UNIT 1 FUNDAMENTAL PROBLEMS OF

ECONOMIC SYSTEMS
Structure
1.0 Objectives
1.1 Introduction
1.2 An Economic System
1.2.1 Scarce Means and Unlimited Wants
1.2.2 An Economic System or Economy
f; 1.2.3 Economic Agents
1.3 Factors of Production
1.3.1 Land
1.3.2 Labour
1.3.3 Capital
1.3.4 Entrepreneurship
1.4 Fundamental Problems of an Economy
1.4.1 What to Rod,uce?
1.4.2 How to Produce?
1.4.3 For Whom to Produce?
1.4.4 The Problem of Growth
1.4.5 Choice between Public and Pfivate doods
1 4.6 The Roblem of Merit Goods
1.5 Production Possibility Curve
1.6 Albcation of Resources
1.6.1 Resource Allocation in a Capitalist Economy
1.6.2 Resource,Alloca~onin a Socialist Economy
1.6.3 Resource Allocation in a id Economy
1.7 Let Us Sum Up
1.8 Key Words
1.9 Answers to Check Your Progress
; 1.10 Terminal Questions

1.0 OBJECTIVES
After studying this unit. you bhould be able to:
cxplain the problem of scarcity of resources for satisfying ever-increasing wants of
a society
state the meaning and nature of an -.conomic system
describe the concept of economic agents
explain thc conccpt of factors of production, as also their main types and
characteristics
state the source, nature and relevant details of the fundamental of an
economy
describe the concept of production possibility curve
state the issues relating to allocation of resources between investment and
consumption, and between private and public goods
explain the methods of resource allocation in a market economy, a socialist
economy and a.mixed economy.

1.1 INTRODUCTION

In this introductory unit you would be introduced to some important fundamental

questions and problems faced by every economy. A familiarity with them would help
you in understanding economic reasoning and theories based upon that reasoning. It
would also become easier for you to understand the nature of problems which an
economy faces and the type of solutions for resolving such problems. In this unit you
will study in detail the meaning of an economic system or an economy, fundamental
problems of an economy, meaning and eharacteristic features of factors of production,
the concept of production possibility curve, and the nature of resource allocation in
different tvnes of economic svstems
1.2 AN ECONOMIC SYSTEM
Before we discuss the fundamental concepts, questions and probIems faced by every
economy, let us first know the meaning and nature of an e c o n o d ~ csystem.
1.2.1 Scarce Means and Unlimited Wants
Every person has some wants. If they are not satisfied, the person concerned feels a
'pain' which may be physical or psychological or both. If, onrhe other hand, a want
is satisfied, the feeling of 'pain' is replaced by that of 'satisfaction' or 'fulfihnent'.
This fact urges every human being to satisfy his wants. Some people try t o reduce
their wants, but even such persons make an effort to satisfy their wants, however
limited they may be. You shouid note that different persons have generally different .
wants, and wants of even the same person keep changing with the passage of time,
change of place and status. This is because wants of a person depend upon a number
of factors. Such factors differ from person to person and also over time. They include
his physical health, his ideas and attitudes, the society he belongs to, the place he
lives in, the season of the year, and so on. Wants of a person also change with thc
change in hisher income.
Human wants have .certain characteristics and you should make note of them for
understanding the nature of an economic system. One such characteristic is thatmany
of the human wants cannot be satisfiedperrmently. We say that these wants 'recur'.
When such a want is satisfied, it emerges .again and has to be satisfied repeatedly.
For example, a person can satisfy his hunger b consuming food. but he becomes
hungry again after some time and needs food to Y satisfy it. Another characteristic of
human wants is that new wants keep conzing up. That is to say, as mme wants are
satisfied, new ones take their place.
These two characteristics of wants, namely, i) recurrence of wants satisfied carlicr.
and (ii) emergence of new wants, mean that human wants are ualimited and keep
increasing. Human beings have a constant urge to improve their standard of living
and to explore the unknown. They feel like trying new things. Also on cvcr changing
state of affairs keep creating new wants.
You should note the fact that satisfaction of a want requires the usc of some goods
or services, called 'means' of satisfadion. Any specific want may be satistied by
various means. Similarly, a specific mean may be usable to satisfy various wants. For
our purpose. however, a more significant basic fact is that the available goods and
services are never sufficient to satisfy all our recurring and ever-increasing wants.
What is the way out of this scarcity? Some thinkers believe that human bcings +houlcl
cut their wants to meet this imbalance. But this philosophy is approvcd by very few
persons and their thinking and behaviour hardly makes any difference to the thinking
and behaviour of the society as a whole. In other words. the fdct is that the society
does not want to check the growth of wants.. It only tries to satisfy more and more
of them. And this is the basic behaviour pattern which we must accept as a reality.
Satisfaction of wants of an increasing scale requires two fold strategy:
1) Meansprovided by nature are insufficient for satisfying all wants of the members
of the society. Therefore, their availability must be increased in possible wa)s
such as, by organising production centres, by training the labour force.
by improving production methods, by creating institutions like money and banking
and so on.
2) YO; have learnt that'all wants of all people cannot be satisfied. Therefore, some
system has t o be devised whereby more important and'more urgent wants are
identified out of the total and are given priority. In the other words, scarce means
have to be rationed out between members of the society and their use for different
wants has to be regulated. It implies that the use of reso&ces has to be
'economised'-which means that the resources cannot be wasted or put to less
important uses.
1.2.2 An Economic System or Economy ?.
societies try to solve these issues in different ways and in the process each
sociAy creates a set-up called 'An economy'. T h e term 'economy' o r 'ecoflOmic system'
is a comprehensive ane.lt covers the entire set-up created for meet@ the basic and
permanent problem of an imbalance between means and wants- Thus it includes not.
only the natural resources Of a country, but also those which are created by man. It
includes the entire arrangement relating to production, trading and exchange,
transportation and distribution of goods and services. Similarly, various institutions
like currency, banking, financial assets, and markets, etc., created and maintained to
meet the above said twin objectives are part of an economic system. You would realise

