Basic Economic Problem

  • The fundamental economic problem is the issue of scarcity and how best to produce and distribute these scare resources.
  • Scarcity means there is a finite supply of goods and raw materials.
  • Finite resources means they are limited and can run out.
  • Unlimited wants mean that there is no end to the quantity of goods and services people would like to consume.
  • Because of unlimited wants – People would like to consume more than it is possible to produce (scarcity)

Fundamental economic question

Therefore because of scarcity, economics is concerned with:

  • What to produce?
  • How to produce?
  • For whom?

Examples of the economic problem

Consumers

Households have limited income and they need to decide how to spend their finite income. For example, with an annual income of £20,000, a household may need to spend £10,000 a year on rent, council tax and utility bills. This leaves £10,000 for deciding which other food, clothes, transport and other goods to purchase.

Workers

Householders will also face decisions on how much to work. For example, working overtime at the weekend will give them extra income to spend, but less leisure time to enjoy it. A worker may also wish to spend more time in learning new skills and qualifications. This may limit their earning power in the short-term, but enable a greater earning power in the long-term.  For example, at 18 a student could go straight into work or they could go to university where they will hope to gain a degree and more earning power in the long-term.

Producers

A producer needs to remain profitable (revenue higher than costs). So it will need to produce the goods which are in high demand and respond to changing demands and buying habits of consumers – for example, switching to online sales as the high street declines. Producers will need to constantly ask the best way of producing goods. For example, purchasing new machines can increase productivity and enable the firms to produce the goods at a lower cost. This is important for fast-changing industries where new technology is frequently reducing costs of production. Without firms adapting to how they produce, they can become unprofitable.

Firms may also need to make long-term investment decisions to invest in new products and new means of production.

Government

The government has finite resources and its spending power is limited by the amount of tax that they can collect. The government needs to decide how they collect tax and then they need to decide whom they spend money on. For example, the government may wish to cut benefits to those on low income to increase incentives to work. However, cutting benefits will increase inequality and relative poverty.

Opportunity cost and the economic problem

The economic problem can be illustrated with the concept of opportunity cost.

Opportunity cost is the next best alternative foregone. A consumer with a limited income of £20,000 year continually faces choices, if they spend £3,000 on a new car, then that is £3,000 they cannot spend on food and drink

If a student spends three years in education, the opportunity cost is the lost potential of earning from a full-time job.

Government

A government may have choices on how to spend limited resources. In this simple model, they have a choice between health care and military spending. If they increase spending on the military, the opportunity cost is less spending on health care.

ppf-curve-health-military

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