The Function of an economy.

The Function of an economy:

An economy is a system, which attempts to solve the basic economic problem. In a national economy the resources in a country are changed by business activity into goods and services, which are bought by individuals. In a household economy the family budget is spent on a range of goods and services. Local and International economies also act in the same way, but at different levels. The function of an economy is to allocate scarce resources amongst unlimited wants. The basic economic problem is often broken down into three questions:

What should be produced?
How should it be produced?
For whom should it be produced?

What should be produced?

In developed economies the number of goods and services produced from resources is immense. The economic system must decide which resources will be used to produce which products. For example, what proportion of the resources should be used to produce food, cars, housing, cigarettes, cosmetics, computers, etc.? Should resources be used for military purposes? Should resources be used to generate wealth for the future?

In less developed economy the decision about what to produce may be simpler. This is because the choices available are limited. For example, a very poor African village maybe faced with a decision whether to produce wheat or maize. However there is still a question of resource allocation and what to produce.

For whom should it be produced?

An economy has to decide how the final goods and services will be allocated amongst competing groups. For example, how much should go to students, should the unemployed receive a share of output, should managers get more than workers?

How should it be produced?

The way in which goods and services are produced can vary. Decisions have to be made about such things as where production takes place, the method of production, the material and labour that will be used.

Advantages of Capitalist economy:

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For whom should it be produced?

How should it be produced?

Advantages of Capitalist economy:

Automated working: It does not require any central directing authority for it’s functioning. It functions directly through the price mechanism.
Higher efficiency and incentive to do hard work: Under capitalism workers and entrepreneurs are encouraged to improve the efficiency and put in hard work to earn higher profits.
Higher rate of capital formation: people can save a part of their income so that it can be invested to earn more income and leave larger properties for their heirs. The rate of capital formation increases when savings are invested. This accelerates economic growth.
Economic Development and prosperity: It is argued that free market will lead to larger, better-quality outputs at lower unit costs. Capitalism offers great incentive for saving and large opportunities for investment. It encourages innovation and technological progress and the optimum use of resources.
Optimum utilization of resources: Every producer and entrepreneur tries to use the resources at his disposal in the most economical manner in order to maximize profits. Otherwise, businesses may suffer higher costs and losses or even bankruptcy or their miscalculations.
Just system: a man who takes the initiative and shows extra ordinary resourcefulness makes the highest profits.
Democratic: In a capitalist economy, individuals have greater freedom to make their own supply and demand decisions. Consumers buy what they like and not what is supplied to them. Hence, the system is democratic.
Encouragement to Enterprise and Risk-taking: Capitalism encourages entrepreneurs to take risks and adopt bold policies, so that they can better production techniques, earn higher profits and cut costs.
Adaptability: the system is flexible, in away it can respond to different conditions of demand and supply.

Disadvantages of Capitalist economy:

The free market doesn’t guarantee everyone what would regard to be the minimum acceptable standard of living in a healthy society. The price mechanism, when it is freely operating, fails to provide a safety net for citizens less able to compete.
There are some goods which by their very nature includes elements of what is known as “non-excludability”. For example all ships using a particular seaway benefit from its lighthouse, all citizens (except for pacifists) could be seen to benefit from a national system of defence.
The free market can lead to great inequality. Those with the means to purchase large quantities of goods can use their money to ensure that the goods and services they want are produced (hence taking away resources from other products).
Resources may not be able to move as freely as a pure market theory suggests. Regarding human resources(labour), people may be resistant to moving to new areas and away from their established roots, they may be reluctant to learn new skills which offer high pay packets, if they feel their jobs doesn’t fulfill for factors such as self-respect, pride in the job and the ability to work at one’s own pace.
Many decisions are made by consumers with an imperfect knowledge of the market. Producers frequently change the details of their products including price, shape, size and packaging. This makes it very difficult for consumers to weigh up alternative purchases, and many decisions are made by impressions rather than hard evidence.
Many resources can be wasted due to a high failure rate of new businesses. A lot of time and money is spent on setting up a new business. When it closes down after a few months, many of its resources may end up as little as scrap.
Merit goods such as education and health may not be available to all, which can be harmful to the economy and society.
Monopolies may occur which are often bad for consumers. Big monopolies can control the market, squeeze out competition and set prices of their own liking.

Private producers will ignore the bad effects of external costs of their activities, such as pollution, if they are allowed complete freedom.