You would realise that in reality the composition of an economy will depend upon a
number of factors. The extent of natural resaurces of a country, its geographical and
climatic factors, its social, political and religious set-up, its past history and many other
forces determine the exact form of the economy of that country. As a result, the economy
of one country can substantially differ from that of another. It is for this reason that we talk
of the Indian Economy as against the British Economy or the Japanese Economy. Thus the
term Indian Economy-representsthe totality of the set-up, institutions, arrangements which
the Indian society has built up for meeting the twin objectives of i) increasing the
availability of means to satisfy wants, and ii) using them in the most economical maaner
possible. AU the natural and man-made productive resources are also part of the Indian
Economy.

Knowledge of salient and distinguishes features of an economy helps you in analysing

its problems and their possible solutions. Accordingly, we also classify economies on
the basis of their distinguishing features. For example, take the case of a capitalist
economy.., In this case the means of production are owned and inherited by
individuals, and various Cconomic decisions are guided by prices of goods and services
in the market. The income of an individual is determined by means of production
supplied by him to the market and the rates at which they are paid for.
Another manner of distinguishing between different eoo?omies is with reference to
the predominance of the type of productive zesources, income and employment, etc.
On this basis an economy may be an agricultural or an industrial one. Similarly,
depending upon its level of development (that is ability to produce means of
satisfaction), an economy may be termed as a developed economy or an
underdeveloped economy. You should also note that with the passage of time, the
salient features of an economy generally undergo a change either through histotical
evolution or through deliberate policy measures.
Therefore, every economy has to solve the basic problem of scarcity of means of
satisfaction in relation to ever increasing wants. The means and wants can be combined in
alternative ways. The problem of scarcity exists whether an economy is developed or
underdeveloped. Hence it has to address itself to two issues:
1) increasing the availability of means of satisfaction, and
2) laying down tHe priorities of the wants to be satisfied. %

1.2.3 Economic-Agents .
Economic agents are the decision-making units of an economic system. Normally, we
think of such economic units as individuals, households, business firms and
companies, institutions, and various organs of State. They undertake a Ggriety of
decisions while acting in different cqpacities, such as consumers, savers, investors,
buyers of inputs, suppliers of goods and services, borrowtrs, lenders and so on. It is
the decisions and activities of economic agents which comprise the working of an
economy and determlrre-ls health and efficiency.
#'
You havc already learnt that the nature pmyides us, free of cost, with only a limited
rewurces which are insufficient fdr satisfying all our wants. Accordingly, their
availability h ~ tos be increased for satisfying additional wants. You can also say that
thew resowws have to be produced. .
In txoadrnk6, the t e r n 'Pr&actton' hnpltes IRk tMaQlbnnPP1Bn elvaritm Illpctts lnto
cmtpabmby i m w ~ n thc g want-sittidyiaig cqmdty aftti&inpwts.,Items which are
so transformed are cailed inpytswhile output is nothifig but the transformed form of
inputs. A particular transfonfiation Is production if the want-satisfying capacity of the
output (also called 'product') is more than that of its inputs. To put it differently
production is nothing bufthe cre9#d11u f d l t t y . Now you may ask what utility is. In
economics,utility mems the expert4 atisfaeticm whlch the consumers hope to derive
fmm the use of various goods and services. Thnsfotmation of inputs into output (i.e.,
productioh) can take many forms. Quite often there is a change in the physical and
chemical form of inputs such as conversion of raw cotton into finished cloth. An item can
acquire utility when it is transported to t h m who need it more. This form of production is
through 'place transformation'. Similarly, many items gain utility when they are stored for
later use. You can also think of various activities like processing, pcking, etc., which
form part of the production set-up of the economy, It is also noteworthy that production
includes the provisian of services even when they do not involve the use of a material
item.

Thisbrings us to the concept of Prdhction ~esaurcesor Factom of ~rductian,that

is, irems which act as inputs in production. Indjviduel items of the inputs can be
classified or grouped into some broad categories such that all units belonging to the
same category are equally productive or homogeneous or perfect substitutes of each
other while those belonging to different categories are not. Classified in this manner, each
group of input units is referred to as a fsrctor of production. In general, the input units are
classified into four main factors ofproduction. They are 1) land, 2) labour, 3) capital and
4) organlsation or entrepreneurship. Let us discuss about each of them in'detail.

