Unit One

Fundamental Concept of Economics

And Allocation of Resources
Economics
Economics as a social science studies about the use of limited resources
in order to satisfy unlimited human wants.
Or,
Economics is the social science that studies how society manages its limited
resources in the production, distribution, exchange and consumption of goods and
services.
Scarcity
Scarcity refers to the availability of less resources with respect to human
wants.
Or,
In ordinary sense, scarcity refers to the shortage of a certain commodity
in the market. In economic sense, a commodity is scare not because it is rare or
unavailable in the market but because the means to have it are limited.
Or,
In economic sense, scarcity refers to the limitation of supply of a
commodity in relation to the demand for such commodity due to the mean to
have it are limited.
Choice
Choice is the act of selecting few alternative
among the bundles of alternatives. In other words,
Choice refers to people's decisions about sharing and
using their resources. It is the allocation of resources to
the production of different goods and services in a
manner such that he maximizes his profit.
Opportunity Cost
Opportunity cost is the price of any other product which can
be produced by the same factors of production but which is not
produced. It’s concept arises due to the scarcity of resources and
alternative uses of resources.
The concept of opportunity cost can be explained with the
help of two goods X and Y as mentioned in the table given below:
 In given table to produce extra 1 unit of X goods
producer must sacrifice certain units of Y goods. From
points A to B to produce extra 1 unit of X; producer must
sacrifice 2 units of Y goods (2:1 is opportunity cost).
Similarly, B to C, to produce extra 1 unit of X, producer
must sacrifice 3 units of Y (3:1- opportunity cost). C to D
to producer extra 1 unit of X; producer must be sacrificed
4 units of Y goods. (4:1 - opportunity cost). Hence,
opportunity cost is also used in time, job, consumption,
game etc. to obtain best options. The negative signs show
the loss or sacrifice.
Points to be noted:
Production refers to the process of transformation of inputs
into output.
Production possibilities refers to the alternative combinations
of final goods and services that a society is capable of
producing with the available resources and technology.
Production possibility curve is a tool used to illustrate and
explain the problem of scarcity and choice.
Production possibility curve shows the various alternative
combinations of goods and services that an economy can
produce when the resources are all fully and efficiently
employed.
Production Possibility Curve
The concept of production possibility curve is
related with the economic problem pointed out by
Robbins that the means are scare in relation to multiple
ends. Prof. Paul Samuelson has brought the concept of
production possibility curve to clarify the relationship
between scarce means and unlimited wants.
The PPC can be used to solve three basic
problem of economic life what to produce? How to
produce? and for whom to produce?
 A production possibility curve is a graphical
representation of all of the possible combination of two
goods that the economy can produce with the efficient use
of resources with given technology at a given period of
time.
It shows the maximum possible production of
different combinations of two goods that can be produced
with the given technology and resources. It also analyzes
how much the production of one commodity has to be
decreased when producing some other commodity.
The curve is also known as product transformation
curve because when moving from one point to another,
the uses of resources from one commodity transfer to the
production of another commodity.
Assumptions
The assumptions of production possibility curve are as below.
(i) Economy is producing only two goods X and Y.
(ii) Number of resources available in the economy are given and
fixed.
(iii) Full employment of resources is assumed i.e.; available
resources are fully utilized.
(iv) Production technique is given and constant i.e., no change in
technique of production.
(v) Time period is given.
On the basis of these assumptions, the PPC can be explained
with the help of table and diagram. Let us assume that economy is
producing only two commodities food and cloth. The following
table shows different possibilities of food and cloth that the
economy can produce by full utilization of the available resources.
Based on the above assumptions, the PPC can be
explained with the help of table follows:
.
 Above table shows the various production possibility of
goods x and y. If all the resources are used for the production of
good x, 5000 units of good x are produced. Similarly, if all the
resources are employed for the production of good y, 15000 units
of good y are produced. These are the two extremes of
production possibilities. In between these two extremes, there
are many other production possibilities, like at combination B,
1000 units of good x and 14000 units of good y can be produced.
