CHAPTER 3

1. Discuss basic problems of economy with suitable

examples

What are Central Problems of An Economy

An economic problem generally means the problem of making choices which occurs because of
the scarcity of resources. The economic problem arises because people have unlimited desires
but the means to satisfy that desire is limited. Therefore, satisfying all human needs are difficult
with limited means.

Causes of Economic Problem

 Scarcity of Resources- Resources like labor, land, and capital, etc. are insufficient as
compared to the demand. Therefore, the economy cannot provide everything that people
want.
 Unlimited Human Wants- Human beings demands and wants are unlimited and never
ends, which means they will never be satisfied. If a person one wants is satisfied, they
will start tempting some new desires. People wants are unlimited and keep multiplying,
therefore, cannot be satisfied because of limited resources.
 Alternative Uses- Resources being scarce they are put into different uses. So, to make
a choice among resources are essential. For instance, petrol is not only used in a vehicle
but it is also used for generator, running machine, etc. So, now the economy should
make a choice within the alternative uses.
You would also want to know- Centrally Planned Economy

List of Economic Problems:

(A) What to produce?

 A country cannot produce all goods because it has limited resources.
 It has to make a choice between different goods and services.
 Every economy has to decide what goods and services should be produced.
 g. If farmer has a single piece of agriculture land. Farmer has to make choice between
two goods whether to grow rice or wheat.
 Similarly, our Government has to decide where to allocate funds. for the production of
defence goods or consumer goods and if both then in what proportion.

(B) How to produce?

 This problem refers to the choice of technique of production. This problem arises when
there is the availability of more than one way to produce goods and services.
 There are mainly two techniques of production. These are:

o Labour intensive technique(greater use of labour)

o Capital intensive technique(greater use of machines)
  Labour intensive technique promotes employment whereas capital intensive technique
promotes efficiency and growth.

(C) For whom to produce?

 The society cannot satisfy all the wants of all the people. Therefore, it has to decide who
should get how much of the total output of goods and services.
 g. Society has to make choice of whether luxury goods or normal goods have to be
produced. This distribution or proportion directly relates to the purchasing power of the
economy.

Examples
Workers
Householders will also face decisions on how much to work. For example,
working overtime at the weekend will give them extra income to spend,
but less leisure time to enjoy it. A worker may also wish to spend more
time in learning new skills and qualifications. This may limit their earning
power in the short-term, but enable a greater earning power in the long-
term.

GOVERNMENT

The government has finite resources and its spending power is limited by
the amount of tax that they can collect. The government needs to decide
how they collect tax and then they need to decide whom they spend
money on

1. Describe different types of economy with suitable

examples

1) Traditional economic system

A traditional economic system is the oldest and most traditional type of
economic system in the world. A huge part of the world follows this
economic system. There are many elements of this economic system
which the modern economic system, such as a mixed economic system,
lacks. This economy still yields goods and amenities, which are a direct
result of their customs, beliefs, tradition, and culture. The parts of the
world which follow traditional economy are mostly rural, second or third
world and are very close to the land because of farming, fishing, and
 cattle herding etc. This economy relies on a barter system and does not
have any concept of money or currency.

The people who fall under this type of economic system are placed
around their tribes and families. The main purpose of this economy is to
produce goods to fulfill the needs of its community. There is no concept
of trading, therefore, people never think about market surplus under this
type of economic system. A traditional economic system is very
susceptible to change in their milieu.

The disadvantage of the traditional economic system is that they still don’t
enjoy the things available commonly in other economies such as medicines,
technology, and centralized utilities.

2) Command economic system

Command economic system is more advanced than the traditional
economic system. This economic system is directed by a single
centralized power such as government, which controls all activities of this
type of economic system. The government has the power to take all
decisions regarding the economy. It is responsible to make decisions
about the type of crops produced and quantities of the crops.

. Countries like China, Cuba, and North Korea are practical examples of a
command economic system. These economies are also called as planned
economies because the government controls all the plans of the economy
and nothing is elected by the free market. This is also a big disadvantage
of this type of economic system because it is impossible for a government
to plan and fulfill the individual needs of its citizens.

Most of the resources are controlled by the government, but the agriculture
sector is completely left its population.

3) Market economic system

A market economy is completely opposite of command economy and it is
similar to the free market economy. In the market economic system, the
government does not control the major segment of the economy such as
vital resources and valuable goods and services. In the market economy,
 industries and households act in self-interest and determine how
resources will be allocated, what kind of goods will be produced or
bought.

There is no true free market economy exist in the world. For instance, the
United States of America is a capitalist nation, but the American
government still controls moral businesses, fair trades, monopolies,
government programs etc.

The biggest advantage of the market economic system is the separation of

government and the market. This makes the government less powerful
and gives some power in the hands of private institutions and businesses.
In theory, a market economic system empowers a nation to undergo a
high expanse of progress. In the free market economy, businesses
produce profitable goods and services and give a lot of incentives for
private enterprises. In the free market economic system, there is a high
scope of innovation because businesses invest a lot in research and
development.

4) Mixed economic system

A mixed economy is a combination of market and command economies.

