Download THE BASIC ECONOMIC PROBLEM

THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY
THE BASIC ECONOMIC PROBLEM
The basic economic problem is scarcity. Scarcity arises because human wants for goods and
services are infinite but the resources required to produce them are finite.
THE BASIC ECONOMIC
PROBLEM
Resources are scarce but human wants are unlimited.
The central purpose of economic activity is the production of goods and services with these
limited resources in order to try and satisfy as many of the unlimited needs and wants as possible.
This is done in order to try and improve or maximise economic welfare.
ECONOMIC WELFARE
The level of prosperity and quality of living standards in an
economy.
THE PROBLEM OF SCARCITY – Not all wants can be satisfied, therefore choices have to be
made over which wants to satisfy, or how the scarce resources are allocated amongst competing
wants. This leads to conflict and economics tries to relieve conflict.
The problem of scarcity means that choices have to be made and therefore an allocative
mechanism is needed to answer the basic economic questions of:
What to produce?
How to produce?
For whom to produce?
ALLOCATIVE
MECHANISM
The method by which resources are allocated between
alternative uses.
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THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY
ECONOMIC WELFARE
Economic welfare is a concept which isn’t easily defined; it refers to how well people within
society are doing. Economic welfare is usually measured in terms of real income, real GDP. An
increase in real output and real incomes suggests people are better off and therefore there is an
increase in economic welfare.
However, economic welfare will be concerned with more than just levels of income. For example,
people’s living standards are also influenced by factors such as levels of congestion and pollution,
levels of literacy and education, healthcare and social service provision etc. These quality of life
factors are important in determining economic welfare.
REAL INCOME
REAL GDP
Real income is the income of individuals or nations after
adjusting for inflation. It is calculated by subtracting inflation
from the nominal income.
Real gross domestic product (GDP) is a macroeconomic
measure of the size of an economy after changes in inflation
have been taken into account.
OPPORTUNITY COST
The problem of scarcity and the fact that choices need to be made leads us to the very important
concept of opportunity cost.
Every choice involves a sacrifice or trade off – in simple terms, choosing more of one thing means
giving up something else in exchange. This is called opportunity cost, i.e. the sacrifice of the next
best alternative. It is the direct result of scarcity and occurs every time a choice is made. The
opportunity cost of a choice is what economists call a real cost – the cost of an item in terms, not
of money, but of the resource, good or service that has had to be given up to obtain that item.
OPPORTUNITY COST
The benefits forgone of the next best alternative use of
resources.
Opportunity Cost is the ‘true’ cost of an economic decision. The true cost of an economic
decision is always measured in terms of opportunity cost and never in monetary/financial terms.
Opportunity cost is the benefits of something real which is actually given up. If we are talking
about the opportunity cost of money it is the benefits of the alternative use of the money rather
than the money itself which constitutes the true cost of a purchasing decision. For example the
opportunity cost of spending £50m on a new warship is not the £50m itself but the benefits
forgone of spending the £50m on a new hospital.
Other opportunity cost examples:
The opportunity cost of the government’s decision to fight the Iraq war is the benefit
that would have arisen from building 10 new schools.
The opportunity cost of spending my monthly income is the benefit I would have
received from saving it.
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THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY
The opportunity cost of buying a new Range Rover is the benefits that would have arisen
from buying a Land Rover.
THE BROAD NATURE OF ECONOMIC ACTIVITY
Economics takes a broad view of what economic activity is. Economics also includes many
activities that may not initially be thought of such as economic activity such as:
Charity work
DIY
Subsistence farming,
Car boot sales
Housework
Barter
Child-rearing
Leisure activities,
Illegal trades (e.g. drugs)
ECONOMIC SYSTEMS
ECONOMIC SYSTEM
A mechanism for determining the allocation of scarce
resources in the face of unlimited and competing human
wants.
The purpose of any economy is to deal with the economic problem; therefore it has to deal with
and try and resolve the three key economic questions:
WHAT - What is going to be produced with the limited resources on offer?
HOW - How is the output going to be produced?
FOR WHOM - Who gets the output that is produced?
The fundamental economic problem facing all societies is what, how and for whom goods and
services should be produced and this is what am economic system tries to resolve.
There are three main types of economic system:
1. Free Market Economy
2. Command or Planned Economy
3. Mixed Economy
FREE MARKET ECONOMY
The term free market economy primarily means a system where buyers and sellers are solely
responsible for the choices they make and thus the allocation of resources. The free market gives
absolute power to prices to determine the allocation and distribution of goods and services.
The role of the government is limited to controlling the law and order of a country and to ensure
that a 'fair price' is charged by the sellers.
FREE MARKET
ECONOMY
Where the competitive interaction of many producers and
consumers, without any intervention by government,
provides the forces of demand and supply which allocate
resources through the price mechanism.
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THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY
SUPPLY
The amount of a good which producers are both willing and
able to sell at a given price.
DEMAND
The amount of a good or service that a consumer is willing to
buy at a particular price.
