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Economics – 0455
The Basic Economic Problem
HomeNotesEconomics – 04551.1 – 1.4 – The Basic Economic Problem
“Economics is the social science that describes the factors that determine the production,
distribution and consumption of goods and services.”
(Source: Wikipedia)

The Nature of the Economic Problem

Resources: are the inputs required for the production of goods and services.
Scarcity: a lack of something (in this context, resources).
The fundamental economic problem is that there is a scarcity of resources to satisfy all
human wants and needs. There are finite resources and unlimited wants. This is applicable
to consumers, producers, workers and the government, in how they manage their resources.

Economic goods are those which are scarce in supply and so can only be produced with an
economic cost and/or consumed with a price. In other words, an economic good is a good
with an opportunity cost. All the goods we buy are economic goods, from bottled water to
clothes.
Free goods, on the other hand, are those which are abundant in supply, usually referring to
natural sources such as air and sunlight.
The Factors of Production
Resources are also called ‘factors of production’ (especially in Business). They are:

 Land: all natural resources in an economy. This includes the surface of the earth, lakes,
rivers, forests, mineral deposits, climate etc.
 The reward for land is the rent it receives.
 Since, the amount of land in existence stays the same, its supply is said to be fixed. But
in relation to a country or business, when it takes over or expands to a new area, you can
say that the supply of land has increased, but the supply is not depended on its price, i.e.
rent.
 The quality of land depends upon the soil type, fertility, weather and so on.
 Since land can’t be moved around, it is geographically immobile but since it can be used
for a variety of economic activities it is occupationally mobile.
 Labour: all the human resources available in an economy. That is, the mental and physical
efforts and skills of workers/labourers.
 The reward for work is wages/salaries.
 The supply of labour depends upon the number of workers available (which is in turn
influenced by population size, no. of years of schooling, retirement age, age structure of
the population, attitude towards women working etc.) and the number of hours they work
(which is influenced by number of hours to work in a single day/week, number of

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holidays, length of sick leaves, maternity/paternity leaves, whether the job is part-time or
full-time etc.).
 The quality of labour will depend upon the skills, education and qualification of labour.
 Labour mobility can depend up on various factors. Labour can achieve high occupational
mobility (ability to change jobs) if they have the right skills and qualifications. It can
achieve geographical mobility (ability to move to a place for a job) depending on
transport facilities and costs, housing facilities and costs, family and personal priorities,
regional or national laws and regulations on travel and work etc.
 Capital: all the man-made resources available in an economy. All man-made goods (which
help to produce other goods – capital goods) from a simple spade to a complex car assembly
plant are included in this. Capital is usually denoted in monetary terms as the total value of all
the capital goods needed in production.
 The reward for capital is the interest it receives.
 The supply of capital depends upon the demand for goods and services, how well
businesses are doing, and savings in the economy (since capital for investment is financed
by loans from banks which are sourced from savings).
 The quality of capital depends on how many good quality products can be produced
using the given capital. For example, the capital is said to be of much more quality in a
car manufacturing plant that uses mechanisation and technology to produce cars rather
than one in which manual labour does the work.
 Capital mobility can depend upon the nature and use of the capital. For example, an
office building is geographically immobile but occupationally mobile. On the other hand,
a pen is geographically and occupationally mobile.
 Enterprise: the ability to take risks and run a business venture or a firm is called
enterprise. A person who has enterprise is called an entrepreneur. In short, they are the people
who start a business. Entrepreneurs organize all the other factors of production and take the
risks and decisions necessary to make a firm run successfully.
 The reward to enterprise is the profit generated from the business.
 The supply of enterprise is dependent on entrepreneurial skills (risk-taking, innovation,
effective communication etc.), education, corporate taxes (if taxes on profits are too high,
nobody will want to start a business), regulations in doing business and so on.
 The quality of enterprise will depend on how well it is able to satisfy and expand demand
in the economy in cost-effective and innovative ways.
 Enterprise is usually highly mobile, both geographically and occupationally.
All the above factors of productions are scarce because the time people have to spend
working, the different skills they have, the land on which firms operate, the natural resources
they use etc. are all in limited in supply; which brings us to the topic of opportunity cost.

Opportunity Cost
The scarcity of resources means that there are not sufficient goods and services to satisfy all
our needs and wants; we are forced to choose some over the others. Choice is necessary
because these resources have alternative uses- they can be used to produce many things. But
since there are only a finite number of resources, we have to choose.

