economic problem s

8/7/2019 Economic Problem s

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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


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Scarcity, choice and the basic economic

problem

Inflation, unemployment, pollution, energy shortages andgovernment deficits are some of the complex problemsconfronting an economy, which have an impact at the

micro level also. These problems arise due to the factthat resources are limited while human wants areunlimited. This leads to dissatisfaction, causing humanbeing to look for ways to fulfill their needs. Thus scarcityleads to the necessity of making choices. Problems of

choice arise at all levels - at the level of the individual, atthe level of producers, and at the level of the overall economy. The problem here is to find a method tomaximize the level of satisfaction, with the resources

available. Let us now look at how consumers, producersand governments try to satisfy their needs.


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Scarcity results when natural resources, human resources and capitalresources are not available in sufficient quantity to satisfy all wants. So aproducer 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 oftrees, then no other product can be produced from that particular stand oftrees. Yet, there are many other products that could have been producedusing the same natural resource, which are also desired by consumers. Theopportunity 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 thedifficulty a person faces when he tries to satisfy his unlimited wants with alimited income. Thus, a purchase decision is based on income, price, andpersonal tastes and preferences.

A consumer can have a choice of alternative products with a limited income ifhe can find a person with whom he can exchange goods or services. By

means of such exchanges, he can increase his level of satisfaction. Suchgains in satisfaction can be termed as gains from trade.

Such exchanges are also possible for producers. Although two producersmay both be capable of producing two products, each can also choose toproduce the one product in which he has a comparative advantage over theother.


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To make the best use of economic resources, the following questions need to beanswered:

What to produce? How to produce?

For whom to produce?

These questions need to be asked because resources are scarce, and can be put toalternative 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 theycannot satisfy all the needs of the economy. They have to choose which goods andservices to produce, with the limited resources available. From an individuals point ofview, 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 beused to produce a given level of output. The best combination is the full employmentof the available resources, to produce the maximum output. Depending on theresources available, techniques of production can be labor intensive or capitalintensive.

For whom to produce?

This refers to the distribution of goods and services between different categories andsections of the population. For example, one needs to see if the scarce resources arebeing used appropriately to cater to the needs of the higher income groups and thelower income groups.


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Opportunity costs, allocation of

resources

Opportunity cost can be defined as the cost of any decision measuredin terms of the next best alternative, which has been sacrificed. Toillustrate 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: havinga 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 themovie over the music concert. Hence, his opportunity cost issacrificing the movie, the next best alternative once he goes for adinner. If we carry forward the same example at the firm level, amanager planning to hire a stenographer may have to give up the ideaof having an additional clerk in the accounts department. This is

applicable even at the national level where the country allocateshigher defense expenditures in the budget at the cost of using thesame money for infrastructural projects. In order to maximize thevalue of the firm, a manager must view costs from this perspective.


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Production possibility curve and

productive efficiency

Now let us analyze how individuals, producers and other economic agentsuse the scarce resources to meet the unlimited needs. This to a large extentis possible with the help of the production possibility curve (PPC). Theproduction possibility curve can be defined as a curve which shows themaximum 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 andservices.

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.


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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


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Growth and the factors of production, land, labour,

capital, enterprise; growth


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The division of labour and specialization


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Positive and normative statements

Another debate about the nature of economics is whether it is apositive or a normative science. According to J. M. Keynes, A positivescience may be defined as a body of systematized knowledgeconcerning what is. A normative science or regulative science is abody of systematized knowledge relating to the criteria of what ought

to be and concerned with the ideal as distinguished from theactual.....The objective of a positive science is the establishment ofuniformities; of a normative science, the determination of ideals.

Positive economics explains economic phenomena according to theircauses and effects. At the same time, it says nothing about the ends; itis not concerned with moral judgments. On the other hand, normative

economics explains how things ought to be. According to MiltonFreidman, positive economics deals with how an economic problem issolved; normative economics on the contrary deals with how theproblem should be solved. A positive statement is based on facts. Anormative statement involves ethical values.


