The scarcity of resources relative to human wants gives rise to various basic problems, issues, or questions that an economy must solve to fulfill its purpose. These basic economic problems are also called central problems of the economy. 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 what that what goods and in what quantities are produced by a society, ‘Guns or Butter’ has been the popular wat of describing this dilemma of choice posed by the scarcity of resources. But this choice between war goods and goods for civilian consumption is not the only problem of choice faced by the society. The society has to choose among thousands of consumer goods themselves and decide about allocation of resources between them. Of special mention in this regard is the choice between necessities and luxuries. For example, how much necessities such as foodgrains and clothing and how many luxury cars and air conditioners are to be produced and resources allocated accordingly. Further, an important choice about the production of goods and resource allocation is to decide about what amounts of consumer goods and capital goods are to be produced. 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 point of view of economic growth.
More generally, in answering the question what goods shall be produced, society would have to choose somehow or other among scores of goods such as cars, hospitals, schools, houses, radios, televisions, nuclear bombs, wheat, rice, cloth, machinery, steel, soap, lipsticks etc. But this decision is only half the story. Once society has decided which goods shall be produced, it must then give proper weights to each of the good it selects to produce. The fact that resources are scare 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 is to be produced would have to be decided. Thus, scarcity of resources forces us to make a choice what goods and in what quantities are to be produced. This will determine the allocation of scare 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 who organize production on the one hand and consumers whose wants are to be satisfied by producing goods and services on the other.
How to produce: Choice of Technique of Production
This means with what methods or techniques a society will decide to produce goods. A combination of resources (or factors) implies a technique of production. Usually, there are various alternative techniques of producing a commodity and the society has to choose among them, each technique using a different combination of resources like labour and capital. For instance, cotton cloth can be produced with either handlooms, or automatic looms (as used in modern textile mills). Production with technique of handlooms involves the use of more labour relatively to capital and therefore represents a labour-intensive technique. On the other hand, the production of cloth with automatic looms of the modern textile mills involves use of more capital relative to labour and hence represents a capital-intensive technique of production. Likewise, alternative technique involving different degrees of capital and labour intensity are available for producing other commodities. With use of better or technologically advanced machines productivity is higher but they require less labour. In the choice of a technique of production prices of different foctors play an important role. However, government in a market economy today affects the choice of methods for producing goods through its fiscal and monetary policies. Obviously, the choice between different techniques would depend on the available supplies of different factors of production and their relative prices.
Scarcity of resources demands that goods should be produced with the most efficient method. If the economy used its resources inefficiently, the output would be smaller and there would be unnecessarily sacrifice of goods that otherwise would have been available. Therefore, it is in society’s interest that those techniques of production are used that make greater use of relatively abundant factors and economic as much as possible on those factors which 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 the society. Productive resources and the resulting output being scarce, we cannot satisfy all wants of all the people. Therefore, a society has to decide who should get how much form the total output of goods and services. This is, as it were, sharing of national cake among the people constituting a society. Obviously, in a free market who would get how much of national output depends on his money income. The greater the money income a person enjoys, the greater the amount of goods he 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 as to how a free-market economy decides about the distribution of money incomes.
Money income can be obtained in two ways. First, it can be obtained through work, that is, selling one’s labour services. Wages (and salaries) represent the incomes 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 made from property such as land, factories and other forms of capital. Rent, interest and profits are the examples of income from property. Differences in the ownership of property in a free-market economy cause differences in income from property. Thus, money incomes of the people made in these ways go to determine the distribution of national output. Therefore, in order to explain the distribution of output, we have to explain how distribution of income, that is, wages of labour, rent of land, interest on capital and profits of enterprise are determined. However, in the market economies government also influences the income of the people through imposition of taxes, grant of subsidies and various government expenditure programmes aimed at redistributing incomes.
How the national income is to be distributed has been a burning topic not only in the field of economics but also in politics. There is perhaps no topic in the whole of 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 on the basis of “from each according to his ability, to each according to his needs”. Another important view has been that each individual should get income equal to the contribution he makes to the national production.