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Micro 1: The Central Problem of Economics

Micro 1: The Central Problem of Economics

At the end of this set of notes, you should be able to explain:

1. The basic economic problem .....................................................................................2

2. Resource allocation systems .....................................................................................2
3. Free market system.......................................................................................................3
4. Command (planned) economy system ....................................................................5
5. Mixed economies ...........................................................................................................7
6. Production possibility curve (PPC) ..........................................................................8

Note: This set of notes is meant to concise with just enough information for “A” level
students. It is best used as a cheat sheet, complementary with official school notes.

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Micro 1: The Central Problem of Economics

1. The basic economic problem

1.1 Economic resources refer to factors of production required to produce goods

and services, and includes:
a. Land;
Naturally occurring resources such as forest, marine life, and minerals.
b. Labour;
Human effort from those who are willing and able to work.
c. Capital;
Man-made resources used for further production such as tools, equipment
and machineries.
d. Enterprise.
The aspect of human resource that contributes to production in terms of
organization and innovation.

1.2 Human wants refer to desires and are independent of affordability and are
assumed to be unlimited and ever increasing.

1.3 The combination of limited resources and unlimited wants give rise to scarcity,
since the existing resources will not be able to fully satisfy their wants.

1.4 In Economics, humans are assumed to be rational, which means that

they are able rank their wants in order and will choose the items highest
in the order.

1.5 The economic agents will therefore need to choose how best to allocate
resources such that they can attain the highest possible level of

1.6 Choosing one (or more of a) good requires giving up (or having less)
something else.

1.7 Therefore, there is a cost associated with choice, and is often measured
as the best alternative that has to be forgone to satisfy the particular
want (opportunity cost).

2. Resource allocation systems

2.1 There are 3 economic systems to solve the problem of resource

a. Free market economy (totally decentralised);
b. Command economy (totalled planned by government);
c. Mixed economy (mixed between both above extremes).

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Micro 1: The Central Problem of Economics

2.2 Every country devises a mechanism to answer the 3 basic micro -

economic questions (arising from the problem of scarcity):
a. What goods & services and how much of each to produce?
b. How to combine inputs to produce these?
c. For whom the resulting outputs are being produced?

3. Free market system

a. Characteristics

3.1 There is private ownership of resources, where individuals and private

institutions own the means of production within a legal framework, with
limited government ownership.

3.2 There is freedom of choice for consumers, firms and all resource
suppliers, in terms of purchase and output.

3.3 There is consumer sovereignty, which means that it is the consumers

who decide what goods and services shall be produced and in what
quantities, though consumption demand patterns.

3.4 Self-interest is the driving force of the market economy, with each
economic agent trying to do what is best for itself.

3.5 There is competition, as the markets consist of relatively large number

of buyers and sellers - market power is dispersed and there is
competition between them.

3.6 Resource allocation (what, how and for whom to produce) is done
through the price mechanism, which is derived by demand and supply

b. What to produce?

3.7 In the market economy, consumers determine what will be produced by

their spending decisions through their preferences as expressed in
their purchases in retail markets.

3.8 Producers respond to profits and decides what goods and services to
produce by interpreting the money votes of consumers.

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Micro 1: The Central Problem of Economics

c. How to produce?

3.9 A level of output can be produced using different combinations of

different inputs.

3.10 Given that these inputs have different prices, these diff erent methods
yield different levels of cost.

3.11 Firms will combine resources in the cheapest way to gain more profits.

d. For whom to produce?

3.12 Goods will be allocated to consumers willing and able to pay the market

3.13 Consumers own factors of production, and they provide factor inputs to
the firms and receive income in payment.

3.14 Consumers with larger incomes (more dollar votes) will be able to get
a bigger share of a country's output.

e. Advantages

3.15 Resources, goods and services are automatically allocated to the most
valued use through the price mechanism, with no need for costly and
complex bureaucracies to co-ordinate economic decisions.

