Economic Problems

1.Scarcity, choice and the basic economic

problem
2.Opportunity costs, allocation of resources
3.Production possibility curve and productive
efficiency
4.Growth and the factors of production, land,
labour, capital, enterprise; growth
5.The division of labour and specialization
6.Positive and normative statements
7.Markets versus planning, free-market
system, command economy
8.Systems of ownership; capitalism and
socialism
9.Economic models
Scarcity, choice and the basic
economic problem
 Inflation, unemployment, pollution, energy
shortages and government deficits are
some of the complex problems confronting
an economy, which have an impact at the
micro level also. These problems arise due
to the fact that resources are limited while
human wants are unlimited. This leads to
dissatisfaction, causing human being to
look for ways to fulfill their needs. Thus
scarcity leads to the necessity of making
choices. Problems of choice arise at all
levels - at the level of the individual, at the
level of producers, and at the level of the
overall economy. The problem here is to
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 Scarcity results when natural resources, human resources

and capital resources are not available in sufficient
quantity to satisfy all wants. So a producer has to decide
what he wants to produce using a particular resource. For
example, if he chooses to produce paper for textbooks
from a stand of trees, then no other product can be
produced from that particular stand of trees. Yet, there are
many other products that could have been produced using
the same natural resource, which are also desired by
consumers. The opportunity cost of the decision thus
becomes an important consideration; by making a choice,
the next best alternative good cannot be produced.
 Consumers typically make their decisions based on two
considerations- budget constraints and personal
preferences. A budget constraint is the difficulty a person
faces when he tries to satisfy his unlimited wants with a
limited income. Thus, a purchase decision is based on
income, price, and personal tastes and preferences.
 A consumer can have a choice of alternative products with a
limited income if he can find a person with whom he can
exchange goods or services. By means of such exchanges,
he can increase his level of satisfaction. Such gains in
satisfaction can be termed as ‘gains from trade’.
 Such exchanges are also possible for producers. Although
two producers may both be capable of producing two
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 To make the best use of economic resources, the following questions

need to be answered:
 What to produce?
 How to produce?
 For whom to produce?
 These questions need to be asked because resources are scarce,
and can be put to alternative uses. Let us now examine these
questions in greater detail.
 What to produce?
 At the level of the government, scarcity of land, labor and capital
means that they cannot satisfy all the needs of the economy.
They have to choose which goods and services to produce, with
the limited resources available. From an individual’s point of
view, he or she has to decide how much to consume and how
much to save.
 How to produce?
 This looks at the combination of resources and the quantity of each
resource to be used to produce a given level of output. The best
combination is the full employment of the available resources, to
produce the maximum output. Depending on the resources
available, techniques of production can be labor intensive or
capital intensive.
 For whom to produce?
 This refers to the distribution of goods and services between
Opportunity costs, allocation of
resources
 Opportunity cost can be defined as the cost of any
decision measured in terms of the next best
alternative, which has been sacrificed. To illustrate
the concept better, let us assume that a person who
has Rs. 100 at his disposal can spend it on either of
the three options: having a dinner at a restaurant,
going for a music concert or for a movie. The person
prefers going for a dinner rather than to the movie,
and the movie over the music concert. Hence, his
opportunity cost is sacrificing the movie, the next
best alternative once he goes for a dinner. If we carry
forward the same example at the firm level, a
manager planning to hire a stenographer may have
to give up the idea of having an additional clerk in
the accounts department. This is applicable even at
the national level where the country allocates higher
defense expenditures in the budget at the cost of
using the same money for infrastructural projects. In
order to maximize the value of the firm, a manager
must view costs from this perspective.
 Production possibility curve and
productive efficiency
 Now let us analyze how individuals, producers and other
economic agents use the scarce resources to meet the
unlimited needs. This to a large extent is possible with the
help of the production possibility curve (PPC). The
production possibility curve can be defined as a curve
which shows the maximum combination of output that the
economy can produce using all the available resources.
 The production possibility curve helps us understand the
problem of scarcity better, by showing what can be
produced with given resources and technology. Technology
is the knowledge of how to produce goods and services.
 The following assumptions are made in constructing a
PPC:
 The economic resources available for use in the year are
fixed.
 These economic resources can be used to produce two broad
classes of goods.
 Some inputs are better used in producing one of these
classes of goods, rather than the other.
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

