Economic Problem Example Essay

The economic problem

All societies face the economic problem, which is the problem of how to make the best use of limited, or scarce, resources. The economic problem exists because, although the needs and wants of people are endless, the resources available to satisfy needs and wants are limited.

Limited resources

Resources are limited in two essential ways:

  1. Limited in physical quantity, as in the case of land, which has a finite quantity.

  2. Limited in use, as in the case of labour and machinery, which can only be used for one purpose at any one time.

Choice and opportunity cost

Choice and opportunity cost are two fundamental concepts in economics. Given that resources are limited, producers and consumers have to make choices between competing alternatives. All economic decisions involve making choices. Individuals must choose how best to use their skill and effort, firms must choose how best to use their workers and machinery, and governments must choose how best to use taxpayer's money.

Making an economic choice creates a sacrifice because alternatives must be given up, which results in the loss of benefit that the alternative would have provided. For example, if an individual has £10 to spend, and if books are £10 each and downloaded music tracks are £1 each, buying a book means the loss of the benefit that would have been gained from the 10 downloaded tracks.  Similarly, land and other resources, which have been used to build a new school could have been used to build a new factory. The loss of the next best option represents the real sacrifice and is referred to as opportunity cost.  The opportunity cost of choosing the school is the loss of the factory, and what could have been produced. 

It is necessary to appreciate that opportunity cost relates to the loss of the next best alternative, and not just any alternative. The true cost of any decision is always the closest option not chosen.

Samuelson's three questions

America’s first Nobel Prize winner for economics, the late Paul Samuelson, is often credited with providing the first clear and simple explanation of the economic problem - namely, that in order to solve the problem of scarcity all societies, no matter how big or small, developed or not, must endeavour to answer three basic questions.

What to produce?

Societies have to decide the best combination of goods and services to meet their needs. For example, how many resources should be allocated to consumer goods, and many resources to capital goods, or how many resources should go to schools, and how many to defence, and so on.

How to produce?

Societies also have to decide the best combination of factors to create the desired output of goods and services. For example, precisely how much land, labour, and capital should be used produce consumer goods such as computers and motor cars.

For whom to produce?

Finally, all societies need to decide who will get the output from the country’s economic activity, and how much they will get. For example, who will get the computers and cars that have been produced? This is often called the problem of distribution.


The fundamental economic problem

The fundamental economic problem is related to the issue of scarcity. Because of limited resources and infinite demands, society needs to determine how to produce and distribute these relatively scarce resources. Of course, it is possible humans could limit their demands and be satisfied with the basic necessity's of life. In some tribal society's / spiritual communities you could argue there is no economic problem because the limited resources are more than adequate to meet all their wishes.
However, society is mostly dominated by people wishing to consume more goods and services than are available. Because there is a shortage of resources, economics considers:
  • What to produce?
  • How to produce?
  • For whom to produce?
Opportunity cost

A key issue in this fundamental economic problem is the issue of opportunity cost. If we devote resources to building guns, then the opportunity cost is that we can't use these resources (land, labour) for growing vegetables. More on opportunity cost

How much should the government intervene in the economy?
From these three key questions there are numerous alternatives and theories about the best way to proceed. One of the fundamental questions has been the extent to which governments should intervene in the production and distribution of resources.

Market forces and the economic problem

Some economists suggest the free market is the best way to deal with this economic problem. The free market can distribute resources according to consumer preferences; firms have an incentive to provide goods and services in demand.

However, other argue that a free market creates many problems; notably inequality of distribution. Therefore, because of this it is necessary for the government to intervene in the economic decision making process.

The market mechanism  dealing with the economic problem

Good becomes more available

In this diagram above, the good becomes more abundant. This causes the supply curve shifts to the right. This leads to a lower price and increase in quantity.

Therefore, if a good becomes more abundant, the market mechanism makes it cheaper and people buy more. For example, when steel became cheaper in the nineteenth century, it started to be used in many more applications

Fall in supply

In this diagram we have a fall in supply. In this case the opposite happens. Because this good is in shorter supply, the price goes up. This increase in price causes a fall in demand.
For example, as we run out of oil, we should expect the price to go up. This increase in the price of oil will cause demand to fall and people to look for alternatives.

Diagram showing increase in price

In this diagram, we have rising demand (D1 to D2) but also a fall in supply. The effect is to cause a large rise in price. For example, if we run out of oil, supply will fall. However, economic growth means demand continues to rise.


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