Inescapable Economic Problems

Scarcity, Trade-Offs and the Three Economic Problems Every Society Must Solve

In the previous post Opens in new window we noted the important fact that we live in world of scarcity Opens in new window.

As a result, any society faces the economic problem that it has only a limited amount of economic resources—such as workers, machines and natural resources—and therefore can produce only a limited amount of goods and services.

Therefore, society faces trade-offs.

Trade-off is the idea that, because of scarcity, producing more of one good or service means producing less of another good or service.

Trade-offs force society to make choices, particularly when answering the following three fundamental questions:

  1. What goods and services will be produced?
  2. How will the goods and services be produced?
  3. Who will receive the goods and services produced?

We briefly discuss each question below.

1.   What Goods and Services will be Produced?

Of course, society does not make decisions; only individuals make decisions.

The answer to the question of what will be produced is determined by the choices made by consumers, firms and governments.

Every day you help to decide which goods and services will be produced when you choose to buy an iPhone rather than a DVD player, or a cappuccino rather than tea.

Similarly, Apple must choose whether to devote its scarce resources to making more iPhones or more MacBook laptop computers.

The federal government must also choose whether to spend more of its limited budget on breast cancer research or on national defence.

In each case, consumers, firms and the government face the problem of scarcity by trading off one good or service for another.

When analyzing the decision to choose between alternative options, economists use the concept of opportunity cost Opens in new window. This is one of the most important concepts in economics.

The opportunity cost of any activity is the highest-valued alternative that must be given up to engage in that activity.

In the above example, if Apple chooses to make more iPhones it must divert resources from MacBook laptops. Or, if you choose to buy a cup of coffee, your opportunity cost is the cup of tea that you could have chosen instead.

Consider the example of an entrepreneur who could receive a salary of $80,000 per year working as a manager at a firm but opens her own business instead.

In that case the opportunity cost of the entrepreneurial services to her own business is $80,000, even though she does not pay herself an explicit salary.

This important concept of opportunity cost is analyzed even deeper in its designated post Opens in new window.

2.   How Will the Goods and Services be Produced?

Firms choose how to produce the goods and services they sell.

In many cases firms face a trade-off between using more workers and using more machines.

For example, a local service station has to choose whether to provide car repair services using more diagnostic computers and fewer car mechanics or more car mechanics and fewer diagnostic computers.

Similarly, movie studios have to choose whether to produce animated films using highly skilled animators to draw them by hand or fewer animators and more computers.

In deciding whether to move production offshore to China, firms are often choosing between a production method in their home country that uses fewer workers and more machines and a production method in China that uses more workers and fewer machines.

3.   Who Will Receive the Goods and Services Produced?

In Australia, as in most countries, who receives the goods and services produced, depends largely on how income is distributed.

Those individuals with the highest income have the ability to buy the most goods and services.

Often, people are willing to give up some of their income— therefore some of their ability to purchase goods and services—by donating to charities to increase the incomes of poorer people.

An important policy question, however, is whether the government should intervene to make the distribution of income more equal.

Such intervention occurs in Australia, because people with higher incomes pay a larger fraction of their incomes in taxes and because the government makes payments to people with low incomes.

There is disagreement over whether the current attempts to redistribute income are sufficient or whether there should be more or less redistribution.

To answer the three questions—what, how and who—societies organize their economies in two main ways Opens in new window.