CHAPTER 1: BASIC ECONOMIC PROBLEM

1.1.1 FINITE RESOURCES AND UNLIMITED WANTS: DEFINITION AND EXAMPLES OF THE ECONOMIC
PROBLEM IN THE CONTEXTS OF: CONSUMERS; WORKERS; PRODUCERS; AND GOVERNMENTS.

Definition of finite resources and unlimited wants

• 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 mean 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)

1.1.2 ECONOMIC AND FREE GOODS: THE DIFFERENCE BETWEEN ECONOMIC GOODS AND FREE GOODS.
ECONOMIC GOODS – DEFINITION AND EXAMPLES

DEFINITION

An economic good is a good or service that has a benefit (utility) to society. Also, economic goods have a degree of
scarcity and therefore an opportunity cost.

This is in contrast to a free good (like air, sea, water) where there is no opportunity cost – but abundance. Free goods
cannot be traded because nobody living by the sea would buy seawater – there is no point.
However, with economic goods where there is some scarcity and value, people will be willing to pay for them (in

Are public goods economic goods?

Public goods have the characteristics of non-rivalry and non-excludability, e.g. street lighting, and law and order.
They are economic goods because there is a scarcity and opportunity cost in providing for them. They are free at the
point of use. But, this does not make them ‘free goods’ according to the strict economic definition. Public goods such
as street lighting are not free to society because you pay for them indirectly out of taxes.
DEFINITION OF A FREE GOOD

Is water a free good?

A free good is a good with zero opportunity cost. This means it can be consumed in as much quantity as needed
without reducing its availability to others.
A free good contrast with an economic good (a good where there is an opportunity cost in consumption)
Examples of Free Good

• Air. Oxygen is something we need and we can simply breathe it in. There is no element of rivalry
(e.g. if I breathe, there is still enough air for you to breath too.)
• Water. In many environments water will be a free good, e.g. if you live next to a river, a small
community can easily take as much water as it wants with very little effort. If you take water from a
river – there is plenty available for everyone else.
• However, water could become an economic good in dry environments. In desert areas,
water is not in plentiful supply; society has to devote many resources to the production
of drinking water. Therefore, water becomes scarce and so it is no longer considered a
free good. These are sometimes known as a ‘common good’ as it is freely available to
all but at a certain point, there is a limited supply.
• Intellectual ideas. If you develop a new invention and don’t patent it (e.g. yoga exercises, how to
tie a knot) anybody can reuse this idea without any opportunity cost.
• Web-page. If you view a web-page, it doesn’t prevent anyone else consuming the good – it is still
available at no opportunity cost.
• Sunlight. Sunlight is available to all.
• Unless your neighbour grows a leylandii hedge and casts your garden in shade.
• By-products. If heat is generated from a recycling plant, this creates a good – heat at no opportunity
cost.
• Music. Once a song is composed, everyone is free to sing the tune.

FACTORS OF PRODUCTION – DEFINITION AND EXPLANATION

Factors of production refer to the different elements that are used in producing goods and services.Factors of
production are inputs into the productive process.
 The four main factors of production are:

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 AND THE ECONOMIC PROBLEM

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.

THE INFLUENCE OF OPPORTUNITY COST ON DECISION MAKING: CONSUMERS; WORKERS;

RODUCERS; AND GOVERNMENTS.

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 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.

Government
Example: 1
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 careon the children could have received, as it is the actual cost to the economy
of giving up the school.

Individual: 2
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)

PRODUCTION POSSIBILITY CURVE:

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.

The following is a curve representing all possible combinations of two goods that can be produced by an economy
where all of its resources are fully and efficiently employed.
Point X:
The economy can exist at this point but it is being inefficient. Point X Is considered inefficient as resources are idle.
This could mean that workers are unemployed or unmotivated, machines are idle or that factories are half used.

Point Y:
Point Y is unattainable as the economy doesn’t have enough resources to produce both of the products.

MOVEMENT ALONG THE CURVE:

Movement along the PPC involves an opportunity cost. For instance, if the economy moves from point A to B less
product B will be formed and less product A will be produced as compared to before. This would result in an
opportunity cost of some product A that was first produced. Therefore, all along the PPC, opportunity cost is
incurred.

SHIFTS IN THE PRODUCTION POSSIBILITY CURVE:

Rightward Shift:

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.

Leftward shift:

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.
CHANGES IN THE SLOPE OF THE PPC:

If there is a change in the quantity and quality of resources, which are specific to the production of one type of
good, then the entire PPC will not shift to the right, but only the slope will change.

E.g. Technological improvement in the production of product B has caused the maximum number of product B to
increase, but the maximum number of product A doesn’t change. It can also be the other way around i.e. where the
slope moves vertically upwards indicating an increase in the maximum number of product A.

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