Chapter 2

The Three Basic Economic Problems and

Private Property Rights

S4____ Name: _________________________ ( )

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2.1 The Three Basic Economic Problems
Imagine you are going to take over the tuck shop in Raimondi College.
You may have to think of the following questions:
• What snacks should I sell in the tuck shop?
• How many staff should I employ? Should I include student helpers?
• Would it be good to introduce discounts for senior-form students?

Because of scarcity, every society faces three basic economic problems.

It has to make choices on how to allocate scarce resources.

1. the “what to produce” problem

• the types and quantities of goods and services to be produced

2. the “how to produce” problem

• the production methods
i.e., the resources and quantities for production of goods and services
• e.g. cheapest? fastest? how to save production cost?

Example
A fast food restaurant can choose between employing more cashiers or introducing self-ordering machines
to serve more customers.

3. the “for whom to produce” problem

• how you distribute your products
i.e., decide on who can get the goods and who cannot
• the target buyers / consumers

2014 DSE Q4 (75%)

Mei Ho House (美荷樓), a public housing block built in the 1950s, was recently graded as a historic building
in Hong Kong. The building was then turned into a hostel which provides double rooms, family rooms and
disabled rooms. The above case is related to the ______________ question(s) in Economics.

A. “how to produce”
B. “for whom to produce”
C. “what to produce” and “how to produce”
D. “what to produce” and “for whom to produce”

2018 DSE Q2 (81%)

The Chief Executive proposed to raise the recurrent education spending by $5 billion. One of her proposals
was to provide a $30,000 subsidy to eligible secondary school graduates studying self-financing programmes.
The above proposal is related to the __________ question(s) in Economics.
A. 'how to produce'
B. 'for whom to produce'
C. 'what to produce' and 'how to produce'
D. 'what to produce' and 'for whom to produce'

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2.2 Three ways to tackle basic economic problems
1. Customs and traditions
Q: What is produced during Chinese New Year?
Sample answer: red packets, candies, …

Q: Wealth / throne is usually inherited to …?

Sample answer: the eldest son / usually not girls

What to produce?
• produce things similar to what their ancestors produced

How to produce?
• produce things in similar ways as their ancestors

For whom to produce?

• distribute things following their ancestors’ way; e.g., inheritance

In a traditional economy, the three basic economic problems are often tackled by customs and traditions.

2. Government decisions
Q: Who decided on the design of and materials used for Cu Masks?
the government

Q: How do citizens get food supply during wartime?

rationing from the government

What to produce?
• the government decides what to produce and what quantity to produce
e.g., deciding on the usage of funds

How to produce?
• the firms follow the government’s instructions regarding the method of production
e.g., commanding the firms to only employ local workers for production

For whom to produce?

• the government sets criteria for allocation / decides on the way of distributing output
e.g., people who apply for public housing has to meet the income and asset limit
e.g., Who enjoys the goods and services? all Hong Kong people? only permanent residents 18-year-
old or above?

In a planned / command economy, the three basic economic problems are often tackled by government
decisions.
• Most resources are owned by the government
• Most resources are allocated / distributed by the government
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Advantages of a planned economy
• less price fluctuation because of central control
• there will be some non-marketable goods (e.g., national defence, education)

3. Market mechanism (price mechanism)

Q: How do firms decide what to produce?
depending on market demand / prices

Q: How do firms decide on the production method?

depending on the cost of production

What to produce?
• When price of a good increases,
- new producers will be attracted to the market and/or existing producers will produce more.
• Price serves as a signal to inform producers of what to produce.
• For example, when the prices of masks go up, mask manufacturers will produce more masks to
maximise their gains.

How to produce?
• The production method depends on prices of factors of production
• Usually, producers will choose to minimise cost.
i.e., the cheapest method of production
• For example, when the wages of cashiers go up, shops may install more self-service checkout facilities
to replace cashiers as a cost-saving measure.

For whom to produce?

• Prices determines who get the goods in a market economy.
• People who are willing and able to pay the price will get the goods or services.

In a market economy, the three basic economic problems are often tackled by price mechanism.
• Most resources are owned privately (private property rights are common)
• Allocation of resources and distribution of goods are guided by market prices (i.e., the price
mechanism)

There is no pure traditional economy, market economy or planned economy. It is only a matter of degree.