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Markets versus planning, free-market

system, command economy

Market Economy

This economic system emphasizes the freedom of individuals asconsumers and suppliers of resources, and allows market forces todetermine the allocation of scarce resources through the pricemechanism. Based on market demand and supply, consumers are freeto buy goods and services of their choice and producers allocate theirresources based on the demand. Decisions made by producers andconsumers are influenced greatly by price.

Price plays a major role in a market economy. The role of thegovernment is negligible: consumers choose the goods they want andproducers allocate their resources based on the market demand fordifferent 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. TheUnited States is an example of a market economy


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Command Economy

In a command economy, all the economic decisions are taken

by the government what to produce, how to produce and forwhom to produce. Thus, all decisions, from the allocation ofresources to the distribution of end products, is taken care offby the government. In this type of systems, efficiency can beachieved only when demands are accurately estimated andresources allocated accordingly. The USSR was an example

of a command economy. The government had completecontrol over the economy, and consumers were just the pricetakers. The government set output targets for each districtand factory and allocated the necessary resources.

Incomes are often more evenly distributed in a command

economy, in comparison to other types of economies. Pricesare controlled and this allows for greater equality in theeconomy. Decisions are not based on individual tastes andpreferences, but on national goals.


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Mixed Economy

A mixed economy is a combination of a free market

economy and a command economy. Here, governmentcontrols the price fluctuations to achieve certainobjectives such as high level of employment and lowlevel of inflation. A mixed economy uses cost-benefitanalysis 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 awhole are taken or accepted only when the social

benefits from the decision of project are greater than thesocial costs.

In a mixed economy, the government organizes themanufacture or provision of essential goods and servicessuch as education and health care.


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Economic models

Economic models is a set of equations or relationships used tosummarize the working of the national economy or of a business firmor some other economic unit. Models may be simple or complex andthey are used to illustrate a theoretical principle or to forecasteconomic behavior.

Economic models can be further classified into Micro EconomicsModels and Macro Economic Models.

Micro Economic Models: Models when they incorporate individualeconomic units such as households and firms, often grouped intoindividuals markets and industries and the relationship between themare called as micro models.

Macro Economic Models: these models are used to explain andpredict the working or performance of the economy as a whole, e.gchanges in the level of NI, the level of employment and inflation.


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What Economists Do

The economy can be looked at with either a micro

or a macro view.

M

icroeconomics vs.M

acroeconomics


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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


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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-relationshipsbetween economic units like consumers, commodities,

firms, industries, markets, etc.

Macroeconomics explains about the total nationalincome, 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 inindividual decision making i.e., managerial decision-

making.

Macro economic study is vital in the formulation andexecution 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.


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Economic Science

Economists attempt to discover an explanation for

how economic systems work.

Economists distinguish between Positive Statements

and Normative Statements


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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


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MARGINAL VALUE

The marginal value of a dependentvariable is the change in this dependent

variable associated with a 1-unit change

in a particular independent variable


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Maximization occurs when marginal

switches from positive to negative.

If marginal is above average, average isrising.

If marginal is below average, average isfalling.

Graphing Total, Marginal, and AverageRelations

Deriving Totals from Marginal and Average Curves Total is the sum of marginals.


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Relationship between output and profit

OUTPUT TOTAL MARGINAL AVERAGE

PER DAY PROFIT PROFIT PROFIT

0 0

1 100 100 100.0

2 250 150 125.0

3 600 350 200.0

4 1000 400 250.0

5 1350 350 270.0

6 1500 150 250.07 1550 50 221.4

8 1500 -50 187.5

9 1400 -100 155.6

10 1200 -200 120.0


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Total, marginal, and average profit

-500

0

500

1000

1500

2000

0 5 10 15

OUTPUT PER DAY

PROFIT

TOTAL

PROFITMARGINAL

PROFIT

AVERAGE

PROFIT


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economic problem s

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