The Basic Economic Problem – How to Produce
1. Nature of the basic economic problem
- Scarcity: the four factors of production (land, labour, capital, enterprise) are limited, whereas human wants are unlimited.
- Because of scarcity societies face the basic economic problem: how to allocate scarce resources to satisfy as many wants as possible.
- Economic goods vs. free goods:
- Economic goods require scarce resources for their production (e.g., a smartphone, a hospital bed).
- Free goods are abundant and available without sacrificing other wants (e.g., air, sunlight).
- Examples of scarcity in action:
- Consumers – limited income forces a choice between a new phone or a holiday.
- Workers – limited time means choosing work or further education.
- Firms – limited capital forces a decision between expanding a factory or investing in new technology.
- Governments – limited tax revenue requires a choice between building a hospital or improving roads.
2. The three fundamental economic questions
- What goods and services should be produced?
- How should these goods and services be produced?
- For whom should the goods and services be produced?
Each question arises directly from scarcity, and the concept of opportunity cost helps explain the trade‑offs involved.
3. Factors of production
| Factor | Definition | Reward | Mobility | Quantity vs. Quality |
|---|
| Land (natural resources) | All natural inputs not created by humans (e.g., farmland, minerals, forests). | Rent | Generally immobile (fixed in location). | More land → more output; higher‑quality land (fertile soil, rich ore) ↑ productivity. |
| Labour | Human effort, both physical and mental, used in production. | Wages | Can be mobile (workers may move between regions or industries). | More workers → higher output; higher skill/education ↑ efficiency. |
| Capital (machinery, buildings, tools) | Man‑made inputs that aid production. | Interest or profit on capital | Relatively mobile (can be relocated or sold). | More machines → larger capacity; newer, more efficient equipment ↑ output per unit of capital. |
| Enterprise (entrepreneurship) | Risk‑taking activity of organising the other factors to produce goods and services. | Profit | Highly mobile – entrepreneurs can start businesses in different locations. | More entrepreneurs → more firms; better ideas/innovation ↑ productivity. |
4. Opportunity cost
- Definition: the value of the next best alternative that must be given up when a choice is made.
- How it influences decisions: every choice involves a trade‑off; the higher the opportunity cost, the less attractive the option.
- Illustrative examples:
- Consumer – buying a new phone means forgoing a weekend holiday; the holiday is the opportunity cost of the phone.
- Firm – using a factory to produce shoes instead of shirts means the foregone profit from shirts is the opportunity cost of shoes.
- Government – allocating £100 million to a new highway means the same amount cannot be spent on a new hospital; the health benefits foregone are the opportunity cost of the road.
- Opportunity cost links directly to the three fundamental questions: the “what” and “for whom” decisions are guided by the value of the alternatives that are sacrificed.
5. Production‑possibility curve (PPC)
The PPC shows the maximum combinations of two goods an economy can produce with its existing resources and technology.
Key features
- Axes: each axis represents a different good (e.g., Cars on the vertical axis, Food on the horizontal axis).
- Shape – bowed outward: reflects increasing opportunity cost; as production of one good expands, resources less suited to its production must be used, raising the cost in terms of the other good.
- Points on the curve: efficient – all resources fully employed.
- Points inside the curve: inefficient – resources under‑utilised (the syllabus wording: “inside the curve = inefficiency”).
- Points outside the curve: currently unattainable (the syllabus wording: “outside the curve = unattainable”).
Movements and shifts
- Movement along the curve: a change in the mix of the two goods; the opportunity cost of the good gained is the amount of the other good given up.
- Shift of the curve: the whole frontier moves outward (economic growth) or inward (contraction). Causes are summarised below.
| Cause of shift | Direction of shift | Explanation (syllabus wording) |
|---|
| Increase in the quantity of resources (e.g., discovery of new oil reserves) | Outward | More resources allow greater output of both goods. |
| Improvement in the quality of resources (e.g., better‑educated labour force) | Outward | Higher‑quality inputs raise productivity. |
| Technological progress (e.g., automation, new production methods) | Outward | More output can be obtained from the same quantity of resources. |
| Natural disaster, war, or depletion of resources | Inward | Fewer or lower‑quality resources reduce the maximum attainable output. |
6. Extension – “How to produce?” (production techniques & cost minimisation)
Note: This material is not required for the IGCSE 0455 syllabus but is useful for A‑Level study or as enrichment.
Key considerations when choosing a technique
- Factor intensity – labour‑intensive (more labour, less capital) vs. capital‑intensive (more capital, less labour).
- Technology level – degree of automation or innovation.
- Economies of scale – average cost falls as output rises.
- Resource availability – relative abundance or scarcity of land, labour, capital and enterprise in the economy.
- Cost minimisation – selecting the technique that yields the lowest total cost for the required output while meeting quality, environmental and legal standards.
Simple cost representation (A‑Level)
When only labour (L) and capital (K) are considered, total cost (TC) can be expressed as:
TC = wL + rK
- w = wage rate per unit of labour.
- r = rental (or interest) rate per unit of capital.
This formula illustrates why producers compare alternative techniques – the technique with the lowest TC is preferred, provided it also satisfies non‑cost criteria.
Decision‑making steps for “how to produce”
- Identify the required level of output.
- List possible production techniques (labour‑intensive, capital‑intensive, automated, etc.).
- Calculate or estimate the total cost of each technique using current factor prices (w, r, etc.).
- Consider non‑cost factors: quality standards, environmental regulations, skill availability, and likely technological change.
- Choose the technique that minimises total cost while meeting all non‑cost requirements.
- Review periodically – changes in factor prices or technology may make a different technique optimal.
7. Summary
The basic economic problem arises because scarce resources must be allocated to satisfy unlimited wants. Understanding scarcity, the distinction between economic and free goods, the four factors of production (and their rewards and mobility), and the concept of opportunity cost equips students to answer the three fundamental questions of economics. The production‑possibility curve visualises the trade‑off between alternative outputs, shows why the curve is bowed (increasing opportunity cost), and illustrates how shifts reflect changes in resources or technology. While the detailed analysis of production techniques belongs to later units, recognising that “how to produce?” is an answer to the basic problem helps learners see the link between resource scarcity, cost minimisation, and the overall allocation of society’s limited inputs.