SOLUTIONS TO THE BASIC ECONOMIC PROBLEMS IN DIFFERENT ECONOMIES

Economic problems are solved through price mechanism in a capitalist economy

state machinery of central planning in a socialist economy and

price mechanism with active intervention and regulation of the state in a mixed economy.

2

SOLUTIONS TO BASIC PROBLEMS IN A CAPITALISTLIC ECONOMY (CAPITALISM)

3

Price Mechanism

What is Price Mechanism?

“Price mechanism is the mechanism in which prices play a key role in directing the activities of producers, consumers and resources suppliers.”

• There are two important elements of price mechanism: (1) Prices,

(2) Markets.

•Prices- * Goods and services have prices - Why?

* Producers are willing to sell goods and services only if they get appropriate prices.

*The services of various factors of production carry their prices.

5

Prices are determined through the impersonal market forces of demand and supply.

6

Buyers (Demand)• create the demand

for goods and services

• competition among the buyers to buy goods and services.

Sellers (Supply)• offer supply of these

goods and services to meet the wants of the buyers

• competition among the sellers to sell goods and services.

Price determination through price mechanism

Equilibrium price “Equilibrium price is the price at which

quantity demanded equals quantity supplied.”

It is through the interaction of the competitive forces of demand and supply that the equilibrium price of

a good, a service or

a factor service is determined.

Prices respond to changes in demand and supply.

Market

In economics a market means. “a system or set-up in which the buyers and sellers of a commodity are able to interact and communicate with each other and strike a deal, i.e., price and the quantity to be bought and sold.”

Types of Market

(i) Goods markets are those markets where goods and services are bought and sold.

(ii) Factor markets are those markets where factor services are bought and sold, such as labour market, capital market, etc.

Capitalism and Price mechanism• Price mechanism acts as the coordinating

agency. • Economic decisions are taken and

implemented through price mechanism. • It is an automatic functioning mechanism. • All economic decisions taken by a large

number of individuals through the market prices are coordinated automatically.

• Thus price mechanism functions without conscious control by any controlling agency in capitalism.

Functions of Price Mechanism • The level of economic activities• Co-ordination of economic decisions • Guiding force to consumers • Determination of factor income • Guide to producers • Allocation of resources • Determination of savings • Bringing flexibility in the economy

Solution to the Basic Problems through Price Mechanism

1. What and how much to produce?• The consumer is regarded as a sovereign

(king) • The basic objective of the producers is to

earn maximum profits. • Producers will like to produce those goods

and services which yield higher profits• An increase in the demand for a

particular commodity will lead to a rise in its price. A rise in the price of a commodity, given the cost of production, will lead to more profits

Effect of Increase & Decrease in Demand

Price

ProfitProduction

Demand

2. How to produce ?• The basic objective of the

producers is to earn maximum profits.

• A producer must minimize the cost of production

• The cost of a technique of production is determined by the prices of inputs and the input prices are determined by price mechanism in the factor market

Technique of production to be used•The producer chooses that technique of production which is least costly. •The cheapest way of producing a commodity depends on relative resource prices:

If labour is relatively cheaper than capital, the producer will adopt a labour-intensive technique if capital is cheaper than labour, capital-intensive technique, will be employed by the producer.

3. For whom to produce?•Distribution of total output of goods and services depends upon the distribution of income. •Incomes of different individuals as determined by price mechanism determines the distribution of goods and services. •As a result of this unequal distribution of income, the distribution of goods is also very much unequal. •The rich people get a larger share of the national product. •The poor people with low incomes, receive a smaller share of the national product.

Conditions Required for Price mechanism to Play its Role • Existence of competition• Costs reflecting the sacrifice• Demand reflecting the needs • Mobility of resources• Correct anticipation of demand• Non economics conditions• No interference by the government

An evaluation of price mechanism

1. Solving economic problems2. Coordinating and organising

force3. Promotes social welfare 4. Preservation of individual

freedom

Limitations of Price Mechanism 1. Decline of competition

2. Consumers' sovereignty 3. Individuals may not be the best judge 4. Social welfare may not be maximised 5. Inequalities in distribution of income &

wealth 6. Economic instability 7. Neglect of low-profit areas 8. Production of public utilities neglected

SOLUTION TO BASIC PROBLEMS IN A SOCIALISTIC ECONOMY (SOCIALISM) 1. What to Produce and How Much to Produce Planning authority makes an estimation of

the available economic and human resources.

It takes into account: a) the requirement of the economy for various.

goods and services. b) the needs of the people and the national

priorities. c) adequate amount of commodities to be

made available to the people.

2. How to Produce?

It has to take into account • the economic efficiency of the

techniques. • the social objectives and development

goalsIt has to ensure that • economic resources of the country are

fully utilised.

3. For Whom to Produce? •All productive resources are owned by the government. •People work only as labourers and earn income in the form of wages only.•a skilled worker gets higher wages than an unskilled worker•administered price mechanism operates in a socialist economy. •The government also distributes various goods, particularly essential goods at fixed or controlled prices through ration shops or fair price shops

Basic principle of distribution“From each according to his

capacity and to each according to his work is the

basic principle of distribution of income in a socialist

economy.”

SOLUTION TO BASIC PROBLEMS IN A MIXED ECONOMY1. What to Produce?• Consumers preferences influence the

production decisions of the firms. • Production in the private sector is also

controlled and regulated by the government through the monetary, fiscal and price control policies.

• In the public sector, it is the planning authority that decides what to produce and how much to produce keeping in mind the overall national objectives.

Fiscal Policy and Monetary Policy• Fiscal policy refers to the policy of

the government regarding taxation, public borrowing and public expenditure.

• Monetary policy refers to the policy of the central bank relating to the availability of credit and the interest rate thereon.

2. How to Produce? • In the private sector it is the price

mechanism that solves the problem of how to produce.

• Firms will choose the method of production on the basis of factor prices. Profit motive motivates them to choose the least costly or the most efficient technique of production.

• In the public sector, the problem of how to produce is solved by the planning authority and the government.

• the planning authority is influenced not only by the input prices, but also by the objectives of generating more employment opportunities, promoting economic growth, etc.

3.For Whom to Produce?• The decision for whom to produce is

taken by the government. • The main objective of the government

is that adequate quantity of necessities must be produced.

• The government controls production in the private sector as well to achieve this objective so as to ensure the availability of necessities.