For Hong Kong,

• The three economic problems are mainly solved by price mechanism,
some by the government, (rental rates of public housing)
some by tradition (inheritance of 丁屋 by males)

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Past Paper Questions
2015 DSE Q3 (75%)
Which of the following is a characteristic of a market economy?
A. Income distribution is uneven in the economy.
B. The government has no role in regulating business activities in the economy.
C. Most factors of production in the economy are privately owned.
D. There is only price competition in the economy.

2017 DSE Q1 (90%)

The operator of a canteen in the government headquarters decides to sell sushi and not burgers anymore
because the former can earn a higher profit. This is an example of using _____ to solve the problem of
_____.
A. government command ...... 'what to produce'
B. government command ...... 'for whom to produce'
C. market mechanism ...... 'what to produce'
D. market mechanism ...... 'for whom to produce'

P.S. We CANNOT compare income distributions / living standards between different types of economies.

2.3 Specialisation & Exchange

• People do not produce everything on their own because they do not have enough time / they are not
good at doing everything.
• For example, Hong Kong people mainly produce (food / manufacturing goods / services).

Definition
• Specialisation is a process when workers concentrate (specialise) in producing a good or a stage of
production of a good.
• Total output of the economy will be higher than that without specialisation.

What is the condition for specialisation to take place?

i.e., Can you enjoy playing mobile games if you only specialise in the field you are good at?

• People can exchange the goods they produce for the goods they want in the market.
- People can consume more goods
- People enjoy a higher standard of living

• Exchange makes specialisation possible.

• Without exchange, people can only consume they own production, and
- people will shift to produce everything on their own again.

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2.4 Private Property Rights
• Would people be willing to pay for getting water from the sea? Why?
• Would people be willing to pay for a bottle of water from 7-Eleven? Why?

• People would not be willing to pay for a common property.

• Exchange is a condition for specialisation, while private property rights are the foundation for
exchange to take place in a market economy.

Definition
A good is a private property if the owner has the

• exclusive right to use

the owner has the right to exclude others from using his or her property
permission is needed to use the owner’s property

• exclusive right to receive income

exclusive right to obtain income from the property [the owner still own the property]

• right to transfer
the owner can give / sell the property to other people

If there is no private property right, no one will be willing to pay for it, i.e. exchange will not occur.

2016 DSE Q5 (88%)

Marlene had bought a cookery book from a bookstore. Her friend, Kitman, said to her, “You have private
property rights to this cookery book.” Which of the following rights would Marlene have after the purchase
of the book?

(1) To follow the recipes in the book in preparing a dinner for Kitman
(2) To scan and upload the whole book to her blog
(3) To leave the book on the bookshelf without reading it
(4) To lend the book to Kitman and ask for a dinner in return

A. (1), (2) and (3) only

B. (1), (2) and (4) only
C. (1), (3) and (4) only
D. (2), (3) and (4) only

Takeaway
• People may not always enjoy FULL private property rights.
• We should also pay attention to intellectual property.

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2.4.1 Importance of private property rights in a market economy
• When regulations defining and protecting private property rights cannot be enforced,
- there is no guarantee that the buyer can use it or generate income from it exclusively from it.
- so, there is no reason for people to pay for the good.

• In a market economy, price is a signal guiding the allocation of economic goods.

- people who are willing and able to pay the market price can obtain the goods
- the price mechanism allocates the economic good to the highest-valued users

• However, without private property rights, price cannot guide resource allocation effectively.
- people will use non-price methods to allocate resources
- the goods may not be allocated to the highest-valued users

Well-defined and well-protected private property rights are the foundation for the functioning of price
mechanism.

Private property rights → Exchange → Specialisation

Practice Questions
Explain whether each of the following people has a FULL set of private property rights over the housing
unit mentioned.

1. The tenant of a public housing unit rented from the Housing Authority
No. The tenant’s right of transferring and receiving income from the housing unit are confined.

2. The tenant of a private housing unit

No. The tenant’s right of transferring and receiving income from the housing unit are confined.

3. The owner of a private housing unit

Yes. The owner has the exclusive right to use, the exclusive right to receive income from it, and the
right to transfer the housing unit.

A person who has the exclusive right to use a good (must / may not) have the exclusive right to receive income
from it, and/or the right to transfer it.

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