SUMMARIZED AEC 201 NOTES ON

● MEANING OF AN ECONOMY
● THE CENTRAL PROBLEMS OF AN ECONOMY
● PRICE THEORY AND THE ROLE OF PRICES IN A FREE MARKET
ECONOMY

MEANING OF AN ECONOMY

An economy refers to the economic system of an area, region or country. It is a

system by which people get a living. India economy consists of farms,
factories, mines, shops, banks, railways, houses etc. which provides the Indian
people with the goods and services which they either use themselves or sell
abroad in order to be able to buy imports.

NOTE:
An economy is a system of parts which are interrelated and interdependent
like the cells of an animals or plants. It is a system of mutual exchange
between producers and consumers.
According to Sir John Hicks: “An economy consists of nothing else but an
immense cooperation of workers or producers to make things and do things
consumers want”.

VITAL PROCESSES OF AN ECONOMY

1.PRODUCTION: It is the first vital process of an economy which must go on

continuously. Production includes any activity and the provision of any
service which satisfies and is expected to satisfy a want. In this wider sense,
production includes products produced on farms like wheat, vegetables,
pulses, etc. and those manufactured in factories such as clothes, bicycles,
television sets, etc. it also includes the services of shopkeepers, traders,
transporters, actors, teachers and the likes who help in satisfying the wants of
the people in the economy through their services.
 The term production excludes certain goods and services though they
satisfy human wants. First, domestic work done within the family by the
housewife, husband, or children. Second, the production of hobby articles like
paintings.

2. CONSUMPTION: It is the second vital process of an economy. It means the

use of economic goods and services in the satisfaction of human wants. The
consumption that goes on in the economy may be of various types which Prof.
Hicks classified into two
● Single-use goods
● Durable-use goods

SINGLE-USE GOODS
They are those which are used up in a single act such good are foodstuffs,
cigarettes, matches, fuel etc. They are the article of direct consumption
because they directly satisfy human wants. Similarly, the service of doctors,
bus drivers or waiters are Included under “single-use-goods”.
DURABLE-USE GOODS
They are those which can be used for a considerable period of time. It is
immaterial whether the period is short or long. Such goods are pens, bicycles,
clothes, fans, television sets, furniture etc.
Prof. Brown characterizes some of the durable-use goods as long lived
things. Furniture and dwelling houses are the long lived things which render
their services year by year over the whole of their useful physical existence.
They are a piece of production for the future and their consumption is spread
over many years. Such goods are fixed investments.
As in production so in consumption, all goods and services which are not
paid for in their act of use are excluded from consumption, such as vegetables
grown in the kitchen garden and the services of the housewife.

3. GROWTH: Looking at the process by which economies grow like living

things. Economic growth is the process whereby the real per capital income of
a country increases over a long period of time. We enumerate the factors
which lead to the growth of an economy.
 (I) Growth of population: Particularly working population is the first cause
of growth. A rapidly growing population in relation to the growth of the
national products keeps the output per head at low level.
(II) Growth in the quantity of capital per head: It is another factor which
tends to raise the growth rate of an economy. Expansion of capital is
particularly essential in those countries where the growth rate of the
population is quite high. Increase in numbers requires more capital to equip
the growing labor force. The tool of capital-output ratio measures the amount
of capital required to produce an extra unit of output or income.
(III) Supply of savings: The main source of savings are the rich, the middle
class, the businessmen, the corporations and the government.

NOTE:
The poor countries hardly save 5% of their national income. The main
reasons being low personal incomes, high propensity to consume, lack of
enterprise and initiative, expenditure on conspicuous consumptions, on
traditional item, on palatial buildings fitted with luxury gadgets and
economically enterprising governments. On the other hand, the rich countries
save about 15 to 20% of their national income. In such countries, the
propensity to save people on the whole is very high, businessmen, traders,
landlords, and corporations make huge profit which are taxed by government.
(IV) Borrowing from abroad: External borrowing is resorted to for two
reasons.
● To supplement low domestic savings
● To get foreign currency for the purpose of importing capital for
developmental purposes.

