Basic Economic Problem and the Factors of Production
Learning Objective
Explain the causes of changes in the quantity and quality of the four factors of production – land, labour, capital and entrepreneurship – and relate these changes to scarcity, opportunity cost and the Production‑Possibility Curve (PPC).
1. The Basic Economic Problem
Because resources are limited, every economy must answer three fundamental questions:
- What goods and services should be produced?
- How should they be produced?
- For whom should they be produced?
These decisions depend on the quantity (how much) and quality (how productive) of the factors of production. An increase in either expands the economy’s capacity to produce, shifting the PPC outward.
1.1 Opportunity Cost
Choosing to allocate resources to one activity means giving up the next best alternative. This trade‑off is the opportunity cost. For example, using a plot of land to grow wheat instead of building a factory incurs the opportunity cost of the forgone factory output.
1.2 Points on the PPC
| Location on the PPC | Interpretation |
|---|
| On the curve | Efficient use of all available resources. |
| Inside the curve | Resources are under‑utilised or inefficiently allocated. |
| Outside the curve | Unattainable with current resources and technology. |
Changes in the quantity or quality of any factor cause the whole curve to shift (movement of the curve), whereas a change in the mix of two goods moves the economy to a different point on the same curve.
2. Factors of Production – Definitions, Rewards & Typical Examples
| Factor |
Definition |
Typical Reward |
Real‑World Example |
| Land |
All natural resources – minerals, forests, water, fertile soil, etc. |
Rent, royalties, lease payments |
Oil royalties from the North Sea |
| Labour |
Human effort – physical and mental – used in production. |
Wages and salaries |
Factory workers, teachers, nurses |
| Capital |
Man‑made goods that aid production – machinery, buildings, tools, infrastructure. |
Interest, profit on capital |
Return on a factory’s machinery |
| Entrepreneurship |
The ability to combine the other three factors, take risks and innovate. |
Profit |
Earnings of a start‑up founder |
3. Quantity vs. Quality of Factors
- Quantity: The amount of a factor available (e.g., hectares of arable land, number of workers, value of machinery).
- Quality: How productive each unit of the factor is (e.g., soil fertility, skill level of workers, modernity of equipment).
Both dimensions affect the shape and position of the PPC. An increase in quality can shift the curve outward even when quantity stays constant.
4. Causes of Changes in Quantity
| Factor |
Quantity‑Increasing Causes |
Quantity‑Decreasing Causes |
| Land |
- Discovery of new natural resources (e.g., a new oil field).
- Land reclamation – draining swamps, creating artificial islands.
|
- Depletion of non‑renewable resources.
- Environmental degradation (desertification, deforestation).
|
| Labour |
- Population growth (birth rate > death rate).
- Immigration of working‑age people.
|
- Emigration.
- Higher mortality or falling fertility rates.
- Ageing population reducing labour‑force participation.
|
| Capital |
- Domestic saving and investment.
- Foreign direct investment (FDI).
- Government spending on infrastructure.
|
- Depreciation without replacement.
- Capital flight.
- War or natural disaster destroying assets.
|
| Entrepreneurship |
- Improved business climate – lower taxes, fewer regulations.
- Better access to finance for start‑ups.
|
- High perceived risk.
- Restrictive legal environment (heavy licensing, weak IP protection).
|
5. Causes of Changes in Quality (Productivity)
5.1 Land – Quality Enhancements
- Improved agricultural techniques (crop rotation, drip irrigation, precision farming).
- Soil fertilisation, conservation and integrated pest‑management.
- Advanced extraction technology (hydraulic fracturing, deep‑sea mining).
5.2 Labour – Human Capital
- Education – primary, secondary and tertiary schooling.
- Vocational training, apprenticeships and on‑the‑job learning.
- Health improvements – better nutrition, medical care, workplace safety.
- Continuous professional development and experience accumulation.
5.3 Capital – Technological Upgrading
- Adoption of newer, more efficient machinery (automation, robotics, 3‑D printing).
- Research & Development (R&D) leading to better designs and materials.
- Regular maintenance, retrofitting and upgrading of existing equipment.
5.4 Entrepreneurship – Innovation & Management
- Development of new products or production processes.
- Improved risk‑management techniques (insurance, diversification, hedging).
- Better market information, networking and use of digital platforms.
- Legal protection for intellectual property encouraging inventive activity.
6. Interaction Between Quantity and Quality
Quantity and quality often move together. Examples:
- Expansion of universities raises the number of graduates (quantity) and, because curricula are modernised, also raises the skill level (quality) of the labour force.
- Foreign direct investment brings new machinery (increasing capital quantity) and introduces advanced technology (raising capital quality).