PRICE MECHANISM
The price mechanism is a term used to describe the means by
which the many millions of decisions taken each day by
consumers and businesses interact to determine the allocation
of scarce resources between competing uses.
The free market system answers the three key economic questions in the following way:
WHAT - generally there is an economic incentive for the firm to choose to produce the most
profitable goods and services and these will be those which are in highest demand.
HOW – there is an incentive for firms to choose the production method which is the least costly
and therefore is the most profitable.
FOR WHOM - the people who get the goods and services produced in a free market are those
who are willing and able to pay the price for them.
ADVANTAGES OF A FREE MARKET ECONOMY
A free market economy or an economy which leans towards the free market system has a number
of advantages:
INNOVATION – The ability to earn profit within a free market gives firms the incentive to
innovate; therefore free markets are wrought with inventions and the money to research them.
Countries classified as having a free market have been responsible for the vast majority of
inventions since the 19th century.
HIGH INCOME MOBILITY - Under a free market system it is easier to move around income
brackets. It is just easier to become rich or poor when as opposed to a command economy where
resources are allocated by the government.
EFFICIENCY AND PRODUCTIVITY - This happens because of the survival of the fittest
aspect of free markets. Firms that have higher costs than others (by producing inefficiently) will
go out of business as those that are more efficient prosper. Thus, firms are always looking for
cheaper ways to do things which drive costs and prices down.
HIGHER GDP - Free market-leaning countries have higher GDPs than command marketleaning economies. This is because they tend to be more efficient and produce more.
PRODUCTIVE TAX SYSTEM - Due to the generally higher wealth level larger tax revenues
can be generated within market-leaning economies. This large amount of tax revenue results in
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THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY
more money being spent on social programs. Free market nations generally spend more or have
more efficient social programs.
DISADVANTAGES OF A FREE MARKET ECONOMY
A free market economy or an economy which leans towards the free market system has a number
of disadvantages:
MERIT GOODS – Lack of provision of merit goods like education, health and social housing.
The poor may be deprived of merit goods. In this way the rich may become richer and the poor
become poorer.
MERIT GOOD
Goods which can be of benefit to society that are under
produced and under consumed in a free market economy.
PUBLIC GOODS - Non provision of public goods (bus stops, parks, street lighting, army,
police, fire services) as they are not profitable to produce as consumers are not willing to pay for
them.
DEMERIT GOODS - Over consumption of demerit goods (drugs, cigarettes, alcohol etc.) if
consumers have a desire for these goods, then they will be provided as they are profitable to
produce, even though it may not be desirable from the point of view of society for them to be
over consumed.
DEMERIT GOOD
Goods which can be of harm to society that are over
produced and over consumed in a free market economy.
EXTERNALITIES – Private firms will ignore externalities such as air, water and noise pollution
as it will reduce their profit levels if they do take these factors into account.
EXTERNALITIES
They are defined as third party (or spill-over) effects arising
from the production and/or consumption of goods and
services for which no appropriate compensation is paid.
SOCIAL INJUSTICE – There may be high levels of social injustice in a free market economy,
where the economically strong get richer and the economically weak get poorer.
COMMAND or PLANNED ECONOMY
PLANNED ECONOMY
Where the means of production are state controlled and the
allocation of resources is managed centrally.
In a Command Economy or Planned Economy, the central or state government regulate the use
of resources. The government is the final authority to take decisions regarding production of
goods and services, the distribution of goods and services and the allocation of the revenues
earned from their distribution.
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THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY
China and former USSR and are perhaps two of the best instances of Command Economy.
Though many countries now-a-days are switching off from Planned Economy to Market or
Mixed Economy. However nations like North Korea and Cuba are some countries where
Planned Economy still exists in full form.
In the case of a Command Economy, both state-owned and private enterprises receive guidance
and directives from the government regarding production capacity, volume, modes of production
and course of their actions.
The planned economic system answers the three key economic questions in the following way:
WHAT - The goods and services produced in a command economy are those which the
government chooses to produce.
HOW - The government chooses the method of production. It can direct resources, including
labour, to whatever activity it chooses.
FOR WHOM - The output of the economy is distributed in whatever way the government sees
fit, e.g. it may try to distribute goods and services equally in order to minimise inequality.
Once again a planned economy has a number of advantages and disadvantages but these are
basically the reverse of the advantages and disadvantages of a free market economy.
MIXED ECONOMIES
MIXED ECONOMY
Where resources are allocated by a mixture of free markets
and government intervention.
In reality all economies are mixed economies and are a mixture of elements from the free market
and planned economic systems.
Simply in such a type of economy there is the presence of private economic freedom and
centralised planning with a common goal of avoiding the problems associated with both
economic systems.
TRANSITIONAL ECONOMIES
TRANSITIONAL
ECONOMY
A transition economy or transitional economy is an economy
which is changing from a centrally planned economy to a free
market.
Transitional economies undergo or are undergoing economic liberalisation. During this process
market forces take over setting prices rather the government. There is privatisation of
government-owned enterprises and resources, and the creation of a financial. The process has
been applied in China, the former Soviet Union and Communist bloc countries of Europe, and
many third world countries.
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