The Basic Economic Problem

The nature of the basic economic problem

Every economic decision, from a household budget to a national spending plan, begins with the same unavoidable fact: there is never enough to go around.

Finite resources, infinite wants

The basic economic problem is that resources are finite while human wants are effectively infinite — this mismatch is scarcity, the starting point for every idea in economics. Scarcity is not the same as poverty: even the wealthiest consumer or richest government still cannot satisfy every want. Needs are essential to survival (food, shelter, clothing); wants are non-essential desires beyond them.

The problem takes a different shape for each decision-maker: a consumer has limited income but unlimited desire for goods; a worker has limited hours but many ways to use them; a producer has limited factors of production but unlimited ways to combine them; a government has limited tax revenue but unlimited demands on its spending.

Resource allocation decisions

Because resources are scarce, every economy must answer three basic questions: what to produce (which goods and services to make with the resources available), how to produce (which combination of factors of production to use), and who to produce for (how output is distributed among consumers).

Economic goods and free goods

An economic good is scarce relative to demand: producing it uses resources that have alternative uses, so it carries an opportunity cost and normally commands a price — bread, a haircut, a smartphone. A free good is available beyond demand at a zero price, so using it involves no opportunity cost — sunlight, or seawater in most places. Free goods are rare, and can become economic goods once demand for them exceeds the available supply.

Factors of production

Whatever is produced — a loaf of bread or a hospital appointment — is built from the same four ingredients economists group as the factors of production.

The four factors and their rewards

Producing any good or service requires some combination of all four factors — even a one-person craft business uses land (workshop space), labour (effort), capital (tools) and enterprise (the risk of starting the business).

Quantity and quality of factors of production

An economy’s productive potential depends on how much of each factor it has, and how productive each unit is. The quantity of factors changes for different reasons: the labour force grows through population growth or immigration; land expands through reclamation or new resource discoveries; capital grows through investment in machinery and buildings; and the number of entrepreneurs rises as more people start businesses.

The quality of factors changes through improvement rather than growth: education and training raise labour productivity; technology makes capital more efficient; irrigation and fertiliser improve land; and experience improves enterprise. Better-quality factors let an economy produce more from the same quantity of resources.

Opportunity cost

Every choice closes off an alternative — and in economics, that forgone alternative has a name and a cost of its own.

Defining opportunity cost

Opportunity cost is the value of the next best alternative given up when a choice is made. It need not be measured in money — it can be time, satisfaction, or the quantity of another good forgone. Because resources are scarce, choosing one option always means giving up another, and it is that forgone option, not the money spent, that economists treat as the true cost of a decision.

Opportunity cost of 1 more unit of X = units of Y given up. It is measured in units of the good forgone, not in money.

Opportunity cost in decision-making

Every decision-maker faces opportunity cost when allocating scarce resources. Consumers spending on one good give up the next best good the same money could buy. Workers choosing one job give up the pay or satisfaction of the next best job. Producers using resources for one good give up the next best good those resources could make. Governments funding one programme give up the next best programme forgone.

Worked example: a farm’s land-use decision

A farm’s land and labour can produce either 800 kg of maize or 200 kg of coffee this season, or any combination in between. The farmer decides to plant the land entirely with maize.

Step 1. Identify the next best alternative use of the land — growing coffee instead. Step 2. State the quantity given up — the maximum coffee output the same resources could produce, 200 kg. Step 3. The cost is measured in kg of coffee forgone, not dollars — no coffee transaction took place. The opportunity cost is 200 kg of coffee forgone.

The production possibility curve

The production possibility curve turns the basic economic problem into a picture: where a point sits — on, inside, or outside the curve — tells a different story about how well an economy is using its resources.

What a PPC shows

A production possibility curve (PPC) shows the maximum possible combinations of two goods, or two categories of goods, that an economy can produce if it uses all of its factors of production fully and efficiently, given the technology available. The curve is normally drawn bowed outward from the origin, because factors of production are not equally suited to producing both goods — as more resources are shifted toward one good, increasingly unsuitable resources must be used, so the opportunity cost of each extra unit rises.

Points under, on, and beyond a PPC

The location of a production point relative to the curve has a precise meaning. A point on the curve, such as point A, is productively efficient — all resources are fully and efficiently employed, and more of one good can only be produced by giving up some of the other. A point inside the curve, such as point U, is attainable but productively inefficient — some resources are unemployed or under-used, so output of both goods could rise without any new resources at all. A point beyond the curve, such as point Z, is unattainable with the economy’s current resources and technology.

Movements along a PPC

A movement along the PPC happens when an economy reallocates existing resources between the two goods — more of one only by producing less of the other, the trade-off described by opportunity cost. Because the curve bows outward, the opportunity cost of each extra unit rises the further along the curve production moves.

Shifts of a PPC

A shift of the whole PPC happens only when productive capacity itself changes. An outward shift is economic growth, caused by more factors of production (population growth, new resources, investment) or better-quality factors (education, technology). An inward shift is a fall in capacity — a disaster, emigration of skilled workers, or resource depletion. A shift need not be symmetrical.