1.3.1 Land
The term does not represent just the area available for cultivation, factories, houses,
roads, etc. It is used in a much broader sense. It includes the materials and the forces
which nature gives us free for the satisfaction of our wants or for the production of
p o d s and services. Thus the t e r n tand not only includes land in ordinary sense of
the term, but also the rexrurces like water, climate, sunshine, minerals and the like.
 In other words, land includes not only the land used for agricultural or indust~ial
purposes, but also at1 the natural resources taken from above or below the soil. Thus,
land represents the sum total of natural resources available to the ecanomy.
I Defined in this way, supply of land is fixed. It is'predetermined by nature, and man
I cannot add to it through his own efforts. While an individual can get more of land
by paying for it, the society as a whole cannot ipcrease its availability. Land has no
mobility. Land cannot be transfered from one place to another. But its use can be
transferred, a plot of land can be used either for paddy or for jute. However, a transfer
price is necessary.
\
What about the maiket prices o f different forms of land or patural resource\?
Although we say that land is a free gift of nature, an individual may not gel the land
freeof cost. He has t o pay 40mc money and buy it. Market price to land comes into
existence as a result of economic arrangements like privatc ownership and
inheritance.

1.3.2 Labour
In economics, the term labour is used to dcnotc ilny manual or mental activity that
is undertaken in exchange for a payment. This concept of It~bour.howcvcr, is confined
t o only human effort ancl thc work pcrformcd by animals and machincs is not
considepcd as labour.

It is noteworthy that lahour cannot hc separated from the person of the labourer
and used as an input. That is t o say. thc labourer has to sell it in person. Another
feature of labour is that it\ pcrformancc cennot He postponed. If a,labourer does not
work during onc month, then thc labour of that period cannot be performed in future.
Labour not performed is labour lost for ever. For this reason, the bargaining strength
of workers tends to be low and thcy frcqucntly have to accept low wages or go withdut
any income. Moreovcr, those workers who do not have any other source of-income
find themselves in a still weaker bargaining position.

Labour is not a homogeneous factor of production. We come across a large variety

of workers, both skilled and unskilled. Clubbing them together in one group of factors
.of pruduction is. therefore. helpful only in a simplified form of economic analysis,
You would note that even unskilled workers do not have-a uniform productive
efficiency. 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 jads. 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 ttained 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 ftorn
one country to another. the population of a cwntry becomes the only source of its
totallabour force. Bvt its size of labour force is influenced by other c a u q s also, such
- .
as the proportion of persons in different age groups, social customs. attitudes. etc.

Till now, we have been talking about the quantity of labour. that is, the number of
workers available for different kinds of employment. However, the discussion of
labour as a factor of production would remain incomplete without a reference to i t s
quality. In the context of a single worker, this concept denotes two aJplecas: i) &e
intensity with which a worker works. and ii) the maximum efficiency which :hat
worker can achieve.

The intensity of labour depends upon the willingness of t h t worker to work without
wasting any time andeffort. It depends upon a number of influencing forces, s u ~ h as
the general social atmosphere, the-loyalty which he feels towards his job, rHe wage
rate, the work atmosphere and s i m i l ~ other
r aspects. Tbe level of efficiency of a
worker, on the other hand, depends upon his education and training, skill, health
and personal qualities, the climatic conditions and the organisationai set-up of the
production unit.
Landand labour are called two primary factors of production. ~roductionis not
possible without using these two primary factors of production. Labour cannot work
unless there is land to work upon, and land by itself cannot produce anything unless
labour acts on it.
1.3.3 Capital
The term capital refers to that group of productive resources which are the resslt af
human labour. Capital represents man-made productive resources. They are produced
means of production. While land is a free gift of nature in the sense thatits availability
is there without spending any labour on it, capital is not a free gift in that sense.
Capital is. in a way, a form of concealed or-crystallisedlabour. It appears in various
forms such as plant and machinery, buildings, roa!s, bridges, means of transportation
and communication, and so on.
The process of development requires skill and training of the labour force so that the
labour force can make use of machines and equipment in an efficient manner. An
underdeveloped country is required to train its labour force in engineering,
t~chnology,medicine, management and a number of other fields. Since skill
formation improves the productive capacity of the labour force, this process is
referred to as human capital formation. Since a healthy worker is considered more
productive, investment in the health of workers is also included in human capital
formation.
You should note that only those products which are meant to used for further
production come under capital. If a product is used for final consumption, it is not a
part of capital goods. It frequently happens that white some units of a particular
product are used as capital, others are used for final consumption. Such products,
thus, become partly capital.
Since capital is the result of human labour going into the production of means of
production instead of goods meant for consumption, there is no end or upper limit
to the extent it can be accumulated. An economic system can keep diverting a portion
of its productive resources to the production of goods meant for further production
and thereby add to its capital stock. This process is called capital formation. We
should note that praduction involves the use of capital stock of the economy.
Therefore, in the process of production, capital stock of the &nomy is reduced. If
a net addition to the capital stock of the economy is to take place, capital
accumulation during a given period must exceed the amount used in production
during the same period.
Why should an economy add to its capital stock? The answer lies in the fact that an
increase in capital stock, when properly used, increases labour productivity. When
the economy diverts its productive resources to the production of capital goods, there
is reduction in immediate.availability of consumption goods. But there will be much
larger increase in the production of consumption goods in later periods.
1.3.4 Entrepreneurship
Economists believe in the existence of a fourth factor of production, namely,
organisation p,r entrepreneurship which is supplied by the entrepreneur. Land, labour
and capital by themselves cannot come together and organise themselves into
produaive processel iojield output. They have to .be procured and put to work in
a systematic and coordinated manner. Most production processes are time consuming.
The entrepreneur procures the inputs-and pays for them in anticipation of receiving
larger sales proceeds when the output is sold. It is the entrepreneur who assumes the
risk of loss and it is he who is entitled to a profit, if there is any. The job of the
entrepreneur is particularly risky in an atmosphere of uncertainty.
 ii) Utility is the wmt-satisfying capacity of a thing.
iii) Reduction ir the mation of utility.
iv) Availability of land t o a country can be increased.
v) A factor of production consisupf various items which can be ~uhstituttd '. +

