CBSE Class 12 Economics — NCERT Solutions

The central problems of an economy arise because resources are scarce and have alternative uses. Since society cannot have everything it wants, it must make choices about how to use its limited resources. The chapter lists three central problems:

1. What is produced and in what quantities?

Every society must decide how much of different goods and services—such as food, clothing, housing, education, health services, and luxury goods—should be produced.

2. How are these goods produced?

Society must decide which resources and techniques to use in producing goods and services. For example, whether to use more labour or more machines, and which technology to adopt.

3. For whom are these goods produced?

Society must decide how the produced goods and services should be distributed among people. It has to decide who gets how much, and whether everyone should get a minimum amount of basic goods and services.

Thus, the central problems of an economy are the allocation of scarce resources among different uses and the distribution of the final output among individuals.

The production possibilities of an economy refer to the different combinations of goods and services that the economy can produce with its given resources and existing technology. Since resources are limited and can be used in different ways, the economy can produce one combination of goods or another, depending on how the resources are allocated.

For example, if an economy can produce corn and cotton, it may be able to produce:

• more corn and less cotton,
• less corn and more cotton,
• or some intermediate combination of the two.

The set of all such possible combinations is called the economy’s production possibilities. These possibilities show the choices available to society when its resources are fully or differently used.

Microeconomics studies individual economic agents and individual markets—for example, consumers choosing what to buy and producers deciding what to produce and at what price. Its focus is on particular buyers, sellers, firms, and markets, and it usually assumes the rest of the economy remains unchanged.

Macroeconomics studies the economy as a whole. It deals with aggregate variables such as total output, general price level, employment, interest rate, wages, profits, inflation, and unemployment. It also studies the interdependence among different sectors of the economy and the policies that affect the economy as a whole.

So, the main difference is:

• Microeconomics: the study of individual units and markets.
• Macroeconomics: the study of aggregate economic variables and the whole economy.

The important features of a capitalist economy are:

1. Private ownership of means of production — land, capital, and other productive assets are mainly privately owned.
2. Production for the market — goods and services are produced mainly to be sold in the market.
3. Wage labour — labour services are bought and sold for a price called the wage rate.

In such an economy, entrepreneurs control production, hire labour, use capital and land, and sell output for profit. Profits may be used later as investment expenditure to expand production.

The budget set is the collection of all consumption bundles that a consumer can buy with her given income at the prevailing market prices.

The budget line is the line showing all bundles that cost exactly equal to the consumer's income.

The four factors of production are labour, capital, entrepreneurship and land. Their remunerations are called wages for labour, interest for capital, profit for entrepreneurship and rent for land.

A production function is the relationship between the inputs used and the output produced by a firm. It shows the maximum quantity of output that can be produced from different combinations of inputs, given the technology. In short, it tells us how much a firm can produce with a given set of factors of production such as labour and capital.

A barter system is a system of exchange in which goods and services are exchanged directly for other goods and services, without the use of money.

Its drawbacks are:

• It requires double coincidence of wants: each person must want exactly what the other offers.
• It is difficult to find suitable exchange partners, so search costs are high.
• It is hard to store wealth in perishable goods like rice.
• Many goods are difficult to divide, transport, or keep safely.
• It becomes inconvenient as the number of people and transactions increases.

So, barter is inefficient in a large economy and money is needed to make exchanges easier.

A perfectly competitive market has these defining features:

• There are a large number of buyers and sellers.
• Each firm produces a homogeneous product.
• Entry and exit are free for firms.
• There is perfect information about price, quality, and other relevant details.

Because of these features, no single buyer or seller can influence the market price, so firms are price takers.

Marginal propensity to consume (MPC) is the change in consumption per unit change in income. It is denoted by $c$ and given by

$$MPC=\frac{\Delta C}{\Delta Y}=c$$

It is related to marginal propensity to save (MPS) as follows:

$$MPS=\frac{\Delta S}{\Delta Y}=s$$

Since $S=Y-C$,

$$s=\frac{\Delta(Y-C)}{\Delta Y}=\frac{\Delta Y}{\Delta Y}-\frac{\Delta C}{\Delta Y}=1-c$$

So,

$$\boxed{MPS=1-MPC}$$

and therefore

$$\boxed{MPC+MPS=1}$$

Market equilibrium is a situation where the plans of all consumers and firms in the market match and the market clears. At equilibrium, the quantity demanded by consumers equals the quantity supplied by firms. The price at which this happens is the equilibrium price, and the corresponding quantity is the equilibrium quantity.

Public goods must be provided by the government because the market mechanism cannot supply them efficiently.

• They are non-rivalrous: one person's consumption does not reduce what is available to others.
• They are non-excludable: it is not feasible to exclude anyone from enjoying their benefits.
• Because users can enjoy them without paying, free-rider problems arise.
• Therefore, private firms will not voluntarily provide them, and the government must step in through public provision financed by the budget.

Examples include national defence, roads, government administration, and measures to reduce air pollution.

Balance of Trade (BOT) is the difference between the value of exports and imports of goods only in a given period. It is called the trade balance.

Current Account Balance is broader. It includes:

• Balance of Trade in goods
• Balance on invisibles such as services, transfers, and income

So, BOT is only one part of the current account balance. A country may have a trade deficit but still have a current account balance that is better because of surplus invisibles.