The economic problem

The main purpose of economic activity is the production of goods and services to satisfy consumers’ needs and wants, and thereby to improve economic welfare.  The consumption and production of goods and services is not limited to those sold in shops and over the internet, they also include housework, DIY and the benefits you get from the natural environment.



There are only a limited amount of resources on the planet; these can be described as scarce or finite resources, for example, oil, coal, trees.


These scarce resources are called economic goods. Not all resources are scarce, these are called free goods, for example, salt water.


In reality nearly all goods are economic goods; clean air was often quoted a free good as it could be used without worrying about scarcity.  Increased pollution has led to many economists questioning whether air is in fact a free good.


Needs and Infinite Wants

There are a number of things humans need to survive, these are our basic needs – food water, shelter and warmth.


People are not satisfied if only their basic needs are met, they would rather enjoy a higher standard of living; this is because we all have an unlimited number of wants, such as yachts, cars, large mansions.


The Economic Problem

The fact that resources are scarce and our wants are infinite gives leads to the basic economic problem. How do we allocate the limited resources so that society can receive the maximum benefit?  Your own point of view will affect how you answer to this question.  There are three basic questions that need to be answered in order to solve the economic problem:

  • What should we produce given the scarce resources available?
  • How should we produce it?
  • For whom should it be produced for?  Who is going to receive the goods and services once they have been produced?


Economics attempts to answer these questions.


Opportunity Cost

An economic agent is any person or group that makes decisions within an economy, for example consumers, firms, governments etc.  Due to the existence of the economic problem economic agents are forced to make choices regarding what to do with their limited resources.


You have £40, do you spend it on a t-shirt or a night out? Does the government spend £100 million on weapons or building a hospital?  Should your school buy 10 computers or 50 chairs?  A rational economic agent will choose the option that gives them the greatest amount of satisfaction (economists call this utility).


The opportunity cost is the satisfaction (or utility) you lose from not being able to have your second choice (the next best alternative), examples of opportunity cost are:

  • If you spend £40 on a night out the opportunity cost will be the t-shirt.
  • If the government spends £100 million on weapons the opportunity cost will be building a hospital.
  • If a school decides to buy 10 computers the opportunity cost will be 50 tables.


Economic goods will have an opportunity cost as they are scarce and can not be used for two different things at the same time.  Free goods have no opportunity cost.


Economic Resources (Factors of Production)

There are many different resources in the world; economists group them into four factors of production:

·      Capital

This includes all of the machinery, buildings, machines etc. used in the production of goods and services.  Capital also includes the money that firm have and use.

·      Enterprise

This is carried out by entrepreneurs who:

  • Think of original ideas or improve upon what is already in the marketplace.
  • Get the business up and running by organising the other three factors of production.
  • Take risks with their own money and the financial capital of other investors.
  • Richard Branson, Alan Sugar and James Dyson are famous entrepreneurs.

·      Land

Confusingly, land isn’t just the ground that is built on, but includes all of the natural resources as well.  Land is divided into two different types:

  • Non-renewable resources, for example, oil and coal.
  • Renewable resources, for example, wood and fish.

·      Labour

This includes the workforce in the economy.  Every worker possesses different skills and qualities – we measure this in human capital.  It is possible to increase an individual’s human capital through education and training.


There is an easy way of remembering the different factors of production – CELL:






The owners of factors of production can sell or loan them and receive payments – these are called factor incomes:

  • The payment for capital is interest
  • The payment for enterprise is profit
  • The payment for land is rent
  • The payment for labour is wages


The factors of production can be bought and sold in factor markets.  These will be discussed in far greater detail later in the year.

Economic Objectives of Individuals, Firms and Government

Different economic agents will have varying objectives.  We make the assumption that each economic agent will act in its own interest, often these interests will be competing.



Unfortunately you and I only have a limited amount of money therefore we have to make decisions about how to spend it.  When faced with a decision about how to spend money consumers will opt for the good or service that gives them the most utility (satisfaction).


Economic theory assumes that people act rationally and attempt to maximise their own welfare



Workers will want higher wages, better job security and improved working conditions.  We often assume that workers will want to maximise the wages that they earn.


Economists assume that most businesses are profit maximisers (profit = revenue – costs).  This is because they are owned by individuals who want to maximise the return on their investment.  It is possible that a business will have other objectives, for example, a school or hospital will be focused upon the quality of service provision rather than making profits.

Factor owners

The owners of the factors of production will want maximise the payment they receive.  This is in comparison to firms who will wish to minimise costs, they will only be prepared to pay what the factor of production is worth in the production process.