each other without affecting total output.

3 Fill in the blanks.
. i) .........................and ..............,.. are two primary factors 41C ,?!~).IULIII.~~

ii) In a production proceks, inputs arc the items which go into it wh;:~.tlutpdr arc
the items which ......... ............ ........ ........... .. . . ... . . . . . . . . . . .. .
iii) Capital is the means of production meant for . .. ..
iv) ~ h i l ;land is a free gift of nature, capital is

1.4 FUNDAMENTAL PROBLEMS OF AN ECONOMY

You have learnt that the basic characteristic of every economic system is the scarcity
of resources in relation to human needs, and'the use of such resources in alternative
ways to meet the ends. Accordingly, every economy is faced with certain basic or
fundamental problems which it must try to solve within its socio-economic framework.
These fundamental problems are:
i) What to produce?
ii) How to produce?
iii) For whom to produce?
iv) The choice between current consumption and growth through saving and
investment.
In addition. every economy has to face other important questions, such as the choice
between public and private goods. There are also certain other problems like
unemployment. balance of payments,, etc., which crop up now and then and which
may or may not be faced by all e'conomies. Let us discuss in detail about these
problems which are central o r basic to every economy.

1.4.1 What to Produce?

You have already learnt that an econQmy does not have enough resowces to produce
everything required by it. So, it must be selective-and decide what to produce and
what not to produce. When some goads are not produced, some wants of the society
remain unsatisfied. The decisions regarding the wants to be satisfied and the goods
and services to be produced are interrelated and one does not stand independent of
the other. This is called allocation of productive resources. If some factors of
production are employed in the production of product X, they are not. to the extent
being employed in the production of product Y. The problems can be illustrated by
the famous Production Possibility Curve which you shall study later in this unit.
You should note that this problem cannot be removed completely from the SLL'ALI.
Developed economies;for example, have more productive resources. Eveff in these
-cases, the resources are not sufficient for meeting all their needs. Moreover, the
nature of this problem does not change by changing the structure of the economy.
Irrespective of ttie type of economic system-a capitalist or a socialist o r a mixed
economy-the allocation of resources between production of different goods he6 to
be decided. Later in this unit, you will study how different econowic systems solke
their problems in different ways.

1.4.2 How to Produce?

This is a problem which covers the deiails of the allocation of productlvc resources
in the production of various goods and services. More precisely, you can say that
when an economy decides to produce product X, it has also to work out exactly how
much of labour, capital, land, etc., would go into its production. The exact proportion
I
of factors af production used in the . production
. - - of-- an item is called the technique i>f
I 4..
production of that item. For example, we may think of which are produced by
using more of labour than capital. In such cases labour intensive techniques qf
production are said to be in use. On the other hand, if more of capital goes into the
production of an item, then we say that it is being produced by a capital-intensive
technique. For any country, ideally speaking, the 'choice of technique of production
depend upon the relative availability of factors of production. A countryolike ours
which has more of labour and less of capital should go in for labour-intensive
techniques of production. Similarly, there are many countries which have abundance
of capital but a shortage of labour. They should prefer capital-intensive methods of
production.
When an individual producer is to decide about the technique of producing any
particular product, he considers the prices and productivities of alternative inputs.
He tries to use those inputs for which the output per unit of cost is the maximum
because it is this choice which is most profitable for him. This way, he can keep the cost of
production low and, thus, maximises profit.
1.4.3 For Whom to Produce?
A society comprises a large number of individuals and households. All the output of
consumption goods and services is ultimately meant for their use. Therefore, all the
goods and services produced are to be distributed amongst the individuals and
households. The share of each individual and household has to be determined and
also the quantities of specific goods and services'which comprise that share. You can
easily see that it is possible to'propose different principles whereby this distribution
may be carried out. In an economic system organised on market principles, the
income shares of individual members of the society are determined in the following
manner. In a market ecynomy, productive resources are privately owned. They are
sold, bought and hired like any other goods or services. The price of a productive
resource is determined by the market forces of demand and supply. Whenever it is
to be employed by a producer, he has to pay its market price to its owner. It is for
the owner to supply it to the market or withold it. The income of each individual,
under these conditions, is determined by the amounts of different productive
resources owned and supplied by him to the market and their respective prices. This
system of illcome distribution has obviously many shortcomings. It is not related to
the effort put in by members of the society. The ownership of means of production
is uneven between members of the society. This leads to large scale inequalities of
income distribution also. In modem economies, governments try to reduce these
inequalities through various measures like taxation, etc.
In a socialist economy, on the other hand, an effort is made to reduce the inequalities
by shifting-the ownership of means of production (other than labour) to the State or
cooperatives, and relating incomes of individual members of the society to their work
performance. The state assures some basic necessities for everyone and it also takes
care of 'the old, sick and children. An individual can get additional income only by
doing some additional work.
You would note that in an underdeveloped economic system, which has a limited
number of households and individuals, it is possible to have complete physical
rationing of goods and services. But with development, the organisational structure
of an economy also becomes increasingly complex. It starts producing a much larger
quantity of goods and services. As the number of occupatjoiis increases, the variety
of inputs and outputs leads to a corresponding increase in the number of goods and
services. Quite often, the size of the society also becomes large. Under such
circumstances, it is no longer possible to have a sysjemof complete physical rationing
sf goods and services. It is more practical to enaure purchasing power to individual
members of the society and at the same time fix prices for goods and services. When
the members have the purchasing power, they can decide on their own what to buy
and how much to buy, subject to the condition that they pay for each purchase. Put
in this manner, the problem 'for whom to produce' boils down to thai of distribution
of income amongst members of the society. It is possible that the actual pattern of
income distribution h a y have such inequalities which are not acceptable to the
society. In that case, the authorities try to modify the income distribution through
various policy measures including taxation.
The problem of distribution does not have any easy solution. It is not always possible
for everyone to agree to a particular rule of income distribution and the extent to
which income inequalities should be allowed. It is also not easy to estimate relative
needs of the members of the society. Moreover, any system of income distribution is
bound to havean impact of incentives for production'by the members of the society
and, therefore; on the lcvcl of national income.