When we choose something over the other, the choice that was given up is called the
opportunity cost. Opportunity cost, by definition, is the next best alternative that is
sacrificed/forgone in order to satisfy the other.
Example 1: the government has a certain amount of money and it has two options: to build a

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school or a hospital, with that money. The govt. decides to build the hospital. The school,
then, becomes the opportunity cost as it was given up. In a wider perspective, the opportunity
cost is the education the children could have received, as it is the actual cost to the economy
of giving up the school.
Example 2: you have to decide whether to stay up and study or go to bed and not study. If
you chose to go to bed, the knowledge and preparation you could have gained by choosing to
stay up and study is the opportunity cost.

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Production Possibility Curves (PPC)

 The Production Possibility Curve (PPC) is an economic model that considers
the maximum possible production (output) that a country can generate if it uses all
of its factors of production to produce only two goods/services

 Any two goods/services can be used to demonstrate this model

 Many PPC diagrams show capital goods & consumer goods on the axes
o Capital goods are assets that help a firm or nation to produce
output (manufacturing). For example, a robotic arm in a car manufacturing
company is a capital good
o Consumer goods are end products & have no future productive use. For
example, a watch

A PPC for an economy demonstrating the use of its resources to produce capital or
consumer goods

Diagram Explanation

 The use of PPC to depict the maximum productive potential of an economy

o The curve demonstrates the possible combinations of the maximum
output this economy can produce using all of its resources (factors of
production)
o At A, its resources are used to produce only consumer goods (300)
o At B, its resources are used to produce only capital goods (200)
o Points C & D both represent full (efficient) use of an economy's resources as
these points fall on the curve. At C, 150 capital goods and 120 consumer
goods are produced

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 The use of PPC to depict opportunity cost

o To produce one more unit of capital goods, this economy must give up
production of some units of consumer goods (limited resources)
o If this economy moves from point C (120, 150) to D (225, 100),
the opportunity cost of producing an additional 105 units of consumer goods
is 50 capital goods
o A movement in the PPC occurs when there is any change in the allocation of
existing resources within an economy such as the movement from point C to
D

 The use of PPC to depict efficiency, inefficiency, attainable and unattainable

production
o Producing at any point on the curve represents productive efficiency
o Any point inside the curve represents inefficiency (point E)
o Using the current level of resources available, attainable production is any
point on or inside the curve and any point outside the curve is unattainable
(point F)

Shifts in a PPC
 As opposed to a movement along the PPC described above, the entire PPC of an
economy can shift inwards or outwards

Outward shifts of a PPC show economic growth & inward shifts show economic decline

Diagram Explanation

 Economic growth occurs when there is an increase in the productive potential of an

economy

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o This is demonstrated by an outward shift of the entire curve. More consumer

goods and more capital goods can now be produced using all of the available
resources
o This shift is caused by an increase in the quality or quantity of the available
factors of production
 One example of how the quality of a factor of production can
be improved is through the impact of training and education on
labour. An educated workforce is a more productive workforce and
the production possibilities increase
 One example of how the quantity of a factor of production can
be increased is through a change in migration policies. If an economy
allows more foreign workers to work productively in the economy,
then the production possibilities increase

 Economic decline occurs when there is any impact on an economy that reduces the
quantity or quality of the available factors of production
o One example of how this may happen is to consider how the Japanese tsunami
of 2011 devastated the production possibilities of Japan for many years.
It shifted their PPC inwards and resulted in economic decline

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Demand, Price & Quantity

Introduction to Demand
 Demand is the amount of a good/service that a consumer is willing &
able to purchase at a given price in a given time period
o If a consumer is willing to purchase a good, but cannot afford to, it is
not effective demand

 A demand curve is a graphical representation of the price & quantity

demanded (QD) by consumers
o If data were plotted, it would be an actual curve. Economists,
however, use straight lines so as to make analysis easier

Individual & Market Demand

 Market demand is the combination of all the individual demand for a

good/service
o It is calculated by adding up the individual demand at each price level

The Monthly Market Demand For Newspapers In A Small Village

Customer 1 Customer 2 Customer 3 Customer 4 Market Demand

30 15 4 4 53

 Individual & market demand can also be represented graphically

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Market demand for children's swimwear in July is the combination of boys &
girls demand

