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Different economies and their central economic problems

Now, the question arises as to how different economies of the world solve their central economic problems. For this purpose, economies of the world are divided into three major categories based on their mode of production, exchange, distribution and role which the government plays in economic activities. They are as follows:
  • Capitalist economy
  • Socialist economy
  • Mixed economy

Capitalist economy

A capitalist economy is an economic system in which the production and distribution of commodities take place through the mechanism of free markets. Hence, it is also called market economy or free trade economy or laissez-faire. Each individual, be it a producer, consumer or resource owner, has considerable economic freedom. In a market economy, there is no Government interference in economic affairs.



The United States of America, Brazil, Japan, etc.


The salient features of market economy are as follows:
  • Right to private property:
    The various factors of production viz., land, labour, capital and enterprise should be under private ownership. Inputs can be used by the owner as per their requirement. However, the government is free to put restrictions for the benefit of the society.
  • Freedom of enterprise:
    This means that any individual is free to engage in any economic activity of his choice. He is also free to start a new enterprise.
  • Freedom to choose:
    This highlights consumer power. Consumers have the freedom to make choice. Hence, producers should take utmost care to ensure that they produce only those goods which the consumers are willing to buy.

Note: Consumer sovereignty means people are free to spend their income as they like..

  • Profit motive:
    It is the main objective of a firm which induces people to work and to produce.
  • Competition:
    There always exists competition among sellers to sell their goods and among buyers to obtain those goods that satisfy their wants. Advertisements and discounts are tools used to handle competition.
  • Inequalities of income:
    Due to unequal distribution of wealth, there exists a wide gap between the rich and the poor.
A capitalist economy’s solutions
In the absence of a central planning authority to solve the problems, a capitalist economy uses the forces of demand and supply or price mechanism to solve its problems.
  • Deciding what to produce
    The main motive of an entrepreneur is to earn profit. Therefore, to earn more profit, an entrepreneur produces only those goods that are demanded by the consumers. In a free market economy, allocation of resources is determined by consumer preference.
    Example: If consumers want more motorcycles, then there will be an increase in price due to an increase in demand, which will lead to more profit. This will induce the producer to produce more motorcycles. On other hand, if there is less demand for cars, then there will be less production of cars in the economy.
  • Deciding how to produce
    To earn more and more profits, the entrepreneur will use the technique of production in such a manner that the cost of production is minimal. There are two techniques or methods of production.
    • Labour intensive method: are primarily used in labour rich countries
    • Capital intensive method: used primarily in capital rich countries
  • Deciding for whom to produce
    In the capitalist economy goods and services are produced based on the capacity of the buyer. The capacity will be based on the income. The higher the income, the higher will be the buying capacity.
    Example: BMW cars are not manufactured for the middle class of the society. It is manufactured for the upper class of the society.
  • Deciding about consumption, savings and investment
    Entrepreneurs invest and consumers save and consumes. But, consumer’s savings depends on interest rates. More savings is possible when the interest rates are high on saving. Decision of investment is based on rate of return. Consumers’ savings depends on the rate of interest. Higher the rate of interest, higher will be the savings. Investment decisions depend upon the rate of return. Higher the rate of interest, greater will be the investment in a capitalist economy. Savings also depend on age group (generation) and disposable income. Generally, the younger generation saves less while the older generation spends less.
    Example: I can buy a television today with ` 10,000. If I save this money, will I be able to buy more after 5 years?
    If yes - save.
    If no - Rather buy now.
Advantages of a capitalist economy
  • Increase in productivity: In a capitalist economy, every farmer, trader or industrialist can hold property and use it in any way he likes. He increases the productivity to meet his own self-interest. This, in turn, leads to an increase in income, savings and investment.
  • Welfare maximization: It is claimed that there is efficiency in production and use of resources to optimum level. The self-interest of individuals also promotes the society’s welfare.
  • Flexible system: : The shortages and surpluses in the economy are generally adjusted by the forces of demand and supply. Thus, it operates automatically through the price mechanism.
  • Non-interference of the state: The State (government) has a minimum role to play. There is no conflict between the individual interest and the society. The economic institutions function automatically, preventing the interference of the Government.
  • Low cost and quality products: The consumers and producers have full freedom and therefore, it leads to production of quality products at low costs and prices.
  • Technological improvement: The element of competition under capitalism drives the producers to innovate something new to boost sales and thereby bring about progress.
  • Awards men for dynamism: Rewards men for initiatives and enterprises.
Disadvantages of a capitalist economy
  • Inequalities: Capitalism creates extreme inequalities in income and wealth. The producers, landlords, and traders reap huge profits and accumulate wealth. Thus, the rich become richer and the poor becomes, poorer. The poor with limited means are unable to compete with the rich. Thus, capitalism widens the gap between the rich and the poor, thus creating inequality.
  • Leads to monopoly: Inequality leads to monopoly. Mega corporate units replace smaller units of production. Firms combine to form cartels, trusts and in this process, bring about a reduction in the number of firms engaged in production. They ultimately emerge as multinational corporations (MNCs) or transnational corporations (TNCs). They often hike prices against the welfare of consumers.
  • Depression: There is over-production of goods due to heavy competition. The rich exploit the poor. The poor are not able to take advantage of the production and hence, are exploited. At another level, over-production leads to glut in the market and hence, to depression. This leads to economic instabilities.
  • Mechanization and automation: Capitalism encourages mechanization and automation. This will result in unemployment, particularly in labour surplus economies.
  • Welfare Ignored: Under capitalism, private enterprises produce luxury goods which yield higher profits and ignore the basic goods required which yield less profit. Thus, the welfare of the public is ignored.
  • Exploitation of labour: Stringent labour laws are enacted to prevent the damages of capitalists. Hire and fire policy will become the order of the day. Such laws also help to exploit the labour by keeping their wage rate at its minimum level or subsistence level.
  • Basic social needs are ignored: There are many basic social needs such as literacy, public health, poverty, drinking water, social welfare and social security. As the profit margin in these sectors is low, capitalists will not invest in these sectors. Hence, most of these vital human issues will be ignored in a capitalist system.