1.4.4 The Problem of Growth

Every economic system tries to overcome the scarcity of productive resources. With
this goal in mind, it wves a portion of its national produce from current consumption'
and uses it for capital formation or addition to the stock of productive resources.
Capital formation, thus, forms an important and necessary function of an economy
both for its survival and growth. Stock of productive resources of an economy keeps
decreasing through use; i.e., through depreciation. Therefore, for achieving a net
addition to capital stock, gross saving and capital formation must exceed the
depreciation.

1.4.5 Choiqe between Public and Private Goods

In order to understand the problem of choicc between private and public goods, you
should first know the meaning of public and privatc goods. Let us understand these
two concepts first.
1 Private Goods : There are certain g o d s (the term goods here includes services also)
whose availability can be restricted to selected individuals only. For example, a
product may be priced in the market and only those who pay its price may be
allowed to have it. This characteristic of a product by which some people can be
prevented from its use is referred to as the cprincipleof exclusion'. Accordingly,
those persons who cannot pay for it or who are not ready to pay, are not allowed
to use it. The use of the goods is thus divisible between different persons. Any goods
which can be p r i d and whom use can be restricted to selected persons is k d
as private goods. You should remember that ~rivategoods are not necessarily produced
by theprivate sector of the economy. I t may also be produced by the3overnment
or public sector or by cooperatives or by pfoduction units owned jointly by the
private and public sectors.
2 Publk Goods : Whcn it is noi possible to restrict the availability of a product to
selected individuals, they are termed as public goods or social goods. Such goods
cannot be so priced as to deprive. some persons from using it. That way, it is
indivisible. Defence service is a typical example of a public service. When a country
is protected against foreign aggression, every citizen is protected. You cannot
declare that only those who gay a stated price to it would be taken care of and
others would be M unptected. Similarly: when street lights are provided,
everyone in the locality gets the benefit. But you should know thaf equal availability
of public goods does not mean that every member of the society actually gets an
equal share in it. For example. people living near the political boundaries of a
countq or nCar the sensitive military targets are likely to suffer more than others
#in a war. The main criterion of indivisibility of goods is that it should be equally
^%vailable to all members of the society without consideration of their ability or
$ wilCingness to pay for it. Such goods have to be provided out of the public funds
.i~ndnot through market @cing.
In actual practice, it is difficult to find pure public or pure private goods. Most of
them are a mixture of both. We, therefore, term goods public or private depending
upon its dominating characteristics.
With its limited resources, an economy cannot have enough of both public and private
goods. It must try to achieve an optimum combination of both. This decision also
brings in another question. Who should be given the responsibility of providing public
goods and who should provide private goods? Ecohomists argue that those goods
which are predominantly public in character should be produced by the public sector,
since their cost of supply cannot be recovered through sale proceeds. On the other
hand, private goods can be provided by both the private sector and the public sector.
The choice depends upon the philosophy which the society believes in.

