The Economic Problem
The nature and purpose of economic activity
As human beings, we all have some basic needs and as individuals, we have a
range of wants that go beyond our basic needs.
An economy and the central purpose of economic activity are to produce
goods and services to provide what we need and want:
Goods are considered to be tangible products, things we can touch such
as a car or CD.
Services are intangible products such as going to the cinema. We do not
buy the cinema however we receive benefits from watching the film at the
cinema.
If we can successfully provide people with their needs and wants, then we will
see an overall increase to economic welfare for the citizens.
Economic welfare is the benefit/satisfaction that an individual or society
gets from the allocation of resources.
The fundamental economic problem
The fundamental economic problem is that people have infinite wants
however there are scarce resources. Since resources are scarce, we must
decide on the best way to allocate these resources to get maximum benefit for
society as a whole. This leads to opportunity cost.
Opportunity cost the next best alternative given up when an economic
decision is made
An example of opportunity cost is a consultant that earns 75 an hour goes to a
concert which costs 25 and lasts 2 hours. The opportunity cost of going to the
concert is losing 150 for two hours of work.
Free goods are goods that have no opportunity cost.
Economic goods are goods that are scarce and therefore have an
opportunity cost. In reality, nearly all goods and services are economic
goods.
The economics resources
There are a number of different resources available for production. Economists
classify them into four main types that they call the factors of production:
Factor
What is it?
Land
Minerals, land itself and resources we take from
the world e.g. fish or forestry etc.
Reward/Payme
nt
Rent
Labour
Capital
Enterpris
e
Potential workforce (physical people, skills,
abilities, intelligence)
Stock of goods used to make other goods and
services e.g. machines, tools to produce other
goods.
Wages
Risk takers who bring the other factors of
production together to produce goods and
services
Profit
Interest
Factors of production give rise to factor incomes the owners of the factors of
production can sell or loan them and in return receive these payments. This
creates a factor market.
Factor market the market for the factors of production that make other
goods and services such as labour or raw materials.
Renewable resources Resources that are able to be replenished over
time e.g. forests or fish stocks
Non-renewable resources Resources not able to be replenished over
time e.g. oil or coal
The economic objectives of individuals, firms and government
In an economy, we have a different number of players; some have more than
one role. There is government, individual consumers, firms and workers. We
assume each agent tends to act in their own interests the first of many
assumptions in Economics.
Consumers
Workers
Firms
Government
Maximise their own welfare through rational (sensible) choices.
Maximised their gains from working:
Higher wages
Better working conditions
Job security
Maximise profits
(Total firm revenue > Total costs)
Increase welfare of people
Increase their own popularity
How the consumer controls the market
Resources are allocated to meet the new choices that the consumers want.
This usually happens in a chain of steps:
1.
2.
3.
4.
Consumer no longer wants product
Consumer no longer buys product
Firms do not make any profit from product
Firms stop producing that product
The firm may then go on to use the resources used to make the old product and
invest it into a new product.
One example is pencils. Consumers may not want pencils anymore and they
want pens instead. Therefore consumers stop buying pencils. Firms stop making
profit from the pencils and as a result, firms will stop producing pencils. The
wood and lead used to make the pencil may then be used by the firm to make
another product which requires those raw materials.
The role of prices and profits in a free market economy
Free market economy one in which there is very limited government
involvement in providing goods and services. Its main role is to ensure
that the rules of the market are fair so that, for example, people cannot
steal each others property.
When you see prices in any market chance, you will need to consider how this
may affect the allocation of resources. Thus prices and profits have three key
functions:
Incentive
Function
Rationing
Function
Signalling
Function
Firms will have an incentive to produce a good when prices
rise because it creates an incentive to supplies to increase
supply as more profit is potentially available. This gives a
reason to why the supply curve is upward sloping. As prices
rise, more firms enter the market as they see a chance to
gain more profit so there is more supply. When prices fall, it
is a disincentive. The incentive function of a price rise is
associated with an extension of supply.
Prices serve to ration scarce resources when demand in a
market exceeds supply. When there is a shortage, the price
is driven up leaving only those with the willingness and
ability to pay to purchase the product. This can be seen in
the market for oil. As oil slowly runs out, its price will rise
and this discourages demand as not everyone will be able
to purchase it. Therefore this leads to more oil being
conserved at lower prices. The rationing function of a price
rise is associated with a contraction of demand.
Prices perform a signalling function they adjust to
demonstrate where resources are required, and where they
are not. If prices are rising because of high demand from
consumers, this is a signal to suppliers to increase supply
to meet the higher demand. If prices fall, there is an excess
supply in the market therefore the suppliers will produce
less to let demand and supply balance each other out.
Complete with graphs tomorrow using link.