Socialist economy

In a socialist economy, the means of production are owned and operated by the State. All decisions regarding production and distribution are taken by the central planning authority. Hence, the socialist economy is also called as a planned economy or command economy. The government plays an active role. Social welfare is given importance; hence, equal opportunity is given to all.
Example: Erstwhile USSR


Note: In today’s world there is no country which has controlled economy.

Features of a socialist economy
  • Social welfare motive: In socialist economies, social or collective welfare will be the prime motive. Unlike capitalism, profit will not be the aim of policy making. The decisions will be taken keeping the maximum welfare of the people in mind. Thus, social well-being of people will be the purpose of development.
  • Limited right to private property: The right to private property is limited. All properties of the country will be owned by the State. That is, the ownership is collective in nature. Hence, no individual can accumulate excessive property as in the case of capitalism.
  • Central planning: Most of the decisions on economic policies will be taken by a centralized planning authority. Each and every sector of the economy will be directed by well-designed planning.
  • No market forces: In a centralized planned system of development, market forces have a limited role to play. Production, commodity and factor prices, consumption and distribution will be governed by development planning with welfare motive.
Advantage of a socialist economy
  • Efficient use of resources: The resources are utilized efficiently to produce socially useful goods without taking the profit margin into account. Production is increased by avoiding wastage due to competition.
  • Economic stability: A socialist economy is free from business fluctuations. Government plans well in advance and everything is well coordinated to avoid over-production or unemployment. There is stability because the production and consumption of goods and services are well-regulated.
  • Maximization of social welfare: All citizens work for the welfare of the State. Everybody receives his or her remuneration. The State concentrates on the production of basic necessaries instead of luxury goods. The State provides free education, cheap and congenial housing, public health amenities and social security for the people.
  • Absence of monopoly: The elements of corporation and monopoly are eliminated since there is an absence of private ownership. The state is a monopoly, but produces quality goods at reasonable prices.
  • Basic needs are met: In socialist economies, basic human needs like water, education, health, social security, etc. are provided. Human development is more in socialist countries.
  • No extreme inequality: As social welfare is the ultimate goal, there is no concentration of wealth. Extreme inequality is prevented in a socialist system.
Disadvantages of a socialist economy
  • Bureaucratic expansion: A socialist economy is operated under a centralized command and control system. People here work out of fear of higher authorities. It does not give any initiative for the people to work hard.
  • No freedom: There is no freedom of occupation. Allocation of factors of production is not done rationally. Jobs are provided by the State. Place of work is also provided by the State. The consumer’s choice is very limited.
  • Absence of technology: Work is monotonous and no freedom is given. Any change in the production process will alter the entire plan. Hence, any innovation cannot be easily enforced easily. Everything is rigid and technological changes are limited.
  • Absence of competition: Absence of competition makes the system inefficient.
  • Less choice for consumer: As the production and distribution is in hands of the state, consumers have less freedom of choice to choose from. Consumers have to choose from whatever the states produce .
  • High form of socialism is impossible.