Diagram Analysis

 A shop sells both boys & girls swimwear

 In July, at a price of $10, the demand for boys swimwear is 500 units & girls is
400 units
 At a price of $10, the shops market demand during July is 900 units

Movements Along a Demand Curve

 If price is the only factor that changes (ceteris paribus), there will be a
change in the quantity demanded (QD)
o This change is shown by a movement along the demand curve

A demand curve showing a contraction in quantity demanded (QD) as prices

increase & an extension in quantity demanded (QD) as prices decrease

Diagram Analysis

 An increase in price from £10 to £15 leads to a movement up the demand

curve from point A to B
o Due to the increase in price, the QD has fallen from 10 to 7 units
o This movement is called a contraction in QD
 A decrease in price from £10 to £5 leads to a movement down the demand
curve from point A to point C
o Due to the decrease in price, the QD has increased from 10 to 15
units
o This movement is called an extension in QD

 The law of demand captures this fundamental relationship between price and
QD
o It states that there is an inverse relationship between price and QD

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 When the price rises the QD falls

 When prices fall the QD rises

2.3.2 Conditions of Demand

Shifts of the Demand Curve
 There are numerous factors that will change the demand for a
good/service, irrespective of the price level. Collectively these factors are
called the conditions of demand

 Changes to each of the conditions of demand, shifts the entire demand

curve (as opposed to a movement along the demand curve)

Condition Explanation Condition Shift Condition Shift

Changes in  Real Income determines how many Income D Income D

Real Income goods/services can be enjoyed by Increases Increases Decreases Decreases
consumers Shifts Shifts
 There is a direct relationship between Right Left
income & demand for goods/services (D→D1) (D→D2)

Changes in  If goods/services become Good D Good D

taste/fashion more fashionable then demand for them becomes Increases becomes Decreases
increases more Shifts less Shifts
 There is a direct relationship between fashionable Right fashionable Left
changes in taste/fashion & demand (D→D1) (D→D2)

Advertising/  If more money is spent Advertising D Advertising D

branding on advertising or branding, then demand Increases Increases Decreases Decreases
for goods/services will increase as more Shifts Shifts
consumers are aware of the product Right Left
 There is a direct relationship (D→D1) (D→D2)
between branding/advertising & demand

Changes in the  Changes in the price of substitute Price of D for Price of D for
prices of goods will influence the demand for a Good A Good B Good A Good B
substitute goods product/service Increases Increases Decreases Decreases
 There is a direct relationship between Shifts Shifts
the price of good A & demand for good Right Left
B

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 For example, the price of a Sony 60" TV (D→D1) (D→D2)

increases so the demand for LG 60" TV
increases

Changes in the  Changes in the price Price of D for Price of D for

prices of of complementary goods will influence Good A Good B Good A Good B
complementary the demand for a product/service Increases Decreases Decreases Increases
goods  There is an inverse relationship between Shifts Shifts
the price of good A & demand for good Left Right
B (D→D2) (D→D1)
 For example, the price of printer ink
increases so the demand for ink printers
decreases

Changes in  If the population size of a country Population D Population D

population changes over time, then the demand for Increases Increases Decreases Decreases
size/distribution goods/services will also change Shifts Shifts
 There is a direct relationship between the Right Left
changes in population size & demand (D→D1) (D→D2)
 Demand will also change if there is a
change to the age distribution in a
country as different ages demand
different goods/services e.g an ageing
population will buy more hearing aids

A graph that shows how changes to any of the conditions of demand shifts the
entire demand curve left or right, irrespective of the price level

 For example, if a firm increases their Instagram advertising, there will be

an increase in demand as more consumers become aware of the product
o This is a shift in demand from D to D1. The price remains unchanged
at £7 but the demand has increased from 15 to 25 units

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An Explanation of How Each of the Conditions of Demand Shifts the Entire

Demand
Curve at Every Price Level

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Supply, Price & Quantity

Introduction to Supply
 Supply is the amount of a good/service that a producer is willing & able
to supply at a given price in a given time period

 A supply curve is a graphical representation of the price and quantity

supplied by producers
o If data were plotted, it would be an actual curve. Economists, however,
use straight lines so as to make analysis easier

 The supply curve is sloping upward as there is a positive

relationship between the price and quantity supplied
o Rational profit maximising producers would want to supply more as
prices increase in order to maximise their profits