3.16 Under the condition of perfect competition, the price mechan ism is
supposed to result in productive and allocative efficiency, as profit-
maximising firms use the least-cost method for any production process,
and market equilibrium ensures efficient resource allocation in the
absence of market failures.

3.17 Since individuals can inherit and own property, there will be incentive to
accumulate wealth and develop entrepreneurship, adding to capital
formation in the economy, and promotes economic growth.

f. Disadvantages

3.18 Economic competition results in a waste of resources, as firms engage

in intensive advertising, the resources of which could be channelled into
the production of more goods and services, and unnecessarily increase
the cost of production.

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Micro 1: The Central Problem of Economics

3.19 Consumer welfare can be ignored as consumers are exposed to

unscrupulous producers that ignore social welfare.

3.20 Necessary and useful goods are often not produced (especially
public goods such as schools, roads), since they are not profitable,
reducing social welfare.

3.21 Economic instability and cyclical unemployment often result from

business cycles, causing unpredictability and may cause long -term
reduction in non-material standard of living.

3.22 As individuals are allowed to own private property and accumulate

wealth, inequalities in income distribution and wealth will result, and
production may be skewed towards luxury goods for those with greater
income and wealth.

3.23 Strong firms can eventually eliminate all competition and become the
sole seller of the product (monopoly), eliminating consumer
sovereignty and causing allocative and productive inefficiency .

4. Command (planned) economy system

a. Characteristics

4.1 The planned or command economy is a system where decision making

is centralised and coordinated within the government.

4.2 Decisions on what, how and for whom to produce are made by the state ,
with an emphasis on greater equality.

4.3 Economic resources, such as land and capital are owned by the state.

4.4 There is still the use of money and prices, with workers paid for their
services, but prices (both factor and product) are fixed by the state.

b. What to produce?

4.5 This decision is made by the central planners according to what they
perceive as the needs of the society.

4.6 Unlike in the market system consumers do not vote for the goods and
services they desire but rather they made do with whatever the planners
made available.

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c. How to produce?

4.7 The central planners decide on how much and what method of production
to use, co-ordinating all aspects of productive activity through an
effective organisational structure.

4.8 The government plans the output of each industry and firm, the
techniques that will be used, and the labour and other resources required
by each industry and firm.

4.9 Although the production method is indirectly determined by the

managers, he does not have the incentive to ensure that the least costly
method of production is chosen.

d. For whom to produce?

4.10 Rationing of finished products in this system is done by the state.

4.11 Depending on the aim of the government, it may

a. Distribute goods according to its judgment of people's needs ;
b. Give more to those who produce more;
c. Distribute goods and services directly through rationing;
d. Decide the income distribution and allow individuals freedom in
spending decisions.

4.12 Since the income distribution is even and prices are determined by the
state, fair distribution of goods and services would likely be achieved.

e. Advantages

4.13 Since individuals are not allowed to own major resources, and all labour
is employed by the government with even distribution of money income
and wealth, there is fairly equal distribution of wealth.

4.14 As the government dictates the mix of consumer versus capital goods in
the economy, a higher level of economic growth can be pursued as a
directive, which speeds up economic growth.

4.15 As price levels are set by the government, the central planning agency
can control inflation and unemployment.

4.16 As resources can be channelled into producing essential goods for all
and not only those who can pay, since all have equal ability to pay,
resources can be allocated better to maximise social welfare.

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Micro 1: The Central Problem of Economics

f. Disadvantages

4.17 An employee running an enterprise owned by the state receives fixed

salaries and does not have the incentive to improve operations and
minimise cost of production, often resulting in productive inefficiency.

4.18 Allocative efficiency may not be attained as well, as goods produced

may not be those desired by the community.

4.19 Shortages and surplus are not automatically eliminated as output is

decided by the planning agency, the accuracy of which depends on the
accuracy and time-lag of the information gathered.

4.20 Consumers lose consumer sovereignty as they have limited freedom

to choose among the goods already decided by the planning agency.

