A capitalist economy has no central planning authority to decide as to what, how and for whom to produce and in the absence of any central authority; it looks like a miracle as to how such an economy functions. There can be confusion and chaos in the country when the producers choose to produce cloth and workers choose to work for the furniture industry, while the consumers are in need of cars.
In order to solve the central problems, such an economy uses the impersonal forces of the market demand and supply or the price mechanism. Such an economy uses the impersonal forces of the 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 prompts the businessmen to compete with one another in order to produce those goods which consumers are willing to buy. Thus, if consumers want more cars, there will be an increase in the demand for cars consequent upon which the prices of cars are bound to increase. A rise in the sale of cars; cost remaining the same, will increase the profits for the entrepreneur. This induces the producers to go in for more production. In other words, when the consumers’ demand for any product decreases, the price would fall thereby reducing the profits for the entrepreneur and the production also goes down.
Deciding how to produce?
An entrepreneur produces his goods with that technique of production which renders his cost of production minimum. If labor is relatively cheap he will use labor intensive method and if labor is relatively costlier he will use capital intensive method. Thus, the relative prices of factors of production help in deciding as to how to produce.
Deciding for whom to produce?
Goods and services in a capitalist economy will be produced for those who have the capacity to buy. 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; however, also on how much property he owns. Higher the income, higher will be his buying capacity and higher generally will be his demand for goods in general.
Deciding about consumption, savings and investment:
Consumption and savings are done by consumers and investments are done by entrepreneurs. Consumer’s savings among other factors are governed by the rate of interest prevailing in the market. Higher the interest rates, higher are the savings. Investment decisions depend upon the rate of return on capital. The greater the profit expectation, the higher will be the investment in any capitalist economy. The prices of capital are – the rate of interest on savings and the rate of return on capital.