Similarly, at combination ‘C’, ‘D’ and ‘E’, the production
possibilities of good x are 2,3,&4 thousand units and good y are
12, 9 and 5 thousand units are produced. Therefore, it is clear
that more of one good can be obtained by cutting down the
production of other good. For example, if the producer produces
within the combination ‘C’, the producer is ready to sacrifice
two units of good y for the production of one more unit of good
x.
The PPC can be illustrated in the figure on the basis of the above table as follows:
 In the above figure, goods x and y are measured
along x-axis and y-axis respectively. AF is the production
possibility curve which is derived by joining the
production possibility points A, B, C, D, E and F. Each
point on PPC shows the efficient for the production.
The economy cannot produce any point outside
the PPC. Let us take point G outside the PPC in figure.
This point G is “desirable” but not “attainable” due to
limited resources. Similarly, point H is inside the PPC
curve which is “attainable” but not “desirable”. At point
H resources are not fully utilized.
Shift in Production Possibility Curve
Production possibilities of an economy can change
over time. Investment in new plant and machinery,
discover of new raw materials, technological advances,
availability of more productive labour leads to shift the
PPC outward as well as PPC shift inwards due to the war
or natural disaster. The shift in PPC can be explained
with the help of following figure.
In the above figure, AE is the initial production
possibility curve. The increase in size of population,
increase in labour productivity and technological
progress causes shift in PPC upward from AE to A’E’.
The economy produces more of both goods at this stage.
The production possibility curve can also shift inwards to
the left as shown in the figure from the curve AE to A"E"
when economy’s production potential declines. This
could occur due to war or natural disaster which reduces
a country’s resources. Any decrease in production
capacity shifts the PPC down ward to the left.
Allocation of Resources
Allocation of resources refers to use of available resources at
the optimal level so that the economy can produce maximum
goods and services.
Or, Allocation of resources refers to the use of resources in
such a way that it could produce optimum output, maximum
satisfaction with minimum wastage.
The problem of resource allocation arises due to the
limited resources. Resource allocation is concerned with the
achievement of optimal use of limited resources to get
maximum possible satisfaction. In a free market or perfectly
competitive market economy allocation of resources deals with
the following fundamental problems of an economy.
(i) What to produce?
The first allocative function of an economy is to
decide how much to produce and what to produce either
consumer good or capital good or war time good
considering the demand of its citizen by allocating the
available resources on the them.
ii. How to produce
The second allocative function of an economy is to
determine the technique of production i.e., labour
intensive technique or capital-intensive technique to be
used in the process of production. A technique of
production which would maximize output or minimize
cost should be used.
(iii) For whom to produce?
This is the problem of sharing of the national
product. An economy has to decide how the produced
goods and services are to be distributed among different
income groups of people that is who should get how
much.
(iv) The problem of full employment
The another allocative function of an economy is
to decide how to achieve full employment of resources
by producing maximum output with minimum effort and
wastages to be made possible.
V. Are the resources economically used.
It is related with the problem of economic
efficiency. An economy has to decide the optimum
combination of factors of production efficiently in order
to prevent wastage of productive resources available in
an economy.
Division of Labour
Division of labour refers to the separation of a work process
into a number of tasks with each task performed by a separate
person or group of persons. It is most often applied to systems of
mass production and is one of the basic organizing principles of the
assembly line. Breaking down work into simple repetitive tasks
eliminates unnecessary motion and limits the handling of different
tools and parts.
Division of labour is the process of splitting a complete task
into many simple parts and each part is taken by different workers
who are specialized in the production of that specific part.
Division of labour is the process of dividing the
responsibilities within the organization in order to achieve the
target, designed by the organization.
Advantage of Division of Labour
1. Increase in Productivity.
With the adoption of Division of Labour,
the total production increases as a result productivity per
worker increases immensely.
2. Maximum utilization of machinery.
By breaking up the production of a
commodity into small and simple operation, the division
of labour increases the possibility of the use of machines
in the small-scale production also. Therefore, in modern
times the use of machines is increasing continuously due
to the increase in the Division of Labour.
3. Large scale production
By breaking up the production of a commodity
into small and simple operation, the division of labour
increases the use of plant and machinery in the
production process as a result production starts
increasing.
4. Increase in Profit
Division of Labour gives more profit to the
producer of the goods as the cost of production of the
commodity diminishes.
