Economic Problems

1. Economic Problems

2. Learning outcomes • At the end of this lecture, you will be able to; • Understand the major economic concepts such as scarcity, choice and opportunity cost and how they arise. • Know the Production Possibility Curve (PPC) • Analyze the fundamental economic questions

3. Scarcity, choice and the basiceconomic problem • Scarcity results when natural resources, human resources and capital resources are not available in sufficient quantity to satisfy all wants. • Consumers typically make their decisions based on two considerations- budget constraints and personal preferences. • A budget constraint is the difficulty a person faces when he tries to satisfy his unlimited wants with a limited income.

4. Thus, a purchase decision is based on income, price, and personal tastes and preferences. • Choice arises out of scarcity and it simply means making the right decision. Because of scarcity of resources, man must make a scale of preference. • A scale of preference is where items are arranged according to order of priority.

5. To make the best use of economic resources, the following questions need to be answered: • What to produce? • How to produce? • For whom to produce? • These questions need to be asked because resources are scarce, and can be put to alternative uses.

6. What to produce? • At the level of the government, scarcity of land, labor and capital means that they cannot satisfy all the needs of the economy. • They have to choose which goods and services to produce, with the limited resources available. From an individual’s point of view, he or she has to decide how much to consume and how much to save.

7. How to produce? • This looks at the combination of resources and the quantity of each resource to be used to produce a given level of output. • The best combination is the full employment of the available resources, to produce the maximum output. Depending on the resources available, techniques of production can be labor intensive or capital intensive.

8. For whom to produce? • This question addresses the targeted market, whether production is for the low income or high income groups, for the young or old people. • The aim here is to produce for those who need the good most since they obtain more satisfaction and are willing to demand more hence pay a higher price.

9. When to produce? • Society is always faced with the problem of choosing between producing now for construction or delaying production and having it later. • For instance consider cutting a forest, should it be done now or leave it for the future generation?

10. Where to produce? • This question is concerned with the location of the firm, i.e. is it near the source of raw material or near the source of energy, near transport system or near the market? • This may be influenced by the perishability of the good or on the loyalty of the society to the political regime if the producer is government.

11. Opportunity costs, allocation ofresources • Opportunity cost can be defined as the cost of any decision measured in terms of the next best alternative, which has been sacrificed. • For instance if a consumer purchases a house instead of 3 cars using his limited income then the opportunity cost of a house is 3 cars. • So opportunity cost is a real cost and it arises out of scarcity and choice.

12. Production possibility curve andproductive efficiency • The production possibility curve can be defined as a curve which shows the maximum combination of output that the economy can produce using all the available resources. • The PPC helps us understand the problem of scarcity better, by showing what can be produced with given resources and technology. • Technology is the knowledge of how to produce goods and services.

13. The following assumptions are made in constructing a PPC: • Two commodities are produced. • The economic resources available for use in the year are fixed. • These economic resources are fully utilized • Technology is efficiently used • Technology remains unchanged during the year.

15. Opportunity cost • If there is no increase in productive resources, increasing production of a first good has to entail decreasing production of a second, because resources must be transferred to the first and away from the second. • Points along the curve describe the trade-off between the goods.

16. The sacrifice in the production of the second good is called the opportunity cost (because increasing production of the first good entails losing the opportunity to produce some amount of the second). • Opportunity cost is measured in the number of units of the second good that are forgone if an additional unit of the first good is made.

17. In the context of a PPF, opportunity cost is directly related to the shape of the curve (see below). Unless a straight-line PPF is used, opportunity cost will vary depending on the start and end point.

18. Characteristics of an Economic System • In general, an economic system consists of individuals, industries, governments, means of production and a medium of exchange (i.e. money) for buying and selling goods and services. How these factors interact and who controls means of production are the main considerations in identifying the different types of economic systems that exist throughout the world.

19. Types • The main types of economic systems include capitalism, socialism and the mixed economy. The latter features characteristics of capitalism and socialism. • Considerations • The specific characteristics of any economic system vary with the type of economy. A free market capitalist system will differ in many ways from a socialist system.

20. Capitalism • A capitalist system is based on principles of private property and free enterprise. • Buyers and sellers interact in a competitive market based on voluntary transactions, with only minimal government involvement.

21. Socialism, or Central Planning • In contrast to capitalism, a socialist government takes an active, leading role in structuring and directing the economy. Rather than private property and free enterprise, industries are government-owned. • Socialism's goals also include equalizing the distribution of wealth.

22. Mixed Economy • Under a mixed system, the private sector controls many resources of production, but government has a role in influencing the direction of the economy. • The government also provides services such as education and health.