The scarcity of resources relative to human wants gives rise to various basic problems, issues, or questions that must be solved by an economy if it is to fulfil its purpose. These basic economic problems are also called central economic problems. All these problems involve choices to be made by society. These problems are:
1. What to produce
2. How to produce
3. For whom to produce
What to Produce
This means that what goods and in what quantities are produced by a society, ‘Guns or Butter’ has been the popular way of describing this dilemma of choice posed by the scarcity of resources. However, the choice between war goods and goods for civilian consumption is not the only problem faced by society. Society must choose among thousands of consumer goods and decide how to allocate resources. Of special mention in this regard is the choice between necessities and luxuries. For example, how many necessities, such as food grains and clothing, and how many luxury cars and air conditioners are to be produced, and resources are allocated accordingly. Furthermore, an important choice regarding the production of goods and resource allocation is to decide the amount of consumer and capital goods to produce. As shall be made clear later, this decision about the allocation of resources between consumer goods and capital goods is of crucial importance from the perspective of economic growth.
More generally, in answering the question of what goods shall be produced, society would have to choose among scores of goods such as cars, hospitals, schools, houses, radios, televisions, nuclear bombs, wheat, rice, cloth, machinery, steel, soap, and lipsticks. However, this decision is only half the story. Once society has decided which goods shall be produced, it must then give proper weight to each of the goods it selects to produce. The fact that resources are scarce means that society cannot produce unlimited amounts of even these selected goods. Therefore, society must decide how much wheat, how many hospitals, how many schools, and how many meters of cloth are to be produced. In fact, most of the goods to be produced would have to be decided. Thus, the scarcity of resources forces us to choose what goods and in what quantities are to be produced. This will determine the allocation of scarce resources among them.
In a free market economy, the choice of what goods and in what quantities are made is decided by the interaction between private firms that organize production on the one hand and consumers whose wants are to be satisfied by producing goods and services.
How to produce: Choice of Technique of Production
This means that society will decide to produce goods using certain methods or techniques. A combination of resources (or factors) implies a production technique. Usually, there are various alternative techniques for producing a commodity, and society has to choose among them, each technique using a different combination of resources, such as labor and capital. For instance, cotton cloth can be produced using either handlooms or automatic looms (as used in modern textile mills). Production with the handloom technique involves the use of more labor relative to capital and therefore represents a labor-intensive technique. On the other hand, the production of cloth with automatic looms of modern textile mills involves the use of more capital relative to labor and hence represents a capital-intensive technique of production. Likewise, alternative techniques involving different degrees of capital and labor intensity are available for producing other commodities. With the use of better or technologically advanced machines, productivity is higher, but they require less labor. In the choice of a technique of production, the prices of different factors play an important role. However, the government in a market economy today affects the choice of methods for producing goods through its fiscal and monetary policies. The choice between different techniques depends on the available supplies of different factors of production and their relative prices.
The scarcity of resources demands that goods be produced using the most efficient method. If the economy used its resources inefficiently, the output would be smaller, and there would be an unnecessary sacrifice of goods that would otherwise have been available. Therefore, it is in society’s interest that production techniques are used that make greater use of relatively abundant factors and economic as much as possible on those factors that are relatively scarce.
For Whom to Produce: How to Distribute Output
For whom to produce means who will get how much for consumption. In other words, it means how the national product is to be distributed among the members of society. As productive resources and the resulting output are scarce, we cannot satisfy all the wants of all the people. Therefore, a society must decide who should receive how much from the total output of goods and services. This is, as it were, the sharing of the national cake among the people constituting a society. In a free market, the amount of national output that a person receives depends on their money income. The greater the money income a person enjoys, the greater the amount of goods they would be able to buy from the market. Therefore, the greater the inequalities in the distribution of money incomes, the greater the inequalities in the distribution of money incomes, the greater the inequalities in the distribution of national output. Therefore, this raises the question of how a free-market economy decides on the distribution of money income.
Money income can be obtained in two ways: first, through work, that is, by selling one’s labor services. Wages (and salaries) represent income from work. Differences in wages earned by various people arise due to differences in production activities, skill, education as well as due to the bargaining powers of various social classes and a host of social and institutional factors. Second, income can be generated from property, such as land, factories, and other forms of capital. Rent, interest, and profits are examples of income from property. Differences in property ownership in a free-market economy cause differences in income from property. Thus, the money income of the people made in these ways determines the distribution of national output. Therefore, to explain the distribution of output, we must explain how the distribution of income, that is, wages of labor, rent of land, interest on capital, and profits of enterprises, are determined. However, in market economies, the government also influences the income of the people through the imposition of taxes, grant of subsidies, and various government expenditure programs aimed at redistributing income.
The distribution of national income has been a burning topic not only in the field of economics but also in politics. There is perhaps no topic in economics on which discussion has been so hot and furious as the distribution of national product and income. Some have argued with a good deal of justification that all people should get equal incomes and hence equal shares from the national product. According to Karl Marx, the distribution of national income should be based on “from each according to his ability, to each according to his needs.” Another important view is that each individual should receive an income equal to the contribution he makes to national production.