The fundamental economic problem is the issue of scarcity – but unlimited wants. Therefore, an underlying features of economics is concerned with dealing how to allocate resources in society to make the most efficient and fair use of resources.
Therefore economic is concerned with:
- What to produce?
- How to produce?
- For whom to produce?
Scarcity implies there is only a limited quantity of resources, e.g. finite fossil fuels and a limited quantity of manufactured goods. Because of scarcity, there is a constant opportunity cost – if you use resources to consume one good, you cannot consume another.
Micro economic problems
The economic problem of pollution
One of the most frequent problems is that economic decisions can have external effects on other people not involved in transaction. For example, if you produce power from coal, the pollution affects people all over the world (acid rain, global warming). One reason this is a particular problem is that we cannot rely on the free market to provide the most efficient outcome. If we create negative externalities, we don’t take them into account when deciding how much to consume. This is why we can get overconsumption of driving a car into a city centre at peak hour. If everyone maximises their utility, it doesn’t lead to the most efficient outcome – but gridlock and wasted resources.
Externalities, usually need some kind of government intervention. For example, taxes on negative externalities (e.g. sugar tax) or subsidies on positive externalities (e.g. free public education)
But, even the solution to market failure (e.g. taxes, creates its own potential problems, such as how much to tax? will there be tax evasion?)
Monopoly was an economic problem that Adam Smith was concerned about in his influential book of economics “A Wealth of Nations”. For various reasons firms can gain monopoly power – and therefore the ability to set high prices to consumers. Given a lack of alternatives, monopolies can make high profits at the expense of consumers, causing inequality within society. Monopoly power can also be seen through monopsony employers who pay lower wages to their workers.
How to deal with the problem of monopoly? – A government may seek to encourage competition, e.g. rail franchising, or price regulation to prevent excessive prices.
Inequality / poverty
Inequality is considered a problem because of normative opinions such as – it is an unfair distribution of resources. Also, you could argue there is a diminishing marginal utility of wealth. If all wealth is owned by a small percentage of the population, this reduces net welfare. Redistributing the money to the very poor, would enable greater net utility to society.
Inequality is a problem. However, it is also a problem to know how much we should seek to reduce poverty. Many will agree of the necessity of reducing absolute poverty – but how far should we take it? Should we aim for perfect equality (Communism) or should we aim for equality of opportunity?
Another issue with reducing poverty is that measures to reduce poverty may cause unintended consequences – e.g. higher income tax on high earners, may create disincentives to work. Giving benefits to the low paid may reduce incentives to work.
Some agricultural markets can have volatile prices. A glut in supply can be bad news because the fall in price can lead to lower revenue for farmers. It could even cause some to go out of business because of a bad year. These volatile markets can cause swings in economic fortunes.
In some asset markets we have seen volatile prices exacerbated by irrational exuberance. Consumers have been caught up in a market frenzy. Hoping that rising prices will make them richer – and expecting prices to keep rising. We can see this in issues such as tulip mania, the South Sea Bubble, railway mania, and the recent property bubbles.
Macro economic problems
Unemployment has been a major economic problem in advanced economies. One of the principle causes of unemployment is swings in the business cycle. A fall in demand for goods during a recession, causes people to be laid off. Because of the depressed state of the economy, there is an imbalance between demand and supply of workers.
Unemployment can also be caused by rapid changes in labour markets, for examples, unskilled workers unable to gain employment in a high tech economy. Unemployment is a problem because it is a waste of resources, but more importantly it leads the unemployment in dire economic and personal problems.
Recession is a period of negative economic growth – a decline in the size of the economy. It exacerbates problems of inequality and unemployment.
High inflation can be a serious problem, if prices rise faster than wages and nominal interest rates. In periods of rapidly rising prices, people with savings will see a decline in their real wealth. If prices rise faster than wages, then people’s spending power will decline. Also, rapidly rising prices creates confusion and uncertainty and can cause firms to cut back on investment and spending. Countries which have experienced hyperinflation, have seen it as a very traumatic period because all the economic certainty is washed away, leaving people without any certainty.
Balance of payments / current account deficit
A current account deficit on the balance of payments means an economy is importing more goods and services than it is exporting. To finance this current account deficit, they need a surplus on the financial / capital account. For many modern economies a small current account deficit is not a problem. However, some developing economies have experienced a balance of payments crisis – where the large deficit has to be financed by borrowing and this situation usually leads to a rapid devaluation in the currency. But, this devaluation increases price of imports, reduces living standards and causes inflation.
Exchange rate volatility
In some cases, the exchange rate can cause economic problems. For example, countries in the Euro were not able to change the value of their currency against other Eurozone members. Because countries like Greece and Portugal had higher inflation rates, they became uncompetitive. Exports fell, and they developed a large current account deficit. The overvalued exchange rate caused a fall in economic growth.
On the other hand a rapid devaluation can cause different problems. For example, when the price of oil fell, oil exporting countries saw a decline in export revenues, leading to a fall in the value of the currency. A rapid devaluation causes price of imports to rise and causes both higher inflation and lower growth. A difficult problem for policy makers to deal with.
Developing economies face similar economic problems, but any issue is often magnified by low GDP and high levels of poverty. For example, unemployment in a developing economy is more serious because there is unlikely to be any government insurance to give a minimum standard of living.
Poverty cycle. Some developing economies may be stuck in a poverty cycle. Low growth, and low saving ratios, lead to low levels of investment and therefore low economic growth. This low growth and poverty causes the low savings and investment to be continued.