‘90s, several strikes occurred in Russia and other countries of the communist bloc.
Thirdly, there was a change in the pattern of employment. There was likely to be large-scale
structural change, with some industries expanding and some of them being contracted and even some
going out of business. This required workers and machines to move from one job to another. However,
many of the machines and workers were not able to do so due to geographical and occupational
immobility. Therefore, they became redundant and unemployed. Similarly, many privatized firms also
tried to become more efficient and surplus workers were made redundant to cut labour costs.
The economic growth rate also fell during the transition because economic activities were
reduced due to unpredictable economic, social and political conditions. New investors were reluctant
to invest and even existing businesses reduced their economic activities as a result real GDP also fell
which further deteriorated the living standards.
The economic transition also led to rapidly increasing inequalities as some exploited their
position as entrepreneurs and traders in commodities, while others suffered from unemployment and
rising inflation.
There was a fall in overall living standards in those economies. Many of the machines were
outdated or out of order. To replace their considerable resources were required. Due to a lack of
resources, many of the consumer goods were forgone.
Another problem faced by those economies was a huge deficit in their balance of payments.
Not only countries spent large resources to import modern machinery to replace outdated machinery
but also had to import common consumer goods.
External Debt and Financial Crises arose during the transition. Many transition countries
started the 1990s with high foreign indebtedness. In Bulgaria, Hungary and Poland, external debt
exceeded 50 per cent of GDP in 1990. In Russia, external debt in 1990 was around 148 per cent of
the GDP. Indeed, Russia defaulted on its sovereign debt in 1998.

Other concepts and terminologies

Economic goods; these goods are in scarce form. Such goods incur an opportunity cost. People will
have to pay a price for such goods. For example, cars, food, clothing etc.
Free goods: these goods are abundantly available in the world. People usually do not have to pay any
price for them. Such goods have no opportunity cost. For example, air, rain, sunshine etc.
Consumer goods: an economic good purchased by a household for final consumption. It is the use to
which it is put that determines whether a good is a consumer good, not the characteristic of the good
itself.
Capital goods: these goods are produced for the sack of further production. Such goods generate
income and wealth. Machinery and raw materials are common examples, but once again, it is the use
to which it is put that determines whether a good is a capital good, not the characteristic of the good
itself.
Durable goods: these goods yield services or utility over time rather than being completely used up
at the moment of consumption, for example, washing machines and machinery.
Non-durable goods: such goods are used up completely at the moment of consumption; raw materials
and foodstuffs are common examples.
Liquidity: the degree to which an asset can be quickly and cheaply turned into money, which by
definition, is completely liquid.
Market: an abstract concept concerning all the arrangements that individuals have for exchanging
with one another like, labour market, commodity market, financial market etc.

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Investment: it is an addition to the capital stock of a firm or economy. It is the part of the total income
which will be used to produce goods in the future or to generate future income.
Value judgment: in economics, it is a subjective assessment of any economic activity, event or
situation. Such assessments are made based on one's priorities. Therefore, usually, these statements
are very much arguable.
Time lag: in economics, it is the delay between an economic decision and the action taken or between
the economic action and a consequence.

Summary:
 Economics deals with limited resources and unlimited wants with the objective of social welfare
 Microeconomics is the study of the economic behaviour of individual units whereas;
Macroeconomics is the study of the behaviour and functioning of the whole economy.
 Needs are necessities whereas wants include comforts and luxuries.
 The economic problem arises when needs and wants to exceed resources
 Scarcity depends on the availability of economic resources for wants.
 Opportunity cost is always in terms of the best alternative forgone.
 PPC is the locus of various combinations of given goods that can be produced by an economy
under the given level of resources and the given state of technology.
 Shapes of PPC depend on the rate of transformation which determines opportunity cost.
 Land includes all natural resources involve in a production process and earn rent as a reward
 Capital means man-made resources which are involved in a production process and earn interest
as a reward.
 Labour means the human mental and physical efforts involved in a production process that earn
a wage as a reward.
 An entrepreneur is a decision-maker and risk bearer and earns a profit as a reward.
 Based on production processes, industries can be classified into primary, secondary, tertiary and
quaternary.
 In the division of labour, work is split into a large number of small production processes where a
specialized worker performs each production process.
 In a barter system, there is a direct exchange of goods without any medium.
 All economic systems, despite their decision-making processes, must answer three fundamental
questions: What will be produced? How will it be produced? And for whom will it be produced?
 A free market economy allocates resources with the help of demand and supply forces.
 In centrally planned economies resources are allocated through planning.
 Mixed economies' resources are allocated by a mix of price mechanisms and planning.