5. Availability of Commodities at a Cheaper Price
Division of Labour helps in mass production.
Thus, production becomes less expensive and more
economical. Therefore, cheaper goods are produced by
manufacturers. Availability of cheaper goods for
consumers improve the standard of living of the
consumers and the people.
6. Increase in Efficiency of Labour
With the Division of Labour a worker has to do
the same work time and again, and he gets
specialization in it. In this way, the Division of Labour
leads to a great increase in efficiency
7. Increase in Skill
Division of Labour contributes to the development of
skill to a great extent. Because with the repetition of the same
type of work, he becomes well versed and specialized in it. This
specialization enables him to do the work in the best possible
way, which improves his skill.
8. Development of International Trade
Division of Labour increases the tendency of
specialization not only in the workers or industries, but in
different countries also. On the basis of specialization, every
country produces only those goods in which it has a
comparative advantage and imports such goods from those
countries which have also greater comparative advantage.
Therefore, Division of Labour is beneficial for the development
of international trade also.
9. Full Utilization of Natural Resources.
Division of Labour in the country helps much in
the full utilization of natural resources, because large
scale production is carried on.
10. Increase in the Number of Efficient-Organizers.
Division of Labour helps much in the
earnings of profit. Therefore, in such countries
entrepreneurs are investing money and are helping
organization to establish well-equipped company.
Advantages of Division of Labour
1. Increase in productivity.
2. Maximum Utilization of Machinery.
3. Large Scale Production.
4. Increase in Profit.
5. Availability of Commodities at a Cheaper Price.
6. Increase in Efficiency of Labour.
7. Increase in Skill.
8. Development of International Trade.
9. Full Utilization of Natural Resources.
10. Increase in the Number of Efficient Organizers.
Dis-Advantages of Division of Labour
1. Danger of Over-production.
Over-production means that the supply of production is comparatively
more than its demand in the market. While producing goods under the
division of labour, each worker efficiently completes the task assigned
to him. Due to which goods are produced in large scale. If the demand
in the market does not increase accordingly, there is possibility of over
production. The over production of goods results economic depression
which is very harmful for the economy.
2. Increased Dependence
Due to the division of labour, no worker is employed independently.
One is dependent on another. If one is absent the whole production
process stops. Such type of dependence is harmful. For example – In
the case of a readymade garments factory, if the man cutting cloth is
lazy, the work of stitching, buttoning etc. will suffer.
3 . Industrial Disputes
When the work is done under division of labour
different people are involved in different jobs. As a
result, in big industries they have to join each other in
groups in some cases due to the lack of understanding
between the workers and employers, the workers
engage in activities such as strikes, lockout etc. which
destroy the industrial peace of the country.
4. Lack of job pride
As a worker performs only a part of the job, he
cannot take pride in the final output. There is little
pleasure of creating something.
5. Greater interdependence
Job, work process and industries become
increasingly interdependent due to division of labour.
Any problem of defect in one part may cause
disturbance in the entire process of production.
6. Monotony of Work
Due to division of labour, the labour performs
same work over and over again. This makes work
monotonous. There remains no happiness or pleasure in
the job for him. It has an adverse effect on the
production.
7. Fear of Unemployment
Due to the specialization under the division of
labour, worker finds difficulty in finding same job in
another industry when she/he is unemployed.

(Note:- only for eg: When the worker produces a

small part of goods he gets specialised in it and he does
not have complete knowledge of the production of
goods. For example – If a man is expert in buttoning
the clothes and if he is removed or dismissed from the
job, it becomes difficult for him to find the job of
buttoning. Thus, Division of Labour has a fear of
unemployment.)
8. Lack of Responsibility
In this none can be held responsible for bad
production because none makes the whole article.
When the result is bad everybody tries to shift the
responsibility to somebody else. This adds to the
difficulties of administration.
Disadvantages of Division of Labour
1. Risk of over production
2. Increased Dependence.
3. Industrial Disputes.
4. Lack of job pride.
5. Greater Interdependence.
6. Monotony of Work.
7. Fear of Unemployment.
8. Lack of Responsibility.
Specialization
Specialization is a fundamental economic concept that
helps to explain the division of labour present within
modern economies of scale. Division of labour leads to
specialization. In common sense, specialization means
focusing on a specific job.