Individual & Market Supply

 Market supply is the combination of all the individual supply for a

good/service
o It is calculated by adding up the individual supply at each price level

The Monthly Market Supply Of Bread From 4 Bakeries In A Small Town

Bakery 1 Bakery 2 Bakery 3 Bakery 4 Market Supply

300 600 180 320 1400 loaves

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 Individual & market supply can also be represented graphically

Market supply for smart phones in December is predominantly the

combination of iPhone & Samsung supply

Diagram Analysis

 In New York City, the market supply for smart phones in December is
predominantly the combination of iPhone & Samsung supply
 At a price of $1000, the supply of iPhones is 300 units & the supply of
Samsung phones is 320 units
 At a price of $1,000, the market supply of smart phones in New York City
during December is 620 units

Movements Along a Supply Curve

 If price is the only factor that changes (ceteris paribus), there will be a
change in the quantity supplied (QS)
o This change is shown by a movement along the supply curve

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A supply curve showing an extension in quantity supplied (QS) as prices

increase & a contraction in quantity supplied (QS) as prices decrease

Diagram Analysis

 An increase in price from £7 to £9 leads to a movement up the supply curve

from point A to B
o Due to the increase in price, the quantity supplied has increased from
10 to 14 units
o This movement is called an extension in QS

 A decrease in price from £7 to £4 leads to a movement down the supply

curve from point A to C
o Due to the decrease in price, the quantity supplied
has decreased from 10 to 7 units
o This movement is called a contraction in QS

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Equilibrium & Disequilibrium

Market Equilibrium
 In a market system, prices for goods/services are determined by
the interaction of demand & supply
o A market is any place that brings buyers & sellers together
o Markets can be physical (e.g. McDonald's) or virtual (e.g. eBay)

 Buyers and sellers meet to trade at an agreed price

o Buyers agree the price by purchasing the good/service
o If they do not agree on the price then they do not purchase the
good/service and are exercising their consumer sovereignty

 Based on this interaction with buyers, sellers will gradually adjust their
prices until there is an equilibrium price and quantity that works for both
parties
o At the equilibrium price, sellers will be satisfied with
the rate/quantity of sales
o At the equilibrium price, buyers are satisfied that the product provides
benefits worth paying for

Equilibrium

 Equilibrium in a market occurs when demand = supply

 At this point the price is called the market clearing price

o This is the price at which sellers are clearing (selling) their stock at an
acceptable rate

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A graph showing a market in equilibrium with a market clearing price at P &

quantity at Q

 Any price above or below P creates disequilibrium in this market

o Disequilibrium occurs whenever there is excess
demand or excess supply in a market

Market Disequilibrium
Disequilibrium - Excess Demand

 Excess demand occurs when the demand is greater than the supply
o It can occur when prices are too low or when demand is so high that
supply cannot keep up with it

A graph that depicts the condition of excess demand in the market for electric
scooters

Diagram Analysis

 At a price of P1, the quantity demanded of electric scooters (Qd)

is greater than the quantity supplied (Qs)
 There is a shortage in the market equivalent to QsQd

Market response

 This market is in disequilibrium

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o Sellers are frustrated that products are selling so quickly at a price that
is obviously too low
o Some buyers are frustrated as they will not be able to purchase the
product
 Sellers realise they can increase prices & generate
more revenue and profits
 Sellers gradually raise prices
o This causes a contraction in QD as some buyers no longer
desire the good/service at a higher price
o This causes an extension in QS as other sellers are
more incentivised to supply at higher prices
 In time, the market will have cleared the excess demand & arrive at a
position of equilibrium (PeQe)
o Different markets take different lengths of time to resolve
disequilibrium. For example, retail clothing can do so in a few days.
Whereas the housing market may take several months, or even years

Disequilibrium - Excess Supply

 Excess supply occurs when the supply is greater than the demand
o It can occur when prices are too high or when demand falls
unexpectedly
 During the later stages of the pandemic the market for face masks was
in disequilibrium

A graph that depicts the condition of excess supply in the market for Covid-19
face masks during the later stages of the pandemic

Diagram Analysis

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 At a price of P1, the quantity supplied of face masks (Qs) is greater than
the quantity demanded (Qd)
 There is a surplus in the market equivalent to QdQs

