Central Problems of an Economy and its Solution in Different Economies

At the micro level, every economy faces three central problems. These are:

 (1) what to produce?
 (2) how to produce? 
 (3) for whom to produce?

 These are the three important offshoots of the basic problem of resource allocation arising out of the fact that resources are scarce and have alternative uses.

1. What to Produce?

Producers have limited resources. They cannot produce anything or everything they wish to produce.
Of course, resources at their disposal can be put to diverse uses. It is for them to decide how their limited resources are rationally managed. In a free economy, rational management of resources implies maximisation of profit.
The problem of what to produce has two dimensions:
(a) kind of goods to be produced, and
(b) quantity of goods to be produced.

Kinds of goods may relate to consumer goods or capital goods. It may also relate to single-use consumer goods (like bread and butter) or durable use consumer goods (like AC and
TV).

Quantity of goods implies how much of different goods is to be produced. Given the resources, greater production of Good-X always implies lesser production of Good-Y. Producers are to strike a balance between the production of X and Y so that their gains are maximized.

Image Credit - Pexels.com

2. How to Produce?

'How to produce' is the second component of the problem of resource allocation. How to produce means how to organise production. It relates to the choice of a technique of production. An efficient technique of production is the central issue.

Broadly, there are two techniques of production:
 (a) Labour Intensive Technique: Under this technique, production depends more on the use of labour.
 (b) Capital Intensive Technique: Under this technique, production depends more on the use of machines(called capital).

3. For Whom to Produce?

'For whom to produce' is the third component of the problem of resource allocation. While deciding 'what to produce' we cannot escape the decision regarding 'whom to produce for'. At the micro level, the decision relates to different sets of buyers in the economy. Broadly, there are rich buyers and poor buyers. In a free economy, producers would obviously be inclined to produce more for the rich buyers (like luxury cars for the affluent people). This would maximise their profits. But, definitely, this would increase the gulf between 'haves' and 'have-nots' in the society. To reduce this gulf, often the government intervenes to regulate the use of resources. So that enough production is done for poorer sections of the society. The government offers subsidy and tax breaks for the production of goods for poorer sections of the society. Social justice remains a priority even in those economies where there is minimum interference by the government.

Solution of Central Problems in Different Economies

Different economies solve the central problems differently, as under:

Market Economy/ Capitalist Economy

A Market economy is a free economy. It means that producers are free to decide 'what, how and for whom to produce'. On what basis do they take their decisions? It is on the basis of supply and demand forces in the market.

What to Produce? The producers will produce those goods which are more in demand and less in supply. Such goods offer a high price and high profit to the producers.

How to Produce? The producers will use those inputs which keep their cost of production as low as possible. So that their profits are maximized.

For whom to Produce? In a free economy, the producers will produce goods for those people who can afford to pay the high price. Poorer sections of the society are often ignored. It causes the problem of Economic Divide, as noted above.

Centrally Planned Economy/ Socialist Economy

In a centrally planned economy, decisions related to 'what, how and for whom to produce' are taken by some central authority appointed by the government of the country.

All decisions are taken with a view to maximising social welfare. Unlike the market economy, profit maximisation is not the consideration. Those goods and services will be produced which the central authority or the government finds as the most useful for the society.  That technique of production is adopted which is socially more useful. In a situation of mass unemployment, for example, labour intensive technology will be preferred rather than capital intensive technology, so that unemployment is reduced. Enough goods will be produced for poorer sections of the society even when production of such goods does not yield a profit. Priority is given to social welfare than profit maximisation.

Mixed Economy

Mixed economy shares the merits of both capitalist/market economy and socialist/centrally planned economy. Decisions regarding 'what, how and from whom to produce' are taken on the basis of market forces as well as on the basis of social consideration.  In certain areas of production, producers are free to take their decisions with a view to maximizing profits. 

In certain other areas, decisions are taken entirely on the basis of social consideration. For example - In India producers are free to produce cloth or steel to maximize their profits. But 'Railways' are the monopoly of the government. The government provides transport services at nominal rates so that poorer section of the society can avail them. Thus, India is an example of Mixed Economy.