Specialization is a method of production whereby
an entity focuses on the production of a limited scope of
goods to gain a greater degree of efficiency.
Thus, Specialization is the basis of international
trade, a few countries have enough production capacity to
be completely self-sustaining.
Note:-
1. Specialization in business involves focusing on one
product or a limited scope of products so as to
become more efficient.
2. Specialization can increase the productivity of and
provide a comparative advantage for a firm or
economy.
3. Microeconomic specialization involves the
individual factors and economic components, and
macroeconomic specialization involves the broad
advantage an economy holds in production.
 Advantages of Specialization
1. Large scale production
Due to specialization, a country is capable to produce
excessive amount of goods with higher quality and sell them
to the foreign countries from where the exporters gets
benefits. Specialization leads to a much more efficient
supply chain and opens up greater production possibility.

2. Benefits to a consumer
Consumers have access to a greater variety of higher quality
products. Consumers can be benefited from the variety of
international product because consumer can get such quality
product at cheaper price.
3. Expansion of Market
Specialization increases the size of the market offering
opportunities for economies of scale. Market can be
expanded internationally. When specialization is achieved in
the production, the produced product easily enter in the
international market.

4. Competition and lower prices

Increased competition act as an incentive to minimize costs,
keep prices down and therefore maintains low inflation. In
the situation of inflation, a country can import the
specialized product from the international market and control
the price level.
5. Decrease in production cost
If different companies specialize in making one
product or one component of a product, they are able to
also work to reduce production costs by producing as a
larger scale and selling more units at a lower profit
margin.
6. Optimum Utilization of Resources
Due to specialization, Countries concentrate on
the production of goods which are best fitted or realize
the comparative cost advantages. This ensures the
optimum utilization of resources. Without
specialization, resources cannot be utilized properly.
Disadvantages of Specialization
1. Danger of unemployment
Even though national level specialization usually
creates more jobs, there is a risk of certain type of
structural unemployment to occur. As the country
moves towards specialization, the workers in the
declining industries may not find suitable work.
2. Over exploitation of resources
Output may be increased by over exploiting
resources. In this case today’s output is increased at
the cost of the future generations.
3. Negative externalities / social cost
There could be external costs like damage to the environment
which is matter of concern.
4. Economic dependency
Due to specialization, a country does not produce all the
necessary goods rather, it imports the goods and services
which are not possible to produce economically. This
situation creates economic dependency.
5. Hamper on economic development
In some cases specialization is regarded as obstacle on the
economic development. Due to specialization domestic
products cannot compete with specialized foreign products.
As a result, domestic industries may close which hinders
economic development.
Economic system
An economic system refers to a system of
production, resource allocation and distribution of goods
and services within a society. Economy differs from one
nation to another depending upon its economic activities
such as production, distribution, exchange etc. More
economic activities means strong economy and vice
versa. Therefore, economy is the combined form of all
economic activities held inside of the country.
Types of economic system
Market Economy
Market economy is an economic system in which all the
economic activities are carried out by the private sector in
order to earn profit with the help of demand and supply. It is
also known as free – market economy or capitalistic economy
where all types of economic activities are done in competition.
In such type of economic system individuals are free to
allocate their resources in to consumption and saving. There is
no control over consumption from due side of government.
The role of government is the monitor and supervision of the
economy, maintaining peace and security, law and order and so
on.
Features of Market Economy
The following are the main features of a capitalist economy.
1. Private sector organizes the economic activities
All types of economic activities are carried by the private
sector. Private sector decides what to produce, how to produce and
for whom to produce. These types of activities are guided by the
market forces – demand and supply.
2. Market mechanism is existed
In such type of economic system, equilibrium price and
quantity are determined by the market forces demand and supply.
3. Right of private property
In such type of economic system, individuals have the right
to conduct their economic activities, earn, income and wealth in
different form and nature, can use their property whatever they
like.
4. Limited role of government
In such types of economic system, the role of
government is limited up to maintaining law and order,
peace and security etc. Government plays the role of
facilitator.
5. Consumer's sovereignty
In such type of economic system, consumers have
high degree of freedom in the context of allocating their
wealth into saving and consumption. There is no
intervention from the side of government. They can
consume everything whatever they want.