 Growth and the factors of production,

land, labour, capital, enterprise; growth


 The division of labour and specialization

 Positive and normative
statements
 Another debate about the nature of economics is
whether it is a positive or a normative science.
According to J. M. Keynes, “A positive science may be
defined as a body of systematized knowledge
concerning what is. A normative science or regulative
science is a body of systematized knowledge relating
to the criteria of what ought to be and concerned with
the ideal as distinguished from the actual.....The
objective of a positive science is the establishment of
uniformities; of a normative science, the
determination of ideals.”
 Positive economics explains economic phenomena
according to their causes and effects. At the same
time, it says nothing about the ends; it is not
concerned with moral judgments. On the other hand,
normative economics explains how things ought to
be. According to Milton Freidman, positive economics
deals with how an economic problem is solved;
normative economics on the contrary deals with how
 Markets versus planning, free-
market system, command
economy
 Market Economy
 This economic system emphasizes the freedom of
individuals as consumers and suppliers of resources,
and allows market forces to determine the allocation
of scarce resources through the price mechanism.
Based on market demand and supply, consumers are
free to buy goods and services of their choice and
producers allocate their resources based on the
demand. Decisions made by producers and
consumers are influenced greatly by price.
 Price plays a major role in a market economy. The role
of the government is negligible: consumers choose
the goods they want and producers allocate their
resources based on the market demand for different
products.
 In such a system, efficiency is achieved through the
profit motive. Producers make goods at the lowest
cost of production, and consumers get higher value
goods and services at lower prices. The United States
 Command Economy
 In a command economy, all the economic
decisions are taken by the government – what
to produce, how to produce and for whom to
produce. Thus, all decisions, from the
allocation of resources to the distribution of
end products, is taken care off by the
government. In this type of systems, efficiency
can be achieved only when demands are
accurately estimated and resources allocated
accordingly. The USSR was an example of a
command economy. The government had
complete control over the economy, and
consumers were just the price takers. The
government set output targets for each district
and factory and allocated the necessary
resources.
 Incomes are often more evenly distributed in a
command economy, in comparison to other
types of economies. Prices are controlled and
this allows for greater equality in the economy.
 Mixed Economy
 A mixed economy is a combination of a free
market economy and a command economy.
Here, government controls the price
fluctuations to achieve certain objectives
such as high level of employment and low
level of inflation. A mixed economy uses
cost-benefit analysis to answer the
fundamental questions discussed earlier -
what, how, and for whom to produce. A
cost benefit analysis helps to assess the full
costs and benefits to society arising from a
particular decision or project. Decisions or
projects affecting the economy as a whole
are taken or accepted only when the social
benefits from the decision of project are
greater than the social costs.
 In a mixed economy, the government
organizes the manufacture or provision of
Economic models

 Economic models is a set of equations or relationships

used to summarize the working of the national
economy or of a business firm or some other
economic unit. Models may be simple or complex
and they are used to illustrate a theoretical principle
or to forecast economic behavior.
 Economic models can be further classified into Micro
Economics Models and Macro Economic Models.
 Micro Economic Models: Models when they incorporate
individual economic units such as households and
firms, often grouped into individuals markets and
industries and the relationship between them are
called as micro models.
 Macro Economic Models: these models are used to
explain and predict the working or performance of
the economy as a whole, e.g changes in the level of
NI, the level of employment and inflation.
What Economists Do
 The economy can be looked at with either
a micro or a macro view.
 Microeconomics vs.
Macroeconomics
What Economists Do
 Microeconomics and Macroeconomics
 Microeconomics is the study of
individual people and businesses and the
interaction of those decisions in the
market.
 Studies:
 Prices and Quantities
 Effects of government regulation and taxes
What Economists Do
 Microeconomics and Macroeconomics
 Macroeconomics is the study of the
national economy and the global
economy as a whole.
 Studies
 Average prices and total employment,
income, and production
 Effects of taxes, government spending , a
budget deficits on total jobs and incomes
 Effects of money and interest rates
Economic Science
 Economists attempt to discover an
explanation for how economic systems
work.
 Economists distinguish between Positive
Statements and Normative Statements
Economic Science
 Positive statements are about what is.
 can be proven right or wrong
 can be tested by comparing it to facts

 Normative statements are about what

ought to be.
 depend upon personal values and cannot
be tested
MARGINAL VALUE
The marginal value of a
dependent variable is the change
in this dependent variable
associated with a 1-unit change
in a particular independent
variable
Maximization occurs when
marginal switches from positive to
negative.
 If marginal is above average,
average is rising.
 If marginal is below average,
average is falling.
 Graphing Total, Marginal, and
Average Relations
 Deriving Totals from Marginal and Average
Curves
 Total is the sum of marginals.

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 Relationship between output and profit
Total, marginal, and average profit
Incremental Concept in Economic
Analysis

 Marginal v. Incremental Concept

 Marginal relates to one unit of output.
 Incremental relates to one managerial
decision.
 Multiple units of output is possible.
 Incremental Profits
 Profits tied to a managerial decision.
 Incremental Concept Example
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