1.4.6 The Problem of Merit Goods

~ h i s . i sanother problem which a modern society faces. Thoee goods whose
consumption Is considered highly desirable for the members of the socfety are termed
Y u f i d ~ ~ f l l u l ~ M ~ m h t ~ ~ f l l n t m l c as
Mtrlt g d 8 ; The important feature of the merit goods Is that their consumption
X)nlrnu ad lWc Conce$b
bcnefits both the users and non-users. For example, if a person is educated, it not only
helps him but also the society as a whole. Education, therefore, is a merit product1
service and it is desirable that every member of the society gets education.
Consumption of merit goods bencfits the society as a whole and raises the level of its
efficfenty and well-beimg.l%erefore. every society hasto decide the eYent it can and
should produce and consume merit goods. It is found that if the production and supply
of merit goods is left in the hands of the private sector, the amount produced remains
quite Insufficient. For example, ed!~cationis a costly merit service, and cvcry one
cannot pay for it. Therefore, if it ib left in the hands of the privi~tesector. miiny
lntelli8ellt and dcaerving but poor students would not he uhle to study. Such ;I
situation would be bad not only for such students themselvcs Illit also for thc socicty
as a whole. Similar disastrous results would follow if health cilre wus left totally in
the hands of the private sector. It allows, therefore, thut the authorities should either
take up the responsibility of providing merit goods themsclvcs, or at Icust supplcmcnt
their supply by the private sector.
5 State wtmbcr errb of the fdkmiry smuwntr is Tiue or Fabe.
i) Abcation s f productive rrsounm is h U n r in d l types of economies.
ii) l l ~ ee m proportion ot factors of produtctim d in the-productionof an
item is d k d the tachniquc of p d m a k m of that item.
iii) Private goods are available to all indtdduals free of cost.
Lv) Ooodr w b a e mailabitity h r s q ~ to ~ C e c t e dindividuals ace crlkd
public goods. tr:
v) C o l n y ~ ~ p t i oofnmerit lpods is benefial only to t b ptnomwho amsum
them.

1.5 PRODUCTION POSSIBILITY CURVE

You have karnt that an economy cannot produce everything it requlres and a choice
has to be made between various goods and services that can be produced. You also
know that increasing the prpduction of some goods Implies a corresponding reduction
in the production of other p o d s because less of productive resources are left for the
lutter. The economy, therefore, has to choose between alternative combinations of
goodstand services. This problem of choice can be illustrated by a simple graph known
as Production Po~lbiiityCurve or a Product Tramfonn~tlonCurve. A typical
Production Possibility Curve (PPC)is drawn on the following assumptions:

i) The country has to choose between alternative combinations of only two goods,
say, guns andbutter.
ii) All productive resources of the country are given and addition to them is not
possible.
iii) All productive resources of the economy are fully employed. There is no wastage
or underemployment.
iv) The productive resources %resuitable for the production of both goods, i.e.,
guns and butter. They can, therefore, be shifted from the production of one to
the other goods. However,-such a shift would reduce the production of the first
goods and increase that of the other.
v) No factor of production is considered to be specific in the production of one good
alone and totally inappropriate for the production of the other.
Vi) We consider the productive efficiency of the productive resources only in
physical terms, i.e., the units of guns and butter which they can produce. No
effect on their prices is taken into account.

B;~scdupon thcsc assumptions, we can illustrate the set of production possibilities

faced by a country by a hypothetical example. Look at Table 1.1 carefully. The figures
in the table show that all the productive resources of the country put together can
produce a maximum of either 30 guns or 30 tonnes of butter or some other
combinations thereof. Note that the maximum possible units of guns and butter need
not be equal. They are only so in our example. It is also seen that as more guns are
produced, the quantity of butter keeps decreasing. Thus, for example, when the
production of guns is increased from 15 to 20 in number, the production of butter
falls from 24 to 20 tonnes. It means a loss of 0.8 tonne of butter for each additional
gun. Similarly, when production of guns is increased from 20 to 25, production of
butter falls from 20 to 14 tonnes. It is a loss of 1.2 tonnes of butter for each additional
gun prdduced. Similar position would be found if we increase the production of butter
and reduce that of guns. Thus when we increase the production of butter from zero
to 14 tonnes, production of gulls falls by fivc. I n other words, each tclnnc or" hutter
causes il reduction of 5/14 or 0.357 gun. Howcvcr. whcn the production of huttcr is
increascd from 14 to 20 tonnes, thc f:tIl in the production of guns pcr tonne of hurter
works out 5th or!).H33 pcr gun. I'hc production po+sihilitics illustrutcd in Table I . I
are also rcprrsc~~tud in Fiyurc I , I ~nthe form o l ;I produclion possibility eurve (PPC).
 Quantities of butter in tonnes are measured along X-axis and the number of guns are
measured along Y-axis. The respective pairs of the quantities of guns and butter are
plotted and joined with each other to yield a curve which is called the Production
Possibility Curve. Thus the PPC represents all the possible combinations of guns and
butter which can be produced by using all the productive resources of the economy.
In that sense, each point on the curve represents the maximum possible output and.
for that reason, it is also termed as the production frontier of the economy.
Table 1.1 Production Posdbilities Faced By Country

Combination GUM Butter L a of Butter for each Loss of Guns for each
Number (Numbers) (Tonnes) additional gun additional tonne d butter
p r o d u d (tonncs) producal (numbers)

1 - 30 0 2.8
2 25 14 1.2 0.357
3 20 20 0.8 0 X3.7
1 15 24 0.6 1.250
5 10 27 0.4 1 .fib7
6 5 29 0.2 2.51Xl
7 0 . 30 S.(W#)