Command economy
Command economy is an economic system where
central government makes all economic decisions and
economic activities are carried by the government. It is also
known as the socialist economy and planned economy. In
such type of economic system, government creates the
laws, regulations and directives to enforce the central
economic plan. Business follows the plan for production to
meet the targets. In such type of economic system,
government owns monopoly business. The industries
produce the required products to meet the objectives of
government. The government tries to use nation capital,
labour and natural resources in the possible efficient way.
Features of Command Economy
The socialist economy has the following main features:
1.Collective Ownership of means of Production
In a Socialist economy means of production are owned by the
government on behalf of the people. The institution of private
property is abolished and no individual is allowed to own any
production unit and accumulate wealth and transfer it to their heirs.
However, people may own some durable consumer goods for their
personal use.
2.Social Welfare Objective
The decisions are taken by the government at macro level
with the objective of maximization of social welfare in mind rather
than maximization of individual profit. The forces of demand and
supply do not play any important role. Careful decisions are taken
with the welfare objectives in mind.
3. Central Planning
Economic planning is an essential feature of a socialist
economy. The Central Planning Authority keeping the national
priorities and availability of resources in mind allocates
resources. Government takes all economic decisions regarding
production, consumption and investment keeping in mind the
present and future needs. The planning authorities fix targets for
various sectors and ensure efficient utilization of resources.
4. Reduction in Inequalities
The institutions of private property and inheritance are at
the root of inequalities of income and wealth in a capitalist
economy. By abolishing these twin institutions, a socialist
economic system is able to reduce the inequalities of incomes. It
is important to note that perfect equality in income and wealth is
neither desirable nor practicable.
5. No class conflict
In capitalist economy the interests of the workers
and management are different. Both of them want to
maximize their own individual profit or earnings. This
results in class conflict in capitalist economy. In
socialism there is no competition among classes. Every
person is a worker so there is no class conflict. All are
co-workers.
Mixed Economy
Mixed economy is an economic system that combines the
features of market and command economy. Mixed economy is
characterized by protection of private property, allowing the free market
and the laws of supply and demand to determine prices, it is driven by
the motivation of the self-interest of individuals. In such type of
economy both the government and private sector direct the economy
and provide the way to sell and buy the product in the market. There is
equal role of government as well in such type economy. It plays the role
in military, international trade, maintain law and order, peace and
security etc. under this system, there is freedom of economic activities
and government interferences for the social welfare. Thus, in a mixed
economy people at large enjoy individual freedom and government
support to protect the interests of weaker sections of the society.
Nepalese economy is considered a mixed economy as it has well
defined areas for functioning of public and private sectors and economic
planning.
Features of Mixed economy
The main characteristics of a mixed economy are
as follows:
1.Co-existence of public and private sectors
The private sector consists of production units that
are owned privately and work on the basis of profit
motive. The public sector consists of production units
owned by the government and works on the basis of
social welfare. The areas of economic activities of each
sector are generally demarcated. Government uses its
various policies e.g., licensing policy, taxation policy,
price policy, monetary policy and fiscal policy to control
and regulate the private sector.
2. Individual Freedom
Individuals take up economic activities to
maximize their personal income. They are free to choose
any occupation and consume as per their choice. But
producers are not given the freedom to exploit consumers
and labourers. Government puts some restrictions
keeping in mind the welfare of the people. For instance,
government may put restrictions on the production and
consumption of harmful goods. But within rules,
regulations and restrictions imposed by the government,
for the welfare of the society the private sector enjoys
complete freedom.
3. Economic Planning
The government prepares long-term plans and decides the
roles to be played by the private and public sectors in the
development of the economy. The public sector is under direct
control of the government as such production targets and plans are
formulated for them directly. The private sector is provided
encouragement, incentives, support and subsidies to work as per
national priorities.
4. Price Mechanism
Prices play a significant role in the allocation of resources.
For some sectors the policy of administered prices is adopted.
Government also provides price subsidies to help the target group.
The aim of the government is to maximize the welfare of the
masses. For those who cannot afford to purchase the goods at
market prices, government makes the goods available either free of
cost or at below market (subsidized) prices