SAMPLE QUESTIONS:
1. Explain the link between the basic economic problem of scarcity and opportunity cost.
[8]
Answer:
Key points: Definition of scarcity and explain how all economic agents (consumers, firms,
governments) face this economic problem, the choice comes in due to scarcity and as a result
opportunity cost is incurred.

Must read: Scarcity, choice, opportunity cost [May 2002]

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Basic Economic Problems

2. Discuss whether an increased division of labour among workers and nations brings only
benefits. [12]
Answer:
Key points: Explain the division of labour and define specialization on an individual and national basis,
advantages of division of labour and specialization for a worker, advantages of specialization for an
economy, drawbacks of the division of labour, drawbacks of specialization for a country and especially
developing economies that face uneven distribution of income (inequalities) and benefits of
international trade which may not be realized on a national level.

Must read: Division of labour, advantages and disadvantages of the division of labour, specialization
and globalization, merits and demerits of globalization, also read the topic of comparative advantage
from the chapter trade theories. [Nov 2003]

3. Discuss whether a mixed economy is the best way for a country to deal with the basic economic
problem. [12]
Answer:
Key points: The basic economic problem is scarcity, which concerns limited resources and unlimited
wants. A mixed economy combines features of the market and planned systems. Private ownership,
the profit motive, price mechanism etc. are features of the free market economy as well as in the
public sector there is government ownership which provides important services, and employment and
intervenes in market mechanisms to protect different segments of society. The balance between the
two varies between time and place. A mixed system should benefit from the advantages of the two
systems. The market system should provide incentives and efficiency while the government should
deal with equity and market failure. However, a mixed economy may suffer from the disadvantages
of both alternatives producing inequality, inefficiency and low levels of welfare.

Must read: Scarcity, economic systems like the free market economy, planned economy and of course
the mixed economy. [Nov 2006]

4. Discuss the view that ‘labour is the most important factor of production and therefore the
division of labour should be applied to its maximum extent’. [12]
Answer:
Key points: Identify and define four factors of production. The importance of any factor of production
depends on the availability of the factor, the nature of the industry and the comparative advantage.
Define the division of labour, the advantages like the best use of abilities, enhanced labour skills,
increased productivity etc. and disadvantages like over-dependency, monotony, de-motivation etc.
the division of labour.

Must read: Factors of production, advantages and disadvantages of the division of labour. [Nov
2005]

5. (a) Explain the contributions of enterprise and division of labour to an economy.[8]

Answer: (a)
Key points: Enterprise is the risk-taking, organizing factor of production; division of labour is the
specialisation of economic activity by product or process. Enterprise organizes the other factors to
promote output, efficiency and change while the division of labour reduces cost, and raises
productivity and living standards.

Must read: Factors of production and division of labour

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Chapter 1
Basic Economic Problems

(b) Discuss the desirability of the worldwide movement towards the market economy and away
from the planned economy. [12]
Answer: (b)
Key points: Features of both economic systems like ownership of resources, allocation mechanism,
motives etc., the advantages of transition like consumers' sovereignty, competition and choice,
efficiencies, more production, improved living standard etc., disadvantages of transition like increased
concentration of wealth in few hands, unemployment may rise, increase in the cost of living, poverty
increases etc. Some East European economies are making fast progress while some former USSR
republics are struggling.

Must read: Free market economy, planned economy and problems faced by economies during the
transition. [May 2007]

6. (a) Show the difference between a movement along, and a shift in, a production possibility
curve.
Explain what might cause each to occur. Use diagrams to support your answer. [8]
Answer:
Key points: Define and draw PPC, movement along the curve determines the change in preference of
the economy to produce a different composition of given goods-it might be due to change in market
forces in the free market and may be due to change in government preferences in planned economies.
Shifts occur due to a change in the availability of resources. Draw appropriate and labelled diagrams
to show these changes.

Must read: PPC, static and dynamic analysis.

(b) Discuss how resources are allocated in planned economies and free-market economies. Consider
which type of economic system is likely to have the more beneficial outcome.
Answer:
Key points: In planned economies resources are allocated through planning by different committees
and no role is played by the price mechanism. The advantages are only the desirable goods are
produced, and may be available to all etc. and the disadvantages like inflexible mechanisms, errors in
a survey, under or overproduction etc.
In a free-market economy, the price mechanism allocates resources and has no role to play in the
state. Flexibility, competition, wider choice etc. are advantages and disadvantages that may be like,
no public goods, underproduction of merit goods, overproduction of demerit goods, unemployment,
negative externalities etc.
A mix of both systems (mixed economic system) may be more desirable which possesses the merits
of both systems and also allow the state to monitor economic activities and protect different
stakeholders.

Must read: Free market economy, planned economic system, mixed economy. [Nov 2017]

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