Economic systems as a type of social system must confront and solve the three fundamental economic problems:
What kinds and quantities of goods shall be produced, “how much and which of alternative goods and services shall be produced?”
How shall goods be produced? ..by whom and with what resources (using what technology)…?”
For whom are the goods or services produced? Who benefits? Samuelson rephrased this question as “how is the total of the national product to be distributed among different individuals and families?”
Problem of allocation of resources
The problem of allocation of resources arises due to the scarcity of resources, and refers to the question of which wants should be satisfied and which should be left unsatisfied. In other words, what to produce and how much to produce. More production of a good implies more resources required for the production of that good, and resources are scarce. These two facts together mean that, if a society decides to increase the production of some good, it has to withdraw some resources from the production of other goods. In other words, more production of a desired commodity can be made possible only by reducing the quantity of resources used in the production of other goods.
The problem of allocation deals with the question of whether to produce capital goods or consumer goods. If the community decides to produce capital goods, resources must be withdrawn from the production of consumer goods. In the long run, however, [investment] in capital goods augments the production of consumer goods. Thus, both capital and consumer goods are important. The problem is determining the optimal production ratio between the two.
Resources are scarce and it is important to use them as efficiently as possible. Thus, it is essential to know if the production and distribution of national product made by an economy is maximally efficient. The production becomes efficient only if the productive resources are utilized in such a way that any reallocation does not produce more of one good without reducing the output of any other good. In other words, efficient distribution means that redistributing goods cannot make anyone better off without making someone else worse off.
The inefficiencies of production and distribution exist in all types of economies. The welfare of the people can be increased if these inefficiencies are ruled out. Some cost must be incurred to remove these inefficiencies. If the cost of removing these inefficiencies of production and distribution is more than the gain, then it is not worthwhile to remove them.
The problem of full employment of resources
In view of the scarce resources, the question of whether all available resources are fully utilized is an important one. A community should achieve maximum satisfaction by using the scarce resources in the best possible manner not wasting resources or using them inefficiently. There are two types of employment of resources:
In capitalist economies, however, available resources are not fully used. In times of depression, many people want to work but can’t find employment. It supposes that the scarce resources are not fully utilized in a capitalistic economy
The problem of economic growth
If productive capacity grows, an economy can produce progressively more goods, which raises the standard of living. The increase in productive capacity of an economy is called economic growth. There are various factors affecting economic growth. The problems of economic growth have been discussed by numerous growth models, including the Harrod-Domar model, the neoclassical growth models of Solow and Swan, and the Cambridge growth models of Kaldor and Joan Robinson. This part of the economic problem is studied in the economies of development.
Monopoly was an economic problem that Adam Smith was concerned about in his influential book of economics “A Wealth of Nations.” For various reasons firms can gain monopoly power – and therefore the ability to set high prices to consumers. Given a lack of alternatives, monopolies can make high profits at the expense of consumers, causing inequality within society. Monopoly power can also be seen through monopsony employers who pay lower wages to their workers.
Some agricultural markets can have volatile prices. A glut in supply can be bad news because the fall in price can lead to lower revenue for farmers. It could even cause some to go out of business because of a bad year. These volatile markets can cause swings in economic fortunes.
A recession is a period of negative economic growth a decline in the size of the economy. It exacerbates problems of inequality and unemployment. A problem of recession is that it can create a negative spiral. When demand falls, firms lay off workers. The unemployed have less money to spend causing further falls in demand.
High inflation can be a serious problem if prices rise faster than wages and nominal interest rates. In periods of rapidly rising prices, people with savings will see a decline in their real wealth. If prices rise faster than wages, then people’s spending power will decline. Also, rapidly rising prices creates confusion and uncertainty and can cause firms to cut back on investment and spending.
Balance of payments/current account deficit
A current account deficit on the balance of payments means an economy is importing more goods and services than it is exporting. To finance this current account deficit, they need a surplus on the financial/capital account. For many modern economies, a small current account deficit is not a problem. However, some developing economies have experienced a balance of payments crisis where the large deficit has to be financed by borrowing, and this situation usually leads to a rapid devaluation of the currency. But, this devaluation increases the price of imports, reduces living standards and causes inflation.
Exchange rate volatility
In some cases, the exchange rate can cause economic problems. For example, countries in the Euro were not able to change the value of their currency against other Eurozone members. Because countries like Greece and Portugal had higher inflation rates, they became uncompetitive. Exports fell, and they developed a large current account deficit. The overvalued exchange rate caused a fall in economic growth.
Developing economies face similar economic problems, but any issue is magnified by low GDP and high levels of poverty. For example, unemployment in a developing economy is more serious because there is unlikely to be any government insurance to give a minimum standard of living.
Poverty cycle. Some developing economies may be stuck in a poverty trap. Low growth and low saving ratios lead to low levels of investment and therefore low economic growth. This low growth and poverty cause the low savings and investment to be continued.