PRODUCTION POSSIBILITY
f URVE
f

The economy can produce any combination of guns and butter represented by a point
either on the PPC or in the shaded area of the diagram. Production c~mbinations
represented by the shaded area imply that the economy can produce either guns or
butter or both, but if it does so it is wasting some of its productive resources. Thus
consider point A which represents a combination of 10 tonnes of butter and 14 guns.
ii
The PPC,however, Shows that with this much sf butter. the economy can produce
27 guns (as shown by point C on PPC). Alternatively, with 14 guns, the quantity of
butter can be increased to 25 tonnes (see point B). i1
.
Any point beyond the PPC, that is in the non-shaded area of the diagram, shows a
combination of guns and butter which the economy cannot produce. For example,

1
point 'Drepresents a combination of 30 tonnes of butter and 20 guns. However, when
4 30 tonnes of butter is produced, no resources are left for the production of guns. On
the other hand, if 20 guns are produced, then the quantity of butter has to be reduced
to 20 tonnes.
Extenslon of the Pductlon Frontier : The PPC or production frontier is subject to a
change over time. As an economy adds to its productive resources, or learns to use
them more efficiently, its productive capacity increases and it can produce more
of both guns and butter. As a result, the PPC moves outwards as, for example, t s
the position shown by the upper line. It should be noted that the new PPC need not
be parallel to the old one.

1.6 ALLOCATION OF RESOURCES

You know that every economy has to decide about the allocation of its productive
I
Pwd.mc"W~olecmomk power to demand basic necessities of life while rich people demand luxuries, and
SyltsnvudBvleC~
make it profitable to produce them. As a result, in such a country, there may be
insufficient production of basic necessities like milk while the economy may be
producing luxuries like airwnditioners. To put it differently, the demand pattern
generhted by inequalities of income distribution may not represent real needs of the
society. A socialist economy tries to remedy this situation.
1.6.2 Resource Allocation in a Socialist Economy
The term socialism is used to represent a number of economic systems which differ
from each other in details. However, main features of a socialist economy are as
follows :
i) The means of production are not privately owned. Instead, they are owned by
cooperatives or by the government.
ii) A socialist economy tries to maximise the welfare of the members of the society.
It tries to ensure that the production of goods and services is in conformity with
the actual needs of the members of the soci,ety. It also tries to reduce income
and wealth inequalities to the minimum possible level.
iii). With these objectives in view, market mechanism is not allowed to work freely.
This means that prices are not allowed to fully reflect the effects of demand and
supply forces. Similarly, decision regarding demand and supply of goods and
services are not atways guided by prices, Such decisions are taken out of the
hands of individual economic units. Instead they are taken by some form of
central planning authority such as the government itself or some agency
appointed by it for this purpose. The central authority takes the necessary
decisions on behalf of individual economic units.
It is the central planning authority which decides the waysthe central problem\
of the economy are to be solved. It is for this reason that a socialist economy
is usually referred to as the centrally planned economy also.
iv) The producers and sellers are not allowed to act rationally. That means they
are not allowed to maximise their profits. Instead, most piices of inputs and
outputs are administered. that is, decided administratively by the authorities.
Some of the essential goods and services may be rationed and provided to all
or selected members ofthe society freely or at subsidised rates. Generally, only
non-essential items arc sold at market prices.
Thus the entire decision-making'regarding resource allocation is in the hands of the
authorities in a centrally planned economy. The market forces are not allowed to
influence these decisions. The authorities decide what goods and in what amounts
are to be produced. They decide the allocation of resources for the production of
these goods. Considerations of prices and profits arc not allowcd to uffcct their
decisions. Instead they have the goal of finding out the real needs of thc society and
direct the productive resources of the economy towards meeting them. A major
drawback of a socialist~systemis that it may reduce the incentive to work and produce.
Therefore, a worker can get additional income only by putting in additional labour.
1.6.3 Resource Allocation in a Mixed Economy
A mixed economy is one in which some decisionsare left to the market forces while
others are taken under direct government regulation or even ownership.
Some selected areas of economic activities are reserved for the government sector.
The government acquires the necessary productive resources for these activities and
employ them in conformity with its priorities. The production pattern of the public
sector, the prices of output items of the public sector and other measures are used to
regulate the allocation of resources in private sector as well. These other measures
include price controls, licensing, taxation, subsidies, and others. Additionally, various
labour welfare measures are undertaken. Similar steps are taken to encourage the
use d productive resources for encouraging the development of backward areas of
the country, for removing specific shortages, and for bringing about a balanced
development of the economy as a whole.
~hClkYmrPmgmssD
1 What is praduction possibility curve?
. . .. ....,.......
...........................................................
1.7 LET US SUM UP
Every society is faced with an unending problem of scarcity of means in comparison
with thcir need to satisfy the ever-increasing and unlimited wants. So, every society
trics to incrcasc thc availability of the means on one hand and to economise their tse
on the other. For this purpose, various institutions, methods and arrangements are
dcviscd. and they, in their totality. v e called an 'economy' or an 'economicsystem'.
The precise naturc of nn cconomic system differs from society to society, Moreover.
the economic system adopted by a society also keeps on changing over time.
Economics may be classified in a number of ways, such as on the basis of
prcdomitiancc of productivc resources in use, the type of goods and services
produccd. the type of institutions and property rights. and so on. Economic agents
arc the decision-making units of iin cconomic system.
Productive rcsourccs or mctrns of production are the inputs used for production. The
tcrm production is tt~kento mcan the creation of or addition to utility (i.e,, the
want-satisfying ci~pi~city of an itcm). Means of production can be classified into groups
of homogeneous units (i.e., units which can be substituted for each other without
affmirbg total production). Each such group is
isscpventional to ktwp the
2) h o u r , 3) capital, and 4)
Land denotes productive resources provided free of cost.by nature. it cammi be
created by man though it is possible to discover existiq$Lm? unknown r e s o w s .
Similarly, it is possible to discover new uses for the k n o ~ r e s o u r c e sLabaurcltands
.
for both physical and mental efforts of hunrdn beings clbed for production. Capital
represents the sum total of man-made resources, (i.e.. the produced m a n s of
production). Entrepreneurship is the ultimate decision-making and risk bearing
function connected-with business activities.
;*
F.very emnomy has some fundamental problems which originate from the
*
~"s .,?
means of production in relation to wants. These problems are i) what to p
C' .
t i ) how to uroduce. iii) for whom to uroduce, and iv) the choice between c u r & &
consumpti& and growth through sa;ing and investment, The problem of wlmr to *
produce is closely related to the allocation of means of p d u c t i o n between dtenj.?3tiw . -.
,

