Economic problems

The fundamental economic problem is the issue of scarcity – but unlimited wants. Therefore, an
underlying feature of economics is concerned with dealing how to allocate resources in society to
make the most efficient and fair use of resources.

Therefore economic is concerned with:

What to produce? How to produce? For whom to produce?

Scarcity implies there is only a limited quantity of resources, e.g. finite fossil fuels and a limited
quantity of manufactured goods. Because of scarcity, there is a constant opportunity cost – if you use
resources to consume one good, you cannot consume another.

Micro economic problems

1. Externalities

One of the most frequent problems is that economic decisions can have external effects on other
people not involved in the transaction. For example, if you produce power from coal, the pollution
affects people all over the world (acid rain, global warming). This is a particular problem because we
cannot rely on the free market to provide the most efficient outcome. If we create negative
externalities, we don’t take them into account when deciding how much to consume. This is why we
can get overconsumption of driving a car into a city centre at peak hour. If everyone maximises their
utility, it doesn’t lead to the most efficient outcome – but gridlock and wasted resources.

Externalities, usually need some kind of government intervention. For example, taxes on negative
externalities (e.g. sugar tax) or subsidies on positive externalities (e.g. free public education)

But, even the solution to market failure (e.g. taxes, creates its own potential problems, such as how
much to tax? will there be tax evasion?)

2. Monopoly

Monopoly was an economic problem that Adam Smith was concerned about in his influential book of
economics “A Wealth of Nations”. For various reasons firms can gain monopoly power – and
therefore the ability to set high prices to consumers. Given a lack of alternatives, monopolies can
make high profits at the expense of consumers, causing inequality within society. Monopoly power
can also be seen through monopsony employers who pay lower wages to their workers.

How to deal with the problem of monopoly? – A government may seek to encourage competition,
e.g. rail franchising, or price regulation to prevent excessive prices.
3. Inequality/poverty

Inequality is considered a problem because of normative opinions such as – it is an unfair distribution

of resources. Also, you could argue there is a diminishing marginal utility of wealth. If all wealth is
owned by a small percentage of the population, this reduces net welfare. Redistributing the money
to the very poor would enable a greater net utility to society.

Inequality is a problem. However, it is also a problem to know how much we should seek to reduce
poverty. Many will agree on the necessity of reducing absolute poverty – but how far should we take
it? Should we aim for perfect equality (Communism) or should we aim for equality of opportunity?

Another issue with reducing poverty is that measures to reduce poverty may cause unintended
consequences – e.g. higher income tax on high earners may create disincentives to work. Giving
benefits to the low paid may reduce incentives to work.

4.Volatile prices

Some agricultural markets can have volatile prices. A glut in supply can be bad news because the fall
in price can lead to lower revenue for farmers. It could even cause some to go out of business
because of a bad year. These volatile markets can cause swings in economic fortunes.

5.Irrational moods

In some asset markets, we have seen volatile prices exacerbated by irrational exuberance.
Consumers have been caught up in a market frenzy. Hoping that rising prices will make them richer –
and expecting prices to keep rising. We can see this in issues such as tulip mania, the South Sea
Bubble, railway mania, and the recent property bubbles.

Macroeconomic problems
Unemployment has been a major economic problem in advanced economies. One of the principal
causes of unemployment is swings in the business cycle. A fall in demand for goods during a
recession, causes people to be laid off. Because of the depressed state of the economy, there is an
imbalance between demand and supply of workers.

Unemployment can also be caused by rapid changes in labour markets, for examples, unskilled
workers unable to gain employment in a high tech economy. Unemployment is a problem because it
is a waste of resources, but more importantly, it leads to very high personal costs, such as stress,
alienation, low income and feelings of failure.

Recession

A Recession is a period of negative economic growth – a decline in the size of the economy. It
exacerbates problems of inequality and unemployment.
Inflation

High inflation can be a serious problem if prices rise faster than wages and nominal interest rates. In
periods of rapidly rising prices, people with savings will see a decline in their real wealth. If prices rise
faster than wages, then people’s spending power will decline. Also, rapidly rising prices creates
confusion and uncertainty and can cause firms to cut back on investment and spending. Countries
which have experienced hyperinflation, have seen it as a very traumatic period because all the
economic certainty is washed away, leaving people without any certainty.

Balance of payments/current account deficit

A current account deficit on the balance of payments means an economy is importing more goods
and services than it is exporting. To finance this current account deficit, they need a surplus on the
financial/capital account. For many modern economies, a small current account deficit is not a
problem. However, some developing economies have experienced a balance of payments crisis –
where the large deficit has to be financed by borrowing, and this situation usually leads to a rapid
devaluation of the currency. But, this devaluation increases the price of imports, reduces living
standards and causes inflation.

Exchange rate volatility

In some cases, the exchange rate can cause economic problems. For example, countries in the Euro
were not able to change the value of their currency against other Eurozone members. Because
countries like Greece and Portugal had higher inflation rates, they became uncompetitive. Exports
fell, and they developed a large current account deficit. The overvalued exchange rate caused a fall in
economic growth.

On the other hand, a rapid devaluation can cause different problems. For example, when the price of
oil fell, oil exporting countries saw a decline in export revenues, leading to a fall in the value of the
currency. A rapid devaluation causes the price of imports to rise and causes both higher inflation and
lower growth. A difficult problem for policymakers to deal with.

Development economics
Developing economies face similar economic problems, but any issue is magnified by low GDP and
high levels of poverty. For example, unemployment in a developing economy is more serious because
there is unlikely to be any government insurance to give a minimum standard of living.

Poverty cycle. Some developing economies may be stuck in a poverty trap. Low growth and low
saving ratios lead to low levels of investment and therefore low economic growth. This low growth
and poverty cause the low savings and investment to be continued.