Mixed economy

In a mixed economy, both public and private institutions exercise economic control. The public sector functions as a socialistic economy and the private sector, as a free enterprise economy. All decisions regarding what, how and for whom to produce are taken by the state. The private sector produces and distributes goods and services. Cost-benefit analysis is used to answer the fundamental questions—what, how and for whom to produce?
Example: India
Features of a mixed economy
  • Co-existence of private and public sector: There are three sectors viz.,
    • Private sector:
      • Profit is the main objective
      • Production and distribution are controlled by private industries
      • However, government may intervene, where it feels necessary
        Example: Reliance and Infosys
    • Public sector:
      • Industries are not primarily profit-oriented
      • Industries are set up for the welfare of the community
        Example: HAL and BHEL
    • Joint sector:
      • Both, the private and public sector join hands to run an enterprise
      • Generally, public sector has to work according to a plan and the government should create an atmosphere, where the private sector is allowed to work on its own
      • Since the advantages of both, free market economy and controlled economy are combined, allocation of resources in this economy is better
      • In order to develop the backward regions, public sector enterprises may be situated in such regions and the government may provide subsidies to private sector enterprises so that they too can set up their industries in the backward regions
      • There exists a system of dual pricing since the market forces determine the prices of the goods in the private sector and the state determines the prices of the goods in the public sector
  • Presence of economic planning: A mixed economy is an economy that thrives on a well developed economic plan and has specific goals and objectives. The public sector enterprises have to adhere to the plan and achieve the objectives laid down. Not just the public sector both also the private sector needs to grow if the economy as a whole needs to flourish. Hence, the government must prepare the development plans in consideration of both the sectors.
  • Encouragement by government: The backward regions can be developed by encouraging the private sectors to establish in such region by the way of subsidies and economic incentives. Also more number of public sector enterprises can be started in those regions.
  • Two-fold pricing system: In case of public sector, the prices are fixed by the state government. For all the basic commodities that are essential for a common man the prices may be fixed by the government. In case of the private sector, the demand and supply function defines the prices of goods.
Advantages of Mixed Economy
  • Benefits of both capital and socialist economy is derived
  • It reduces the gap between poor and rich
  • It brings economic stability
  • It is a helping hand to poor countries for their economic development
  • It allows market based mechanism
Disadvantage of Mixed Economy
  • The coordination of both private and public sector is difficult
  • The extensive command discourages the private sector
  • It may lead to dangers like partiality, etc

Production possibilities curve

Another important question regarding basic economic problems is: how do we make a choice in an economy? At the individual level, one may have to choose among alternatives like,
  • Whether to watch a serial on T.V. or study for another extra hour ?
  • Whether to buy a text book for ₹ 100 or spend the money for watching a movie ?
  • Whether to help your dad in washing his car or play cricket during that time ?
It is important to note that choices are made due to scarcity of time. If there is no scarcity, there would be no need to choose. Similarly, as a choice must be made from alternatives, it involves a comparison of cost and benefit.

Opportunity cost

When you choose a particular alternative, the next best alternative must be given up. For example, if you choose to watch a serial on T.V., you must give up an extra hour of study. The choice of watching serial on T.V. results in the loss of the next best alternative of an extra hour of study instead. Thus, by watching T.V., you have forgone the opportunity of scoring an extra five or ten marks in an examination. Thus, the “opportunity cost” is the cost of something in terms of an opportunity forgone (and the benefits that could be received from that opportunity). In other words, the opportunity cost of an action is the value of the next best alternative forgone. Therefore, it must be ensured that the benefits of one’s choice must exceed the opportunity cost, i.e., the benefits you receive from watching the T.V serial must be more than the benefits you reap from studying, in order to make a rational decision.

