People have multiple wants but only limited resources to fulfil them. They need different goods and services to satisfy different wants. But due to scarcity of resources, we cannot produce all the different types of goods and services for everybody in the economy at the same time. Also due to scarcity, we cannot afford to waste the resources. So every economy must find solutions to these problems.

The economy has to decide what goods and services are to be produced and how resources are to be used. The issue of ‘choice’ arises because a) the resources are scarce and b) the resources can be put to many alternative uses.

There are three major problems facing any economy. These are:

  1. Problem of Allocation of Resources
  2. Problem of Utilisation of Resources
  3. Problem of Growth of Resources

1. Allocation of Resources

An economy confronts three fundamental economic problems:

  1. What goods and services shall be produced and in what quantities?
  2. How shall goods and services be produced?
  3. For Whom goods and services are to be produced?

1. What to Produce

Every society may face similar problem of choice, however the priorities may be different. In less developed economies the choice may be between production of food crops and manufacture of bicycles. In advanced economies the choice may be between building more shopping malls or producing more cars.

2. How to Produce

It is related to the method by which these are to be produced. Once the goods to be produced are decided, there is a problem of how to produce them. What tools are needed, how much land and how many workers are needed. There are many different ways of making things. For example, clothes can be produced by employing more labour and less machines or more machines and less labour. 

If goods and services are produced by employing more of labour and less of capital, it is known as labour intensive method of production. If goods and services are produced by employing more of capital, it is called capital intensive method of production.

3. For Whom to Produce

It is not possible to satisfy everyone’s want due to scarcity, so it must be decided to whose wants are to be satisfied. All these decisions refer to the distribution of income and wealth in the society.

Resource Allocation in a Capitalist Economy

Capitalist economy is an economic system in which factors of production are privately owned and goods and services are produced with the objective of earning maximum profit. In a capitalist (market-oriented) economy, there is no central authority to guide the choice of goods and services. The production is in the hands of individuals - farmers, manufacturers, producers, service providers and others.

The resources like land, labour, capital etc. are owned privately by people. All these individuals produce for the market and are guided by profit motive. They produce only those goods which are demanded by the consumers. They try to produce the goods in the cheapest possible way so that they can earn maximum profits. These individual producers will try to move their resources away from producing things which people do not buy, towards the production of goods which people like to buy. The products are meant for the people who demand such products and can afford to buy these.

Thus, the important characteristics of a capitalist economic system are:

  • Only those goods and services are produced which the consumers want.
  • Maximum quantity of goods are produced at the minimum cost per unit.
  • Goods and services are produced for everyone who can pay for them.

Resource Allocation in a Planned Economic System

In a planned economic system, there is a central planning authority of the government which decides what to produce, how to produce and for whom to produce. The planning authority sets the production targets. The government sets the goals and the firms try to meet the goals. When there is an agreement on the targets, the firms start the production. It is unlike the market economies, where people who have money can satisfy their wants and people who do not have money cannot afford to buy things to satisfy their wants.

In a planned system, the government wants everybody to be equal. They produce the goods which everybody needs and can be shared equally by everyone. It is not that people who can afford can have more. At least in case of services like health and education, roads and housing, everyone should get equal opportunity, irrespective of their affordability.

Thus, in case of planned economies, the government decides to produce the goods and services which it thinks people should have and not what people think they should have. Thus, the government produces goods and services to satisfy the wants of masses.

As the government determines the production of various goods and their quantities, it is possible that the government produces more scooters and tractors whereas the consumers demand car. Regarding how to produce, the central planning authority may not be able to calculate the cost of so many things and there is a danger that resources are not allocated in an ideal manner.

A socialist economy solves the problem of whom to produce on the basis of basic needs of people like food, clothing and shelter are sought to be satisfied. Everyone is treated alike and no one gets precedence over the other. It is however said that planned economic system does not allocate the resources in the most ideal manner as it is not based on the choice and preference of people. It is based on the decision of government. However, the system is based on the principle of social welfare.

Resource Allocation in a Mixed Economy

A mixed economic system combines government planning with the free market economy. No economy in the world is totally centrally planned or totally market oriented. Most of the economies today are mixed economies. In the mixed economic system the choice of goods and services to be produced by the private sector depends on the basis of profit motive.

The choice of goods and services to be produced by the government depends on the basis of needs and requirements of the people. It combines the efficiency of production with the justice of distribution; the government owns scarce resources to produce goods and services that they think their country and people need. People and firms in the private sector also own some scarce resources with the aim of making as much money as possible.

Thus, mixed economic system attempts to combine the advantages of the market economic system with the advantages of the planned economic system.

2. Utilisation of Resources

The other central problem of an economy relates to full utilisation of resources - land, labour, capital. If all the resources in the economy are fully employed, then the quantity of one commodity can be increased only by forgoing some quantity of the other.

This happens when production takes place efficiently. But in reality, most of the time production does not take place efficiently. The factors are not fully employed and the production is below the optimum capacity of economy. 

Some people are unemployed despite being educated. Similarly, in agricultural land we still grow only one crop in a year. This is not a good sign, as the resources are already scarce. If these scarce resources are also not utilised fully, it is wastage of resources. Thus, it is the duty of an economy to ensure that the scarce resources do not remain under-utilised.

3. Growth of Resources

If resources like labour, capital and technology grow over a period of time, the problem of scarcity can be addressed. Thus, for the growth of any economy, the resources available to the economy should grow.

It is only through the effective growth of resources that a society can enjoy a higher standard of living. This is how the countries have developed. If the resources have failed to grow, the countries continue to be underdeveloped. Thus, the economies should make efforts so that their resources grow gradually to meet the growing needs.