1.1 – 1.

4 – The Basic Economic Problem

“Economics is the social science that

describes the factors that determine the
production, distribution and consumption of
goods and services.”
(Source: Wikipedia)
The Nature of the Economic Problem
Resources: are the inputs required for the
production of goods and services.
Scarcity: a lack of something (in this context,
resources).
The fundamental economic problem is that
there is a scarcity of resources to satisfy all
human wants and needs. There are finite
resources and unlimited wants. This is
applicable to consumers, producers, workers
and the government, in how they manage
their resources.

Economic goods are those which are scarce

in  supply and so can only be produced with
an economic cost and/or consumed with a
price. In other words, an economic good is a
good with an opportunity cost. All the goods
we buy are economic goods, from bottled
water to clothes.
Free goods, on the other hand,  are those
which are abundant in supply, usually
referring to natural sources such as air and
sunlight.
The Factors of Production
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
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.
Example 1: the government has a certain
amount of money and it has two options: to
build a school or a hospital, with that money.
The govt. decides to build the hospital. The
school, then, becomes the opportunity cost
as it was given up. In a wider perspective, the
opportunity cost is the education the children
could have received, as it is the actual cost to
the economy of giving up the school.
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)
Because resources are scarce and have
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.
Let’s look at the PPC named A. At point X and
Y it can produce certain combinations of
good X and good Y. These are points on the
curve- they are attainable, given the
resources. Th economy can move between
points on a PPC simply by reallocating
resources between the two goods.
If the economy were producing at point Z,
which is inside/below the PPC, the economy
is said to be inefficient, because it is
producing less than what it can.
Point W, outside/above the PPC, is
unattainable because it is beyond the scope
of the economy’s existing resources. In order
to produce at point W, the economy would
need to see a shift in the PPC towards the
right.
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.
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.
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.