4.21 The lack of motivation on the part of managers and workers as well as
the low level of savings results in low rate of capital accumulation and
entrepreneurship, which results in slower economic growth.

5. Mixed economies

5.1 In reality, all economies are mixed systems that have elements of private
decision-taking and central planning.

5.2 The mixed economy relies on both the market and government planning
to allocate resources, and represents an attempt to make use of both
methods to get the best economic performance.

5.3 The role of the government in a mixed economy is to maintain efficiency,

stability in the system, and equity.

5.4 The case for government intervention arises whenever the market fails.

5.5 There are many kinds of market failures:

a. Market imperfections;
b. Missing markets (Non-production of public goods);
c. Externalities;
d. Macroeconomics instability;
e. Unequal distribution of income and wealth.

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5.6 There are four main areas in which government role is seen inevitable:
a. Providing a clear and predictable legal framework for
b. Providing a stable environment for businesses, via
macroeconomics policies, and ensuring that markets are
competitive, for example via free trade.
c. Investing in infrastructure and manpower, which will lower
business costs and also make it attractive for investors to invest
in the country.
d. Facilitate businesses, be it for local consumption, exports or
investments overseas or vice versa.

6. Production possibility curve (PPC)

6.1 In a world of scarcity, the use of a resource requires a trade-off for one
or more alternative uses, and is represented by the opportunity cost.

6.2 The PPC outlines all possible combination of total output that could
be produced by an economy assuming:
a. The quantity of resources is fixed;
b. Resources are utilised fully and efficiently;
c. A given state of technology.

6.3 Taking an example, where a country produces only 2 goods: rice and
meat – Table 1 shows the possible combinations that the country can
produce for both goods.

Meat (tonne) Rice (tonne)

0 15
1 14
2 12
3 9
4 5
5 0

Table 1: Production possibilities between meat and rice.

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Micro 1: The Central Problem of Economics

6.4 The production possibilities can be illustrated by the PPC, in Figure 1:

Figure 1: PPC for meat and rice.

6.5 The PPC can be used to illustrate a number of economic concepts :

a. Any point outside the curve represents a combination of output
that is unattainable given the country's present productive
capacity, illustrating scarcity.
b. Any point within the curve represents inefficient use or under-
utilisation of available resources, illustrating unemployment.
c. The country can choose to produce either more meat or rice, but
not more of both at the same time given its existing resources and
the state of technology, illustrating choice.
d. To get 1 more unit of meat, some units of rice must be given up -
the negative slope of the PPC measures opportunity cost per
unit meat (the rate at which rice can be transformed into meat).

6.6 The PPC illustrated is described as concave from the origin, which
describes the usual case where the successive opportunity cost of a
good rises with increased production of that good.

6.7 A major reason is that economic resources are not equally adaptable
to alternative uses - some factors of production are better suited for the
production of one good than they are for others.

6.8 Thus, as more of the good is produced, increasingly less suitable

resources are transferred and the cost of this additional output (in terms
of the alternative goods forgone) increases.

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6.9 If any of the factors affecting the quantity &/or quality of economic
resources change (e.g. new technology or new resources discovered),
the PPC will shift, as in Figure 2, illustrating economic growth.

Figure 2: Economic growth

6.10 As society reduces unemployment, it will move from a point within the
PPC to another closer to, or on the curve, as in Figure 3.

Figure 2: Increasing employment

6.11 Capital accumulation refers to the increased production of capital

goods (man-made goods for further production) which adds to society's
stocks of these goods.

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6.12 Capital accumulation allows the economy to grow at a faster rate in

the future, however society must devote fewer resources to consumer
goods in the present due to limited resources.

6.13 The opportunity cost of producing more capital goods can therefore
be measured in terms of the consumption goods that have to be forgone .

6.14 Therefore producing more capital goods today reduces the material
standard of living today, but will lead to a higher material standard of
living in future, than if less capital goods were produced today.

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