SOLVE THEIR CENTRAL PROBLEMS

How do capitalist economies solve their central problems?

A capitalist economy has no central planning authority to decide what, how and for whom to produce. In the absence of any central authority, it looks like a miracle as to how such an economy functions. If the consumers want cars and producers choose to make cloth and workers choose to work for the furniture industry, there will be total confusion and chaos in the country. However, this does not happen in a capitalist economy. Such an economy uses the impersonal forces of market demand and supply or the price mechanism to solve its central problems.

Deciding ‘what to produce’ The aim of an entrepreneur is to earn as much profits as possible. This causes businessmen to compete with one another to produce those goods which consumers wish to buy. Thus, if consumers want more cars, there will be an increase in the demand for cars and as a result their prices will increase. A rise in the price of cars, costs remaining the same, will lead to more profits. This will induce producers to produce more cars. On the other hand, if the consumers’ demand for cloth decreases, its price would fall and profits would go down. Therefore, business firms have less incentive to produce cloth and less of cloth will be produced. Thus, more of cars and less cloth will be produced in such an economy. In a capitalist economy (like the USA, UK and Germany) the question regarding what to produce is ultimately decided by consumers who show their preferences by spending on the goods which they want.

Deciding ‘how to produce’: An entrepreneur will produce goods and services choosing that technique of production which renders his cost of production minimum. If labour is relatively cheap, he will use labour- intensive method and if labour is relatively costlier he will use capital-intensive method. Thus, the relative prices of factors of production help in deciding how to produce.

Deciding ‘for whom to produce’: Goods and services in a capitalist economy will be produced for those who have buying capacity. The buying capacity of an individual depends upon his income. How much income he will be able to make depends not only on the amount of work he does and the prices of the factors he owns, but also on how much property he owns. Higher the income, higher will be his buying capacity and higher will be his demand for goods in general.

Deciding about consumption, saving and investment: Consumption and savings are done by consumers and investments are done by entrepreneurs. Consumers’ savings, among other factors, are governed by the rate of interest prevailing in the market. Higher the interest rates, higher will be the savings. Investment decisions depend upon the rate of return on capital. The greater the profit expectation (i.e. the return on capital), the greater will be the investment in a capitalist economy. The rate of interest on savings and the rate of return on capital are nothing but the prices of capital.

Thus, we see above that what goods are produced, by which methods they are produced, for whom they are produced and what provisions should be made for economic growth are decided by price mechanism or market mechanism.