The Economic Problem

What the spec says we need to know about:

The Nature and Purpose of Economic Activity

Economic Resources
The Economic Objectives of Individuals, Firms and Governments
Scarcity, Choice and the Allocation of Resources
Production Possibility Diagrams
Value Judgements, Positive and Normative Statements

The nature and purpose of economic activity

The central purpose of economic activity is the production of goods and services to satisfy
needs and wants, and thereby to improve economic welfare.
Everyone has certain needs in life- e.g. food, water, a place to live and so on. Everyone
also has an infinite list of things they want- e.g. designer clothes, smartphones, holidays,
houses, etc.
However, there's a limited amount of resources available to satisfy these needs and wantsresources are scarce.
These facts lead to a basic economic problem:
How can be available scarce resources be used to satisfy people's infinite needs and wants
as effectively as possible?
Scarcity requires a careful allocation of resources. In economics, a wide range of things
count as economic activity.
Since there's an endless array of things that could be produced and consumed, but only
limited resources, this leads to three fundamental questions:
What to produce?
How to produce it?
Who to produce it for?
The agents in an economy can usually be thought of as:
Producers - firms or people that make goods or provide services
Consumers - people or firms who buy the goods and services

 Governements - a government sets the rules that other participants in the economy
have to follow, but also produces and consumes goods and services
Each of these economic agents has to make decisions that affect how resources are
allocated. In a market economy, all economic agents are assumed to be rational, which
means they'll make the decisions that are best for themselves. These decisions will be
based on economic incentives, such as profit making or paying as little as possible for a
product.
Considering people's incentives helps to answer those fundamental questions above:
What to produce? This will be those goods that firms can make a profit from.
How to produce it? Firms will want to produce the good in the most efficient way
they can, in order to maximise their profits.
Who to produce it for? Firms will produce goods for consumers who are willing
to pay for those goods.
Economic resources
The scarce resources (inputs) used to make the things people want and need (outputs)
can be divided into four factors of production. These factors are land, labour, capital and
enterprise.
Land includes all the natural resources in and on it:
As well as actual territory, land includes all the Earth's natural resources:
Non-renewable resources, such as natural gas, oil and coal
Renewable resources such as wind or tidal power, or wood from trees
Materials extracted by mining (e.g. diamonds and gold)
Water
Animals found in the area
Nearly all things that fall under the category of 'land' are scarce- there aren't enough
natural resources to satisfy the demands of everyone
Labour is the work done by people:
Labour is the wok done by those who contribute to the production process. The
avaiable population who are available to do work is called the labour force
There's usually also a number of people who want to work and are old enough to
work, but who don't have a job. Economists refer to these people as unemployed
There are also people who aren't in paid employment but still provide things people
need or want

 Different people have different levels of education, experience or training. These

factors can make some poeple more valuable or productive in the workplace than
others- they have a greater amount of human capital
Capital is the equiptment used in producing goods and services
Capital is the equiptment factories and schools that help to produce goods or
services
Capital is different from land because capital has to be made first
Much of the capital in an economy is paid for by the government- e.g. a country's
road network is a form of capital
Enterprise is the willingness to take a risk to make a profit
Enterprise refers to the people (entrepreneurs) who take risks and create things
from the other three factors of production
They set up and run businesses using any of the factors of production
available to them
If the business fails, they can lose a lot of money. But if the business is a
success, the reward for their risk taking is profit
Free goods and economic goods
A free good is a good with zero opportunity cost. This means that it can be produced by
society in as much quantities as need with little or zero effort.
An economic good is a good or service that has a benefit (utility) to society. Also, economic
goods have a degree of of scarcity and therefore an opportunity cost.
The economic objectives of individuals, firms and governments
Different economic agents will have different economic objectives. Quite often, these
objectives are to maximise a particular quantity.
Producers
A firm's profit is their total revenue (money received by the firm) minus their total
costs
Firms are often assumed to want to maximsie profit- this could be for various
reasons:
Profit means the firms can survive, and loss-making firms might eventually
have to close
Greater profits allow firms to offer better rewards to the owner (or
shareholders) and staff...

 ... or profit can be reinvested in the business in the hope of making even
more profits in the future
But firms may want to maximise other quantities instea, such as total sales, or the
firm's market share
A large market share could lead to more monopoly power- this would mean
that the firm could charge higher prices due to a lack of competition
Bigger firms are often considered more prestigious and stable, so they are
able to attract the best employees
Some firms may also have ethical objectives- i.e. doing something good, even if it
doesn't increase profits
Consumers
Consumers are assumed to want to maximise their utility, while not spending
more than their income
Utility will involve different things to different people
But whatever somebody spends their money on, you'd assume they're
acting rationally to increase their utility in the way that makes most sense
to them
Consumers can also act as workers- workers are assumed to want to maximise
their income, while having as much free time as they need or want
Governments
Governments try to balance the resources of a country with the needs and want
of the population- i.e. economists assume that governments try to maximise the
'public interest'.
This is likely to include some or all of the following:
Economic growth- usually measured by growth in a country's GDP
Full employment- everybody of a working age, who is capable of working,
having a job
Equilibrium in the balance of payments- a balance between the
payments into a country over a period of time and the payments out
Low inflation- keeping prices under control, as high inflation can cause
serious problems
In practice, these are competing objectives- policies that help achive one
objective may make it more difficult to achieve another (e.g. extra government
spending may help create jobs, but it could lead to higher inflation)
Scarcity, choice and the allocation of resources

Econcomic activity involves combing the factors of production to create outputs that people
can consume. The purpose of any economic activity is to increase people's economic
welfare by creating outputs that satisfy their various needs and wants.
Production possibility diagrams
The basic problem in economics is how to best allocate scarce resources. A production
possibility frontier (PPF) shows the options that are available when you consider the
production of just two types of goods or services.

Points A,B and D (and every other point in the PPF) are all achieveable without using any
extra resources. However, they are only achieveable when all the available resources are
used as efficiently as is actually possible.
A trade-off is when you ahve to choose between conflicting objectives becuase you
can't achieve all you objectives at the same time. It involves compromising, and
aiming to achieve each of your objectives a bit.
Point E lies outside the PPF, so it isn't achievable using the current level of resources in the
economy. To build that many consumer goods and capital goods at the same time, extra
(or better) resources would need to be found.
Point F lies inside the PPF, which means that making this mix of goods is productively
inefficient.
The trade-off described above involves an opportunity cost.

An opportunity cost is what you give up in order to do something else- i.e. it's the cost of
any choice that is made.
Economic growth shifts the PPF:
A PPF shows what's possible using a particualr level of resources

If this level is fixed, then movements along the PPF just show a reallocation
of those resources
However, if the total amount of resources change, then the PPF itself moves
Improved technology or improvements to labour (e.g. through training) can also
shift the PPF outwards, because it allows more output to be produced using the
same resources
An outward shift in the PPF shows economic growth
With fewer natural resources the opposite happens- the PPF shifts inwards,
showing that the total possible output has shrunk. This shows negative economic
growth

Value judgements, positive and normative statements

Positive statements are objective statements that can be tested, amended or rejected by
referring to the available evidence. Positive economics deals with objective explanations
and the testing and rejecting of theories.
A value judgement is a subjective statement of opinion rather than a fact that can be tested
by looking at the available evidence.
Normative statements are subjective statements- i.e. they carry a value judgement.