NOTE:
All countries have to borrow in the early stages of their development. The
inflow of capitals is in forms of loans, technical know-how, skilled personnel,
organization experience, capital equipment etc.
Thus, all economies whether they are capitalist, socialist or mixed perform
these important functions of consumption, production and growth.
 THE CENTRAL PROBLEMS OF ECONOMY

The main problem of an economy is of economizing scarce resources. In

this sense, economics is the study of allocation of scarce resources to
alternative ends.
The problems of scarcity arises because human wants are numerous and
the means to satisfy them are limited. This leads to the problem of choice of
selecting alternatives uses to which scarce resources can be put.
The solution to this problem of allocating scarce resources lies in the
pricing system which exists in every economic system, whether it is capitalist,
socialist or mixed. For this, the economic system must solve five basic
problems which we discuss one by one.

1. WHAT TO PRODUCE AND IN WHAT QUANTITIES?

The first central problems of an economy is to decide what goods and
services are to be produced and in what quantities. This involves the
allocation of scarce resources in relation to the composition of total output in
the economy. Since the resources are scarce, the society has to decide about
goods to be produced: wheat, cloth, roads, television, power, buildings, and so
on.
Once the nature of goods to be produced is decided, then their quantities
are to be decided. How many tones of wheat, how many television, how many
buildings etc. since resources are scarce, if some goods are produced in lager
quantities , some other goods will have to be produced in smaller quantities.

2. HOW TO PRODUCE THESE GOODS?

The next basic problems of an economy is to decide about the techniques
or methods to be used in order to produce the required goods. This problem is
primarily dependent upon the availability of resources within the economy. If
land is available in abundance, it may have extensive cultivation. If land is
scarce, intensive methods of cultivation may be used. If labor is in abundance,
it may use labor-intensive technique while in the case of labor shortage,
capital-intensive techniques may be used.
 The technique to be used also depends upon the type and quantity of
goods to be produced. For producing capital goods and large outputs,
complicated and expensive machines & techniques are required. On the other
hand, simple consumer goods and small outputs require small and less
expensive machines and comparatively simple techniques. Further, it has to
be decided what goods and services are to be produced in the public sector
and what goods and services in the private sector.

3. FOR WHOM ARE THE GOODS PRODUCED?

The third basic problem to be decided is the allocation of goods among the
members of the society. The allocation of basic consumer goods or necessities
and luxuries comforts and among the household takes place on the basis of
among the distribution of national income.
Whoever possesses the means to buy the goods may have them. A rich
person may have a larger share of luxuries goods, and a poor person have
more quantities of the basic consumer goods he needs.

4. HOW EFFICIENTLY ARE THE RESOURCES BEING USED?

This is one of the important basic problems of an economy because having
made the three earlier decisions, the society has to see whether the resources
it owns are being utilized fully or not. In case the resources of the economy
are lying idle, it has to find out ways and means to utilize them fully. If the
idleness or resources, say manpower, land or capital is due to their male
allocation, the society will have to adopt such monetary, fiscal or physical
measures whereby this is corrected.

5. IS THE ECONOMY GROWING?

The last and most important problem is to find out whether the economy
is growing through time or is it stagnant. If the economy is stagnant at any
point inside the production possibility curve PP whereby the economy now
produces larger quantities of consumer goods & capital goods. Economic
growth takes place through a higher rate of capital formation which consist of
replacing existing capital goods with new and more productive ones by
adopting more efficient production techniques or through innovations.
 NOTE:
Economy growth enable the economy to have more of both the goods. All the
above central problems of an economy are interrelated and interdependent.
They arise from the fundamental economic problems of scarcity of means and
multiplicity of ends which leads to the problem of choice or economizing of
resources. The solution to these five basic problems lies in the price
mechanism.

PRICE THEORY AND THE ROLE OF PRICES IN A FREE MARKET ECONOMY.