The government is the elected representative of the consumers, therefore it should simply act on behalf of the people.  The government has to decide whether to intervene in the economy.  Governments of different countries will make different decisions, for example, healthcare in the UK is provided free of charge, whilst a system of private healthcare operates in the USA.


The Role of Prices and Profits in a Free Market Economy

Prices are profits are used as signs in the economy to consumers and firms – this process is known as the price mechanism.  Decisions made by consumers and firms are based upon the prices and profits available in a particular market.  Prices and profits have three main functions in an economy:

  • Rationing – we know that resources are scarce, but consumer wants are infinite.  Prices are used to help determine how these scarce resources will be allocated between competing uses, in other words prices are used to ration resources.  Supply will be rationed to those who are willing to pay the price for it.  The increase in price acts as a way of further rationing demand and a fall in the price will lead to an end in the rationing as more consumers are able to purchase it.
  • Signalling – the price of a good is a vital piece of information to both buyers and sellers.  The price reflects market conditions and will therefore act as a signal, communicating information to those in the market. Decisions about buying and selling are based on those signals.
  • Incentive – the price acts as an incentive for the consumers and firms in the market. Low prices are incentive for buyers to purchase more goods.  Rising prices will also increase the incentives for firms supplying the market.


Production Possibility Boundaries (PPB)

The PPB or production possibility frontier (PPF) demonstrates the concepts of choice and opportunity cost.  If we assume that a country can only produce investment and consumer goods, the diagram below shows a PPB that demonstrates a menu of choices for the economy of what it is able to make, for example it could produce:

  • 0A investment goods, or
  • 0B consumer goods, or
  • 0C investment goods and 0D consumer goods.


If the economy is producing at any point inside the PPB, such as point X, it is not producing as efficiently as it could, because it could increase production of consumer goods and investment goods with the resources it already has.  It is not possible to produce at any point outside of the PPB.

An economy is able to produce more consumer goods and investment goods by moving from point X to Y (which is on the PPB).


If an economy is producing at any point on the PPB, such as Y, it is using all of its resources efficiently.  This means the economy is producing a much as it can given the present levels of technology and productivity, and the amount of factors of production it has.  Any point on the PPB is said to be productively efficient as every firm in the economy is producing at their lowest possible costs.  It a firm was not operating at its lowest possible costs then it would be wasting resources and therefore the economy would not be on the PPB.


Any point on the PPB is also allocatively efficient as it is not possible to make somebody better off without making somebody else worse off.


Opportunity Cost and the PPB

If that country wanted to increase its production of consumer goods, it would have to sacrifice the production of some investment goods.  Therefore we can say the opportunity cost of producing more consumer goods is investment goods.

The country is presently producing 3 units of consumer goods and 9 units of investment goods.  If it wants to expand output of consumer goods to 4 units the opportunity cost will be 2 units of investment goods.

It is also demonstrate the concept of increasing opportunity costs using a PPB.  This means as a county wants to produce more and more of one good it has to give up increasing amounts of the other good.  The table below provides the figures for an economy; a PPB has been drawn based upon this data.

Assume the economy is presently only producing investment goods.  In order to produce the first unit of consumer goods only 0.1 units has to be given up.  The opportunity cost of the second unit of consumer goods has increased to 0.4.


Increasing opportunity costs occur because the factors of production have different properties.

  • Capital, for example, machinery is better equipped to produce one good rather than another one.
  • Land, for example, land differs in quality in different parts of the country.
  • Labour, for example, people have different skills and varying levels of human capital.


If the opportunity costs were constant the PPB would be a straight line.  It is because of increasing opportunity costs that the PPB is bowed outwards.



As you know, a nation is unable to produce outside of the PPB. A nation is able to shift its PPB to the right (so that it can produce a greater amount of goods) in one of two ways:

  • Increasing the quantity of factors of production available for production, for example, increase in the number of workers or factories.
  • Increasing the quality of factors of production available for production


An outward shift of the PPB can be shown below:

If the increase in the quality or quantity of factors of production only affected one of the two products, we would see a shift in the PPB as below.

Positive and Normative Economics

Positive economics deals with scientific or objective explanations and statements about the economy – they are facts and can not be argued with.  For example, it is possible for me to state that “in the case of normal goods an increase in the price will lead to a decrease in the quantity demanded”.


Normative economics attempts to describe the economy through value judgements – these are opinions and can be debated.  For example, “all debt held by developing nations should be cancelled”.

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