Lecture 2: 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.

Economics is defined by this economic problem; in each of the remaining

chapters, this definition will be discussed and developed into a clear description
of the science of economics.

Economics is a social science that studies how society chooses to allocate its
scarce resources, which have alternative uses, to provide goods and services
for present and future consumption

Let’s break down this definition into clear words

What are goods and services?

A good is anything that fulfills a need, which is the primary goal of production—
providing goods that meet demands. Goods are produced to be consumed,
thereby satisfying those needs. A product can be either tangible or intangible.
Tangible goods include physical objects like bulldozers or pizzas, while
intangible goods, such as healthcare or education, are referred to as services.
Both goods and services fulfill needs and can therefore be classified as
products.

Resources

Satisfying wants requires the use of resources, also known as inputs or factors of
production. These resources are categorized into land, labor, capital, and
entrepreneurship. Land refers to the earth itself and the natural resources it
provides. Labor is human effort, both physical and intellectual. Capital, in this
context, refers not to money but to man-made tools of production—goods that
have been created to help produce other goods.

What are sustainable resources?

A resource is anything that is useful to people. Natural resources can be divided

into renewable and non-renewable resources.

A renewable resource can be used again and again, so is more sustainable, eg

water, wind, wood, sun and wave energy.

A non-renewable resource will eventually run out, so it is not sustainable in the

long run, eg fossil fuels such as gas, oil and coal. There is only a finite supply of
non-renewable resources.

All resources, both non-renewable and renewable, need to be carefully managed.

For example, you can use a non-renewable resource in a way that helps to
lengthen its use, eg re-using old tyres in road building materials. Some
renewable resources may become polluted or overused by man.

Classification of goods:

Goods can be made either for direct consumption, as consumer goods, or to

help create other goods, as capital goods. Capital goods, such as a mechanic's
wrench or a school building, are produced resources that combine with other
inputs like land and labor to generate more output.

A good may be classified as a consumer or capital good depending on its use.

For example, a personal computer used for playing games is a consumer good,
but when used for work, like writing a textbook, it becomes a capital good. To
determine whether a good is for consumption or production, ask if it will be
used directly by consumers or to create more goods. If it's for direct use, it's a
consumer good; if for further production, it's a capital good.

Classification Type of Goods Characteristics/ Examples

Explanation
By Nature of Private Goods Excludable, rival in Food, cars, clothing
Consumption consumption.
By Nature of Public Goods Non-excludable, non-rival Street lighting, national
Consumption in consumption. defense
By Elasticity Normal Goods Demand increases with New clothes,
income. electronics
By Elasticity Inferior Goods Demand decreases with Generic brands,
 income. second-hand goods
By Elasticity Luxury Goods Demand increases Designer clothes,
significantly with income. luxury cars
By Durability Durable Goods Long-lasting, provide utility Cars, furniture,
over time. appliances
By Durability Non-Durable Consumed quickly, need Food, toiletries
Goods frequent replacement.
By Production and Consumer Goods Consumed by end-users for Groceries, clothing
Use personal/household use.
By Production and Capital Goods Used in production of other Machinery, factories,
Use goods/services. tools
By Market Substitute Goods Goods that can replace Tea and coffee
Competition each other.
By Market Complementary Goods that are used Cars and gasoline
Competition Goods together.

Scarcity – definition
The problem of scarcity is regarded as the fundamental economic problem
arising from the fact that, while resources are finite, society’s demand for
resources is infinite. Scarcity is a relative rather than an absolute concept – for
instance, while water covers most of the earth, an economist would still consider
it scarce because the demand for water exceeds its availability for different
uses.

Resources are limited; and scarcity arises from the relationship between how
much of resource exist and how much of is desired. Resources are scarce
because we have more uses for them than there is supply.

Now imagine a world without scarcity “ where all goods are free” this would
mean people could have unlimited access to everything they desire without
sacrificing something else. However, few goods, if any, are truly free. Air might
seem free, but even clean air can be scarce in certain areas, like smog filled
cities, people often pay to avoid pollution .

Free goods

A free good is one that is so abundant that its consumption does not deny anyone
else the benefit of consuming the good. In this case, there is no opportunity cost
associated with consumption or production, and the good does not command a
price. Air is often cited as a free good, as breathing it does not reduce the
amount available to someone else.

Limited resources
Resources are limited in two essential ways:

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

quantity.
• Limited in use, as in the case of labour and machinery, which can only be
used for one purpose at any one time.
Characteristics of needs
Characteristic Explanation
Essential for Survival Basic requirements for life, like food, water,
and shelter.
Universal Needs are common to all humans regardless
of culture or location.
Limited in Number Needs are finite, unlike wants which are
unlimited.
Non-Satiable Once satisfied, needs arise again (e.g., hunger
after eating).
Hierarchical Needs follow a hierarchy, starting from basic
to higher-level needs (e.g., Maslow's
hierarchy).
Vary by Intensity Some needs are more urgent than others
(e.g., air vs. esteem).
Can Lead to Motivation Unmet needs drive people to act (e.g.,
hunger drives the search for food).
Impact Well-being Lack of needs negatively affects physical and
mental well-being.
Objective in Nature Needs are measurable and objective, unlike
wants which are subjective.

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. 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. Making a choice results in the loss of benefit that an 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 school
could have been used to build a 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 economic problem
societies must endeavour to answer three basic questions – What to produce?
How to produce? And, For whom to produce?

What to produce?
Societies have to decide the best combination of goods and services to meet
their varied wants and needs. Societies must decide what quantities of different
resources should be allocated to these goods and services.

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 to produce consumer goods such as
computers and motor cars?

For whom to produce?

Finally, all societies need to decide who will benefit from the output from its
economic activity, and how much they will get. This is often called the problem
of distribution.
Different societies may develop different ways to answer these questions.