Chapter-2 Central Problem of an Economy

Central Problem of an Economy

Every economy in the world faces the economic problem of unlimited wants and limited resources. This economic problem gives rise to people making choices about how they would like to use scarce resources. This economic problem gives rise to the central problems of an economy which are as following

 

  • What to produce and in what quantities
  • How to produce?
  • For whom to produce?

 

These are called central problems because every economy has to face them and seek solutions to them. Collectively, these central problems are called the Problem of Allocation of Resources.

 

 

 

 

 

 

 

 

 

 

WHAT TO PRODUCE: It is the problem of choosing which commodities should be produced and in what quantities. This problem involves selection of goods and services to be produced and the quantity to be produced of each selected commodity.

The problem of what to produce has two aspects:

 

What possible commodities to produce – An economy has to decide, which consumer goods and which of the capital goods are to be produced.

How much to produce – After deciding the goods to be produced, economy has to decide the quantity of each commodity that is selected.

 

The problem of what to produce and in what quantities to be produced can be solved by a government that decides the allocation of resources in different areas of production. Alternatively, it can be solved based on the preferences of people in an economy and on the price of goods and services in market.

 

HOW TO PRODUCE:  It is the problem of choosing method or technique of production.This problem refers to selection of

technique to be used for production of goods and services.

 

In Labour-intensive technique : In a production process when more units of labour are used in proportion to capital, it is termed as a labour intensive technique

In capital-intensive technique : when the proportion of capital used is more than labour, the production process is called a capital intensive technique.

 

 

The solution of the problem of how to produce is based on the extent of output that is produced for a given level of resources. Any producer would like to maximize the level of output from the available resources. At the same time cost of using a technique is equally very important. A producer will use that particular technology which is available at least cost.

 

 

FOR WHOM TO PRODUCE: It is the problem of distribution of income among pactors of production which help in production.This problem refers to selection of the category of people who will ultimately consume the goods that is whether to produce goods for more poor and less rich or more rich and less poor.

 

This problem can be two main heads

Personal Distribution – It means how national income of an economy is distributed among different groups of people.

Functional Distribution – It involves deciding the share of different factors of production in the total national of the country.

 

Here guiding principle in solving the problem of distribution is to fulfill the urgent wants of each productive factor to the maximum possible extent.

 

Opportunuity Cost

“Opportunity Cost is the cost of next best alternative forgone.”

For example A person is working in the bank at the salary of Rs. 40,000 per month. Suppose he receive two more job offer

To work as an executive at Rs 30,000 per month.

To become a journalist at Rs 35,000 per month.

 

In the given case, the opportunity cost of working in the bank is the cost of next best alternative foregone that is Rs 35000.

 

 

 

PRODUCTION POSSIBILITIES CURVE/FRONTIER

PPC shows alternative production possibilities of two sets of goods with

the given resources and techniques of production. PPC is a graphic representation

of PPC. It is also called Production Possibility Frontier (PPF). This curve is also

called Transformation Curve since it indicates that if more of butter is to be

produced, then factors will have to be withdrawn from the production of guns and

transferred towards the production of butter.

 

 

 

Possibilities Guns (units) Butter (units) MRT
A
B
C
D
E
F
15

14

12

9

5

0

0

1

2

3

4

5

4

2

3

4

5

 

 

 

PPC has two following properties

  1. a) PPC slopes downward: This means that more of a good can be produced only by sacrificing some quantity of the other good.

(b) PPC is concave to the point of origin: The rate at which the units of a good is reduced to increase a unit of another good is called marginal rate of transformation (MRT).

 

Can PPF be a Straight line?

 

PPF can be straight line if we assume that MRT is constant, i.e. same amount of a commodity is sacrificed to gain an additional unit of another commodity. It is possible only when we assume that all the resources are equally efficient in production of all goods. In such case, PPf will be a straight line

 

Marginal rate of Transformation (MRT)

 

MRT is the of number of units of a commodity sacrificed to gain an additional unit of another commodity.

 

MRT = change in units sacrificed / change in units gained.

 

 

Production possibilities Wheat (lakh tones) Tanks (thousand) Marginal Rate of transformation
A 0 15
B 1 14 1T:1W
C 2 12 2T:1W
D 3 9 3T:1W
E 4 5 4T:1W
F 5 0 5T:1W

 

Change in PPC

The change in PPC can be of two types:

 

1) Shift in PPC – The PC can shift cither towards right or towards left, when there is change in resources or technology with respect to both the goods.

 

Rightward shift in PPC – when there is advancement of technology or increase in availability of resources in respect to both the goods the PPC will shift to the right.

 

Leftward shift in PPC – PPC will shift towards left, when there is a technology degradation or decrease in resources with respect to both the goods.

 

2) Rotation of PPC – It happens when there is change in productive capacity with respect to only one good.

                

Rotation for commodity on the X-axis – When there is a technological improvement or an increase in resources for production of the commodity on the X-axis then PPC will rotate from AB to AC.

 

In case of technological degradation or decrease in resources for production of the other commodity then PPC will rotate to the left from AB to AD.

 

Author: Ravi Kashyap

Commerce Expert

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