MEANING OF PRICE THEORY

Oscar Wilde once remarked “ Am economist is someone who knows the
price of everything and the value of nothing.”
Price theory also known as micro economics is concerned with the
economic behavior of individual consumers, producers, and resource owners.
Price theory as defined by Prof. Leftwich, is concerned with the flow of goods
and services from business firms to consumers, the composition of the flow
and the evaluation or pricing of the component parts of the flow.

PRICE THEORY LIMITATIONS

1. It simply provides a theoretical analysis of the working of the individual

parts of the economy.
2. It only lays down guidelines based on given data.
3. Even the assumption of rationality on which decision making is based to
achieve the most efficient use of scarce resources is seldom observed by
businessmen and consumers.
4. Price theory may not give a description of the real world since it is based on
limited data and unrealistic assumptions.

PRICE SYSTEM OR PRICE MECHANISM

 Price theory operates in the price (or market) systems or price mechanism.
Price system is a system of economic organization in which each individual
in his capacity as a consumer, producer & resource owner is engaged in
economic activity with a large measure of freedom.

IT'S LIMITATIONS

1. There is always an element of uncertainty when constant adjustments are

taking place in the forces of demand & supply.
2. The process of adjustments is often painful and costly. Mistakes creep in.
The economy is often engulfed in inflationary or deflationary processes.

PRICE SYSTEM AND EFFICIENCY

Every price system (or economy) seeks to attain efficiency with the limited
resources at its disposal. In general, efficiency means the ability to make the
best use of an economy’s available resources. Efficiency is of two types:
● Technical efficiency
● Economic efficiency

NOTE:
When an economy is producing the maximum output by making the fullest
possible utilization of it's existing resources and technology, it is said to be
technically efficient. On the other hand, an economy achieves economic
efficiency when it is producing the largest possible output of goods and
services from it's available resources.

LIMITATIONS OF PRICE MECHANISM IN A FREE MARKET ECONOMY

The price mechanism does not operate freely. It acts under the certain
restraints placed by the government in a free enterprise economy. Moreover,
there are “ imperfections of competition” which obstruct the working of the
price mechanisms. We discuss the factors below.
1. The government issues directives to producers to manufacture goods of
different types and in fixed quantities which are required to meet the
social wants.
2. The imposition of administrative controls, regulating the supplies of
goods, rationing of commodities, issuing of licenses, fixation of quotas
etc. are some of the devices which tend to modify the working of an
automatic price system.
3. Measured aimed at nationalization of social services also tend to modify
the price system in favor of a mixed economy.
4. The price mechanism functions under the assumptions of perfect
competition.
5. The price mechanism has increased income inequalities instead of
reducing them. This is because the supply and demand do not work
properly.

ROLE OF PRICE MECHANISM

1. What and How Much To Produce: The first function of prices is to

resolve the problem of what to produce and in what quantities. This
involves allocation of scarce resources in relation to the composition of
total output in the economy. Since resources are scarce, the society has
to decide about the goods to be produced .
2. How To Produce: The next task of prices is to determine the techniques
to be used for the production of articles . Prices of factors service are the
rewards received by them.
3. To Determine Income Distribution: Another function of prices is to
determine the distribution of income. In a free enterprise economy
product-distribution and income-distribution are interdependent. It is a
system of mutual exchanges where the producers and consumers are
largely the same people. The owners of factors sell their services for
 money and then spend that money to buy the goods produced by factor
services.
4. To Utilize Resource Fully: The price mechanism also helps in full
utilization of the resources of an economy. Full utilization of resources
implies their full employment. This requires increase in income through
large investments, and ultimately to the equality of saving and
investment.
5. To Provide An Incentive To Growth: Lastly, prices are an important
factor in providing for economic growth. The impetus for improvement,
innovation and development comes through the price mechanism.
Higher prices and profits encourage large industrial concerns to spend
huge sums on research and experimentation to improve and develop
better techniques.

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