7. Market Basics – Demand, Supply and Price Determination
Understanding how markets work underpins the analysis of factor‑price changes.
- Demand: Quantity of a good or service that consumers are willing and able to buy at each price, ceteris paribus. Downward‑sloping demand curve.
- Supply: Quantity that producers are willing and able to sell at each price, ceteris paribus. Upward‑sloping supply curve.
- Equilibrium: Intersection of demand and supply – determines market price and quantity.
- Disequilibrium: Surplus (price above equilibrium) or shortage (price below equilibrium) leads to price adjustments.
7.1 Elasticities (Key for IGCSE/AS Level)
| Elasticity | Formula | Interpretation |
|---|
| Price Elasticity of Demand (PED) | Δ% Qd / Δ% P | ‑ > 1 = elastic, = 1 = unitary, < 1 = inelastic, = 0 = perfectly inelastic. |
| Price Elasticity of Supply (PES) | Δ% Qs / Δ% P | Similar interpretation; supply is usually more elastic in the long run. |
8. Market Failure and Government Intervention
When markets do not allocate resources efficiently, government may intervene.
- Public goods – non‑rival and non‑excludable (e.g., national defence).
- Merit goods – socially desirable but under‑consumed (e.g., education, vaccinations).
- Demerit goods – socially undesirable but over‑consumed (e.g., tobacco, alcohol).
- Externalities – costs or benefits that affect third parties (e.g., pollution, herd immunity).
- Monopoly – a single firm with price‑setting power; can lead to higher prices and lower output.
8.1 Typical Government Tools
| Tool | Purpose | Typical Example |
|---|
| Tax on demerit goods | Reduce consumption | Excise duty on cigarettes |
| Subsidy for merit goods | Encourage consumption | Student grants |
| Regulation / standards | Correct negative externalities | Emission limits for factories |
| Public provision | Supply non‑excludable goods | National health service |
9. Micro‑Decision‑Makers Overview
| Decision‑Maker | Key Choices | Relevant Economic Concepts |
|---|
| Households |
What to consume, how much to save, whether to borrow. |
Utility maximisation, budget constraint, interest rates. |
| Workers |
How much labour to offer, which job to take. |
Labour‑supply curve, wage determination, human capital. |
| Firms |
What to produce, how much to produce, which production technique to use. |
Cost curves, profit maximisation, economies of scale. |
| Entrepreneurs |
Whether to start a new business, which innovation to pursue. |
Risk assessment, market information, IP protection. |
10. Diagram Guidance – Using the PPC in Exams
When a question asks you to illustrate a factor change, follow these steps:
- Label the axes “Quantity of Good A” (horizontal) and “Quantity of Good B” (vertical).
- Draw the original PPC (concave to the origin).
- Show the new PPC and clearly indicate the direction of the shift with an arrow.
- Briefly state why the shift occurs (e.g., “Improved capital quality – newer machines increase output per worker”).
Typical shifts:
- Improvement in capital quality – outward shift of the whole curve (both axes).
- Increase in land quantity – outward shift, more pronounced on the axis of land‑intensive goods.
- Decrease in labour quantity (ageing population) – inward shift, especially affecting labour‑intensive goods.
11. Summary Table – Key Drivers of Change
| Driver | Effect on Quantity | Effect on Quality |
|---|
| Population growth | + Labour quantity | Neutral unless paired with education |
| Immigration | + Labour quantity | Potentially + quality if migrants are skilled |
| Education & training | Neutral | + Labour quality (human capital) |
| Investment (domestic & foreign) | + Capital quantity | + Capital quality (modern equipment) |
| Technological change | Neutral | + Quality of all factors (more productive land, labour, capital, entrepreneurship) |
| Government policy (taxes, regulation) | Can raise or lower entrepreneurship quantity | Can improve or hinder quality of entrepreneurship and investment |
12. Examination Checklist
- Define the quantity and quality of each factor of production.
- State the typical reward paid for each factor (rent, wages, interest, profit).
- Identify at least three causes of quantity change for each factor.
- Identify at least three causes of quality change for each factor.
- Explain opportunity cost and relate it to the basic economic problem.
- Describe points on, inside and outside the PPC and explain why shifts occur.
- Use accurate terminology: human capital, depreciation, FDI, elasticity, externalities, monopoly, etc.
- Provide real‑world examples (e.g., discovery of North Sea oil, expansion of vocational colleges, introduction of 3‑D printing).
- When required, draw a correctly labelled PPC diagram showing the relevant shift.
- Briefly outline the role of demand, supply and price determination, and note any market failure that might affect factor markets.