Economic Problems

1. Scarcity, choice and the basic economic problem2. Opportunity costs, allocation of resources3. Production possibility curve and productive efficiency4. Growth and the factors of production, land, labour, capital,

enterprise; growth5. The division of labour and specialization6. Positive and normative statements7. Markets versus planning, free-market system, command economy8. Systems of ownership; capitalism and socialism9. 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 find a method to maximize the level of satisfaction, with the resources available. Let us now look at how consumers, producers and governments try to satisfy their needs.

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 products, each can also choose to produce the one product in which he has a comparative advantage over the other.

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 different categories and sections of the

population. For example, one needs to see if the scarce resources are being used appropriately to cater to the needs of the higher income groups and the lower income groups.

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. Technology remains unchanged during the year.

Production Possibilities

Sugar ( in Tons) cloth (‘000 mts)

A 0 15

B 1 14

C 2 12

D 3 9

E 4 5

F 5 0

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 the problem should be solved. A positive statement is based on facts. A normative statement involves ethical values.

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 is an example of a market economy

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. Decisions are not based on individual tastes and preferences, but on national goals.

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 essential goods and services such as education and health care.

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 QuantitiesEffects 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.

StudiesAverage prices and total employment, income,

and productionEffects of taxes, government spending , a

budget deficits on total jobs and incomesEffects of money and interest rates

Micro Economics Macro Economics

Microeconomics studies the economic behavior of individual entities such as individuals, households, firms, industry, etc.

Macroeconomics studies the economy as a whole.

Microeconomics explains the inter-relationships between economic units like consumers, commodities, firms, industries, markets, etc.

Macroeconomics explains about the total national income, aggregate demand and supply, general price level, total employment, etc.

Microeconomics analyzes the conditions for efficiency in consumption and production.

Macroeconomics analyzes the fluctuations and trends in the overall economic activity in a country and/or between various countries in the world.

Microeconomic theory describes product pricing which explains the theories of demand, production, and cost; factor pricing which explains concepts of wages, rent, interest, and profit; and the theory of economic welfare.

Macroeconomic theory describes the theory of income and employment to explain economy-wide consumption and investment, the theory of the general price level and inflation, theories of economic growth, and the macro theory of distribution.

Understanding microeconomics helps a great deal in individual decision making i.e., managerial decision-making.

Macro economic study is vital in the formulation and execution of economic policies by government.

Microeconomic analysis helps in addressing the problems related to the quantity to be produced, the procedure to be followed for production of goods, and the final consumers for the goods produced.

Macroeconomic analysis includes study of national aggregates of output, income, expenditure, savings and investment.

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.

Relationship between output and profit

OUTPUT TOTAL MARGINAL AVERAGE PER DAY PROFIT PROFIT PROFIT

0 01 100 100 100.02 250 150 125.03 600 350 200.04 1000 400 250.05 1350 350 270.06 1500 150 250.07 1550 50 221.48 1500 -50 187.59 1400 -100 155.6

10 1200 -200 120.0

Total, marginal, and average profit

-500

0

500

1000

1500

2000

0 5 10 15

OUTPUT PER DAY

PRO

FIT

TOTAL PROFIT

MARGINALPROFIT

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