The economic problem

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The fundamental economic problem

  • There are infinite wants but finite resources. There is scarcity. Therefore, in nearly all circumstances there is opportunity cost. 
  • In reality, nearly all goods/ services are economic goods not free goods e.g. air is no longer a free good because of the rising population, but 'clean' air is a free good. 

Economic resources can be classified into 4 areas with payment for their use:

1. Land - goods like minerals, land itself, and all resources taken from the world... rent

2. Labour - potential workforce; but not just physical people, but their skills and ability too...wages

3. Capital - stock of goods used to make other goods or services e.g. machines, tools etc. *money as capital represents what the money is used to buy, not the money itself.... interest

4. Entreprise - risk takers prepared to work to bring the other three factors of production together. Entrepreneurs organise and make this happen, they are catalysts for action and different from ordinary workers... profit 

Some resources are renewable e.g. fish stocks whilst others like oil are not. 

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The economic objectives of individuals, firms and


  • people who have a limited amount of income and therefore need to make choices. 
  • Objective - to maximise their own well-being or economic welfare.


  • want to maximise gains from working.
  • Objective - higher wages and better working conditions, and job security


  • Objective - maximise profit (especially in modern Western capitalist economies: USA/ UK where businesses are often owned by private individuals)


  • supposed to represent the poeple and act in their best interests.
  • This is, however, hard as everyone has different interests -  there must be a balance. 
  • They also have a political objective to their actions. 
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Scarcity, choice and the allocation of resources

  • the 'incentive to maximise' is what drives the system of allocation of resources.
  • resources are allocated to meet the new choices that consumers want. The consumer, in theory, drives change, although in reality, new inventions and marketing allow firms to take control in influencing the consumer i.e. changing wants into needs.
  • a key signal is price - if this changes, it alters the choices made by all the agents, causing them to reallocate to new activities. 

The role of prices and profits in a free market economy: 

  • The higher the price of a g/s, the more attractive it is for entrepreneurs to supply the g/s. The price therefore creates an INCENTIVE for suppliers to offer goods for sale, IF they can cover costs. 
  • But a price rise causes consumers to RATION their choices, cutting back on luxury items. 
  • High prices also indicate potential profit for producers and send a SIGNAL to increase output or for new firms to enter the market. 
  • Similarly, when prices FALL, consumers extend their demand, rationing ends, a signal is sent to producers that there is excess supply and creates an incentive for producers to leave the market. 
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The Production Possibility Boundary (PPB)

  • any point on the PPB describes resources being used efficiently i.e. producing as much as physically and technologically possible - productive efficiency
  • Any point that lies within the PPB indicates that some resources are not being fully utilised. 
  • Any point beyond the PPB is not possible as PPB indicates MAXIMUM possible output.
  • PPB is used to show opportunity cost. 

Shifting the PPB: 

  • In order to shift the PPB to the right, new resources need to be found, tech and understanding needs to improve or the quality of the resources needs to improve. 
  • Investing in human capital makes the system more efficient and shifts the PPB outwards. 
  • If efficiency and productivity increases in the production of one good only, it will be represented on the PPB as below. 
  • The PPB can shift to the left from a natural disaster or war but this is less common.
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