employments, while choice of techniques highlights the problem of how to

In addition, every economy has also to decide between the private and pub
- .
as also the extent to which private goods should be pwdrrced in the priv
 flurther more, every economy is faced with the need to increase t h e supply of merit
goods i.e., goods whose consumption is believed to be beneficial both for the
consumers and for the society as a whole.

The problem of what to produce is generally illustrated with the help of a 'Production
Possibility Curve (PPC)' or 'product transformation curve'. It is drawn on the basis
of some simplifying assumptions. The main idea conveyed by a PPC is that when an
econqmy is using its resources fully, then with given techniques of production, it
cannot increase the production of some goods without simultaneously reducing that
of the others. However. with economic growth it is possible tosimultaneously increase
the production of all goods and the PPC moves outwards.
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
characterised by large scale in~qualitiesof 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 owhed 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. However, where need be, even private economic units opcratc
under a variety of government regulations such as price controls, subsidies, taxes,
licenses, quotas, labour laws, and so on.

-
1.8 KEY WORDS
Capital : Man-made or produced means of production.
Capitalist Economy (Market Economy) : An economic system in which the means of
production are owned and inherited by individuals. They take the economic decisions
and they are guided by the prices of goods and services in the market.
Economic Agents : The decision-making units in an economic system.
Economic System or An Economy : The sum total of all institutions, methods and
arrangements to deal with the problem of scarcity of means (resources) in relation to
unlimited wants and the choice of wants to be satisfied.
Entrepreneurship : The ultimate decision-making and risk-bearing connected with
business activities. This is the organising function which combines the services
proyided by other resources so that goods are produced.
Factors of Production : The inputs (land, labour, capital and cgtrepreneurship)
necessary to carry on production.
, Input : An item which goes into the production process.
Labour :.Human effort, physical and mental, which is used as input fpr production
Land : Those means of production which are provided free of cost by nature. It
 includes land used for agricultural or industrial.purposes, as well as natural resources
taken from above or below the soil.
Market Mechanism : Denotes the interaction between demand, supply and prices
and the response of decision-making econonlic units to changes in prices.
Merit ~ o o d s ' :The goods whose consumption is believed to be desirable for the
benefit of the society and the consuming individuals.
Private Goods : Goods whose availability can be restricted to selected users. It is
divisible in that sense.
Production : Creation of utility by different methods.
Production Possibility Curve or Product Transportation Curve : A graphic
representation of the combinations of maximum amounts of goods X and Y which
can be produced with the given productive resources of the economy and'under
certain other simplifying assumptions. P

Productive' Resources : Items which can be used as inputs in production.

~ u b l i Goods
c : Goods or services whose availability cannot be restricted to selected
users only through pricing or through other measures. The benefits of the good$ are
indivisible and people cannot be excluded.

1.9 ANSWERS TO CHECK YOUR PROGRESS

A 3 i) False ii) False iii) False iv) False v) True
vi) True vii) False viii) False
B2 i) False ii) True iii) True iv) False v) True
3 i) Land, Labour ii) come out of it iii) further productron
iv) created by man
C6 i) False ii) True iii) False iv) True v) False
D2 i) False ii) False iii) True iv) False v) True vi) False
3 i ) dcmand, supply and prices ii) rationality iii) marketlcapitalist

1.10 TERMINAL QUESTIONS

1 -what is an economic sysrem? Explain the fundamental problems of an ecdnomy.
2 What are the main characteristics of human wants?
3 'Scarcity is the' mother of every economic system7: Explain.

, 4 What do you understand by factors of production? Briefly explain each of the four
main factors. , ,
5 Write short notes on the following :
a) Public goods and private goods
b) Merit goods
c) Human wants
6 Explain how the solutions to the fundamental problems of an economy are
interlinked &th each other.
7 Explain the concept of a production possibility curve. Enumerate its assumptions.
Illustrate it with the help of an example.
8 Briefly explain how resource allocation takes place in the following economic
system. t

a) Market economy
b) Socialist economy
' c) ~ i x e economy
d
. Note : These questions will help you to understand the unit better. Try to write
answers to them: Do nbt send these answers to thc university for assessment.
They are for your practice only.