1.1 – 1.

4 – The Basic
Economic Problem
“Economics is the social science that describes the
factors that determine the production, distribution and
consumption of goods and services.”
(Source: Wikipedia)

The Nature of the Economic Problem

Resources: are the inputs required for the production of

goods and services.

Scarcity: a lack of something (in this context, resources).

The fundamental economic problem is that there is a
scarcity of resources to satisfy all human wants and
needs. There are finite resources and unlimited wants.
This is applicable to consumers, producers, workers and
the government, in how they manage their resources.

Economic goods are those which are scarce in supply

and so can only be produced with an economic cost
and/or consumed with a price. In other words, an
economic good is a good with an opportunity cost. All the
goods we buy are economic goods, from bottled water to
clothes.
Free goods, on the other hand, are those which are
abundant in supply, usually referring to natural sources
such as air and sunlight.
The Factors of Production

Resources are also called ‘factors of production’

(especially in Business). They are:

Land: all natural resources in an economy. This

includes the surface of the earth, lakes, rivers,
forests, mineral deposits, climate etc.
The reward for land is the rent it receives.
Since, the amount of land in existence stays the
same, its supply is said to be fixed. But in
relation to a country or business, when it takes
over or expands to a new area, you can say that
the supply of land has increased, but the supply
is not depended on its price, i.e. rent.
The quality of land depends upon the soil type,
fertility, weather and so on.
Since land can’t be moved around, it is
geographically immobile but since it can be
used for a variety of economic activities it is
occupationally mobile.

Labour: all the human resources available in an

economy. That is, the mental and physical efforts and
skills of workers/labourers.
The reward for work is wages/salaries.
The supply of labour depends upon the number
of workers available (which is in turn influenced
by population size, no. of years of schooling,
retirement age, age structure of the population,
 attitude towards women working etc.) and the
number of hours they work (which is influenced
by number of hours to work in a single day/week,
number of holidays, length of sick leaves,
maternity/paternity leaves, whether the job is
part-time or full-time etc.).
The quality of labour will depend upon the skills,
education and qualification of labour.
Labour mobility can depend up on various
factors. Labour can achieve high occupational
mobility (ability to change jobs) if they have the
right skills and qualifications. It can achieve
geographical mobility (ability to move to a place
for a job) depending on transport facilities and
costs, housing facilities and costs, family and
personal priorities, regional or national laws and
regulations on travel and work etc.

Capital: all the man-made resources available in an

economy. All man-made goods (which help to
produce other goods – capital goods) from a simple
spade to a complex car assembly plant are included
in this. Capital is usually denoted in monetary
terms as the total value of all the capital goods
needed in production.
The reward for capital is the interest it receives.
The supply of capital depends upon the demand
for goods and services, how well businesses are
doing, and savings in the economy (since capital
 for investment is financed by loans from banks
which are sourced from savings).
The quality of capital depends on how many
good quality products can be produced using
the given capital. For example, the capital is said
to be of much more quality in a car
manufacturing plant that uses mechanisation
and technology to produce cars rather than one
in which manual labour does the work.
Capital mobility can depend upon the nature
and use of the capital. For example, an office
building is geographically immobile but
occupationally mobile. On the other hand, a pen
is geographically and occupationally mobile.

Enterprise: the ability to take risks and run a

business venture or a firm is called enterprise. A
person who has enterprise is called an entrepreneur.
In short, they are the people who start a business.
Entrepreneurs organize all the other factors of
production and take the risks and decisions
necessary to make a firm run successfully.
The reward to enterprise is the profit generated
from the business.
The supply of enterprise is dependent on
entrepreneurial skills (risk-taking, innovation,
effective communication etc.), education,
corporate taxes (if taxes on profits are too high,
nobody will want to start a business), regulations
 in doing business and so on.
The quality of enterprise will depend on how well
it is able to satisfy and expand demand in the
economy in cost-effective and innovative ways.
Enterprise is usually highly mobile, both
geographically and occupationally.

All the above factors of productions are scarce because

the time people have to spend working, the different skills
they have, the land on which firms operate, the natural
resources they use etc. are all in limited in supply; which
brings us to the topic of opportunity cost.

Opportunity Cost

The scarcity of resources means that there are not

sufficient goods and services to satisfy all our needs and
wants; we are forced to choose some over the others.
Choice is necessary because these resources have
alternative uses- they can be used to produce many
things. But since there are only a finite number of
resources, we have to choose.

When we choose something over the other, the choice

that was given up is called the opportunity cost.
Opportunity cost, by definition, is the next best
alternative that is sacrificed/forgone in order to
satisfy the other.
Example 1: the government has a certain amount of
money and it has two options: to build a school or a
hospital, with that money. The govt. decides to build the
hospital. The school, then, becomes the opportunity cost
as it was given up. In a wider perspective, the opportunity
cost is the education the children could have received, as
it is the actual cost to the economy of giving up the
school.
Example 2: you have to decide whether to stay up and
study or go to bed and not study. If you chose to go to
bed, the knowledge and preparation you could have
gained by choosing to stay up and study is the
opportunity cost.

Production Possibility Curve Diagrams (PPC)

Because resources are scarce and have alternative uses,

a decision to devote more resources to producing one
product means fewer resources are available to produce
other goods. A Production Possibility Curve diagram
shows this, that is, the maximum combination of two
goods that can be produced by an economy with all
the available resources.

The PPC diagram above shows the production capacities

of two goods- X and Y- against each other. When 500
units of good X are produced, 1000 units of good Y can
be produced. But when the units of good X increases to
1000, only 500 units good Y can be produced.

Let’s look at the PPC named A. At point X and Y it can

produce certain combinations of good X and good Y.
These are points on the curve- they are attainable, given
the resources. Th economy can move between points on a
PPC simply by reallocating resources between the two
goods.
If the economy were producing at point Z, which is
inside/below the PPC, the economy is said to be
inefficient, because it is producing less than what it can.
Point W, outside/above the PPC, is unattainable because
it is beyond the scope of the economy’s existing
resources. In order to produce at point W, the economy
would need to see a shift in the PPC towards the right.
For an outward shift to occur, an economy would need
to:

discover or develop new raw materials.

Example: discover new oil fields
employ new technology and production methods to
increase productivity
increase labour force by encouraging birth and
immigration, increasing retirement age etc.

An outward shift in PPC, that is higher production

possibility, will lead to economic growth.

In the same way, an inward shift can occur in the PPC

due to:

natural disasters, that erode infrastructure and kill the

population
very low investment in new technologies will cause
 productivity to fall over time
running out of resources, especially non-renewable
ones like oil or water

An inward shift in the PPC will lead to the economy

shrinking.

How is opportunity cost linked to PPC?

Individuals, businessmen and the government can
calculate the opportunity cost from PPC diagrams. In the
above example, if the firm decided to increase production
of good Y from 500 to 750, it can calculate the
opportunity cost of the decision to be 250 units of good
X (as production of good X falls from 1000 to 750). They
are able to compare the opportunity cost for different
decisions.

Notes submitted by Lintha

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