It is also called a dual economic system because of the amalgamation of
two economies. However, there is no clear definition of the mixed
economic system. In most of the common economies, industries run the
economy with a strong regulation by the government in specific areas like
public transportation and public goods and services. Most of the western
economies are considered mixed economies. In such economies, neither
government nor the private sector can run the whole nation.

Both play a critical role in the success of the system. In mixed economies,
the government has less interference as compared to it has in the
command economy. Therefore, private businesses can run more
efficiently.

However, there are many benefits of applying mixed economic system, but
there are still few who believes that over-interference of government is not good
and another common problem is that government-run companies become
uncompetitive and cause loss to the government and creating debt.

CONCLUSION

In conclusion, there is a total of four types of economic systems and the

type of economy has a lot to do with its progress. It is apparent that many
nations are light-years behind the other nations. It is the responsibility of
fast-paced economies to help slow-economies to grow. Therefore, all
economies are important and have their own advantages and
disadvantages.

2. Explain CFI in simple economy, 3tier, 4tier economy

INTRO
The circular flow of income describes the movement of goods or services and income
among the different sectors of the economy. It illustrates the interdependence of the
sectors and the markets to facilitate both real and monetary flow. The real flow refers
to the flow of factor services and flow of goods and services. The flow of factor
services from the households to the firms and the flow of goods and services from
firms to the household is the real flow.

2 SECTOR
The Circular Flow of Income in a Two-Sector Model In this model, the economy is
assumed to be a closed economy and consists of only two sectors, i.e., the household
and the firms. A closed economy is an economy that does not participate in
international trade. In this model, the household sector is the only buyer of the goods
and services produced by the firms and it is also the only supplier of the factors of
production. The household sector spends the entire income on the purchase of goods
and services produced by the firms implying that there is no saving or investment in
the economy. The firms are the only producer of the good and services. The firms
generate income by selling the goods and services to the household sector and the
latter earns income by selling the factors of production to the former. Thus, the income
of the producers is equal to the income of the households is equal to the consumption
expenditure of the household. The demand of the economy is equal to the supply. In
this model, Y = C where, Y is Income and C is Consumption. The circular flow of
income in a two sector model is explained with the help of the following diagram.
3 SECTOR

Circular Flow of Income and Expenditure 6. The Circular Flow of Income in a Three – Sector
Model The three sector model of circular flow of income highlights the role played by the
government sector. This is a more realistic model which includes the economic activities of
the government however; we continue to assume the economy to be a closed one. There are
no transactions with the rest of the world. The government levies taxes on the households and
the firms and it also gives subsidies to the firms and transfer payments to the household
sector. Thus, there is income flow from the household and firms to the government via taxes
in one direction and there is income outflow from the government to the household and firms
in the other direction. If the government revenue falls short of its expenditure, it is also
known to borrow through financial markets. This sector adds three key elements to the
circular flow model, i.e., taxes, government purchases and government borrowings. This is
explained with the help of the following diagram called, Model 2.
___________________________________________________________________________
_________________________ Circular Flow of Income and Expenditure In this model, the
equilibrium condition is as follows: Y = C + I + G Where, Y = Income; C = Consumption; I
= Investment and G = Government Expenditure In a closed economy, aggregate demand is
measured by adding consumption, investment and government expenditure..

4
SECTOR______________________________________________________________
_____________________________________Circular Flow of Income and
Expenditure 7. The Circular Flow Of Income in a Four Sector Model This is the
complete model of the circular flow of income that incorporates all the four
macroeconomic sectors. Along with the above three sectors it considers the effect of
foreign trade on the circular flow. With the inclusion of this sector the economy now
becomes an ‘open economy’. Foreign trade includes two transactions, i.e., exports and
imports. Goods and services are exported from one country to the other countries and
 imports come to a country from different countries in the goods market. There is
inflow of income to the firms and government in the form of payments for the exports
and there is outflow of income when the firms and governments make payments
abroad for the imports. The import payments and export receipts transactions are done
in the financial market. This is explained with the help of a following diagram, called
Model 3. In this model, the equilibrium condition is as follows: Y = C + I + G + NX
NX = Net Exports = Exports (X) – Imports (M)

___________________________________________________________________________
_________________________ ECONOMICS PAPER No. : 4 – Basic Macroeconomics
MODULE No. : 2- Circular Flow of Income and Expenditure Where, Y = Income; C =
Consumption; I = Investment; G = Government Expenditure; X = Exports and M = Imports.
CONCLUSION

The circular flow of income describes the movement of goods or services and income among
the different sectors of the economy. It illustrates the interdependence of the sectors and the
markets to facilitate both real and monetary flow.

A two-sector model is the simplest model of the circular flow of income. It is assumed to be a
closed economy. There are only two sectors – the household sector and the firm sector. The
flow of income and expenditure is between these two sectors only.

 In a three-sector model, apart from the above two sectors there is another sector called the
government sector. The economy is still a closed economy meaning that there is no
transaction with the rest of the world.

 A four-sector model is the complete model of the circular flow of income. It considers the
effect of the foreign sector which includes transactions with the rest of the world. The
economy is now an open economy