Market Response

 This market is in disequilibrium

o Sellers are frustrated that the masks are not selling and that
the price is obviously too high
o Some buyers are frustrated as they want to purchase the masks but
are not willing to pay the high price
 Sellers will gradually lower prices in order to generate more revenue

o This causes a contraction in QS as some sellers no longer desire to

supply masks
o This causes an extension in QD as buyers are more willing to
purchase masks at lower prices
 In time, the market will have cleared the excess supply & arrive at a position
of equilibrium (PeQe)

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Changing Market Conditions

Causes & Consequences of Price Changes
 Real world markets are constantly changing & are referred to as dynamic
markets

 Market equilibrium can change every few minutes in some markets (e.g.
stocks and shares), or every few weeks or months in others (e.g clothing)

 Any change to a condition of demand or supply will temporarily

create disequilibrium & market forces will then seek to clear the excess
demand or supply

Real World Example: Changes to Demand That Increase Price

 During lock downs associated with the Covid-19 pandemic, furniture retailers
experienced unexpectedly high demand for their products (especially desks
and sofas)

Diagram showing an increase in demand for desks due to a temporary change

in tastes/fashions

Diagram Analysis

 Due to the Covid mandated change of working from home, consumers

experienced a temporary change in taste as they sought to set
up comfortable home offices
o This led to an increase in demand for desks from D1→D2

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 At the original market clearing price of P1, a condition of excess

demand now exists
o The demand for desks is greater than the supply

 In response, suppliers raise prices

o This causes a contraction of demand and an extension of
supply leading to a new market equilibrium at P2Q2
o Both the equilibrium price (P2) and the equilibrium quantity (Q2) are
higher than before
o The excess demand in the market has been cleared

Exam Tip

Be systematic in thinking through the order of changes in market conditions. E.g. An

increase in demand (shift in demand) will cause a rise in price. The higher price will
cause an extension of supply (not a shift of supply)

Real World Example: Changes to Supply That Increase Price

 In September 2022, Hurricane Fiona destroyed much of Puerto Rico's crop

of plantains (a necessity in the diet of local people)

Diagram showing a decrease in supply of plantains in Puerto Rico due to a

supply shock caused by Hurricane Fiona

Diagram Analysis

 Due to Hurricane Fiona, Puerto Rico is experiencing a supply shock in its

plantain market
o This causes a decrease in supply of S1→S2

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 At the original market clearing price of P1, a condition of excess

demand now exists (shortage)
o The demand for plantain is greater than the supply

 In response, sellers in Puerto Rico raise prices

o This causes a contraction of demand & an extension of
supply leading to a new market equilibrium at P2Q2
o The equilibrium price (P2) is higher & the equilibrium quantity (Q2) is
lower than before
o The excess demand in the market has been cleared

Real World Example: Changes to Demand That Decrease Price

 Demand for lobsters in Maine, USA has been falling steadily in recent
months
 This has resulted in a price fall from $12.35 /pound on the 1st April to $9.35
/pound on the 1st May

Diagram showing a decrease in demand for lobsters due to a decrease in real

income

Diagram Analysis

 In recent months the USA has been experiencing an increasing

rate of inflation
o Inflation lowers the purchasing power of money in a consumer's
pocket & so effectively reduces their real income
o With reduced real income fewer luxuries are consumed
o This led to a decrease in demand for lobsters from D1→D2

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 At the original market clearing price of P1, a condition of excess supply now
exists
o The demand for lobsters is less than the supply

 In response, suppliers gradually reduce prices

o This causes a contraction of supply & an extension of
demand leading to a new market equilibrium at P2Q2
o Both the equilibrium price (P2) & the equilibrium quantity (Q2) are
lower than before
o The excess supply in the market has been cleared

Real World Example: Changes to Supply That Decrease Price

 In order to help meet their climate targets & to lower energy costs for
households, the EU is providing subsidies for solar panels

Diagram showing an increase in supply of solar panels in the EU due to a per

unit subsidy

Diagram Analysis

 To help meet its climate change targets & lower household energy bills the
EU has provided a subsidy to solar panel retailers

o This causes an increase in supply of S1→S2

 At the original market clearing price of P1, a condition of excess supply now
exists (surplus)
o The supply of solar panels is greater than the demand

 In response, sellers in the EU lower prices

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o This causes an extension of demand & a contraction of

supply leading to a new market equilibrium at P2Q2
o The equilibrium price (P2) is lower & the equilibrium quantity (Q2) is
higher than before
o The excess supply in the market has been cleared

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