Production possibility curve or frontier or transformation curve

Like an individual, a society as whole, has limited resources. It has to decide what to produce with the limited resources. It has to make a choice about the quantity of different commodities. Choice emanates from scarcity. Thus, our choice is always constrained or limited by scarcity of our resources. All such choices can be made with the help of Production Possibility Curve. This curve separates outcomes that are possible for the society to produce from those which cannot be produced subject to the available resource. In economics, a Production Possibility Curve (PPC) is a graph which shows the different combination of two goods that an individual or group can efficiently produce with limited productive resources. Let us consider an economy with many people, many industries, regular supply of electricity and ample natural resources, is deciding what shall be produced and how these resources are to be allocated among thousands of different possible commodities. How many industries are to produce iron? How much electricity is to be provided for industries and how much for domestic purpose? Should free electricity to small scale and cottage industries be provided or not? These problems are complicated. Therefore, to simplify them, let us assume that there are only two goods to be produced- chocolates and biscuits.

Assumptions of PPC

  • There are only two types of goods to be produced and minimum quantity of each good to be produced.
  • Technology remains constant.
  • Resources are fixed.
  • Resources are neither unemployed nor underemployed.

Production possibility schedule

When the production possibilities are represented in the form of a table or a schedule, it is known as the production possibility schedule.
Following is an example:

Production possibilities



Opportunity cost







15 - 14 = 1




14 - 12 = 2




12 - 9 = 3




9 - 5 = 4




5 - 0 = 5

In this table, we can see that, if all the resources are employed for the production of biscuits, 15 biscuits can be produced. Similarly, if all the resources are employed for production of chocolates, 5 chocolates can be produced. When an economy moves from one production possibility to another, it takes away some resources from production of biscuits and puts them in production of chocolates. If we plot the above data on a graph, we get Production Possibilities Curve (PPC) between chocolates and biscuits
Description: 15641.png
AF is the curve formed joining points A and F on the graph which is called the Production Possibilities Curve (PPC). It is also known as Production Possibility Frontier (PPF). It shows the various quantities of two goods which the economy can produce with a given amount of resources. Since the resources are fully utilized, the combination of goods can lie anywhere on the PPC only and not inside or outside it.

Nature of PPC or Production Possibility Frontier

PPC is always concave to the origin because of increasing marginal opportunity cost. Increasing marginal opportunity cost means that for an additional unit of a good, the sacrifice of units of the other good goes on increasing. PPC may be a straight line, if the opportunity cost is constant.


Note: PPC is negatively sloped not due to increasing opportunity cost, but due to the scarcity of resources.

Unemployment and PPC

When an economy operates on PPC, it means there is no unemployment or underemployment of the resources and all the resources are efficiently used. It means that all goods and services are produced with least cost. A point inside the PPC means that there is under or unemployment/ underutilisation of resources and production can be increased.

Description: 15480.png
In the above figure, point ‘R’ shows that the resources are not being used fully. Points ‘B’,’C’ and ‘D’ show that the resources are fully employed. Point ‘S’ shows the economy’s incapability to produce with the given technology and resources. If there is a shift from a point inside the PPC to any point on the PPC, it shows that the resources which were earlier under-utilized are now being utilized fully.

Economic growth and PPC

Growth of an economy is indicated by an outward shift or a shift towards the right in the PPC. PPC will shift to the right when:
  • There is an improvement in the technology
  • New ways of production are found
  • There are greater savings, investment and capital formation
  • When skill and efficiency of human resource increases
An outward shift of the PPC shows that more of both the goods can be produced. However, a shift of the PPC towards the left indicates that
  • There is a reduction in resources due to natural calamities or war
  • There prevails unemployment to a large extent
  • Underutilisation of resources
In the below fig., PPC curve shifts from ‘PP’ to’ P1P1. It indicates economic growth or improvement in the production capacity of the economy.
Description: 8375.png

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