Lesson Explainer: Fundamental Economic Problem

In this explainer, we will learn how to recognize the fundamental economic problem.

The basic building blocks of economic activities are human needs and resources. Let us recall the definition and characteristics of human needs.

A need of an individual is a feeling of distress leading them to act to diminish or satisfy the need. While a need may be satisfied by consuming suitable resources, the quantity of an individual’s needs continues to increase over time. In the context of a society, we also know that human needs are widely varied between different individuals. In other words, there is a limitless and diverse demand for resources in a society.

We also recall that resources are categorized as free or scarce, in terms of their availability. The availability of free resources, such as air and water, far exceeds the demand for their consumption. If all resources were free, there would not be any economic problem in the society since they would be able to satisfy everyone’s needs.

However, we know that most resources are scarce, which means that needs for the resources far exceed their availability. Any economic problem can be traced back to the fundamental conflict between scarcity of resources and the limitless and diverse nature of human needs, which is known as the fundamental economic problem.

Definition: Fundamental Economic Problem The fundamental economic problem states that human needs are diverse and continuously increasing, while resources to satisfy them are relatively limited.

We can represent the fundamental economic problem using the following diagram.

For instance, we can consider a need for transportation, which can be satisfied by purchasing a car. We know that a car is a scarce resource, which means that there is a greater number of people with this need compared to the number of available cars. Hence, some individuals will be able to obtain cars to satisfy their needs, while other individuals’ needs will not be satisfied. Furthermore, individuals with cars will likely develop new needs, for example, to obtain better cars, leading to an unending cycle of the fundamental economic problem that cannot be fully resolved.

Recall that a need for transportation is a secondary need, which is for achieving the happiness of the individual or improving the condition of the society. When we consider the fundamental economic problem involving this secondary need, its consequences do not seem grave. Let us consider this problem involving a primary need, which is essential for an individual’s survival.

The need to eat is a primary need, and every individual in a society has this need. The need to eat is also frequently renewed, and the satisfaction of the primary need to eat often motivates a new secondary need to eat better or more scarce food. Since these needs are limitless and diverse, there will not be enough food to satisfy every individual’s need. Because this need is tied to the individual’s survival, the scarcity of food creates a much more serious problem compared to the scarcity of cars. The survival of individuals is at stake when the fundamental economic problem is tied to primary needs.

In our first example, we will consider the root causes of the fundamental economic problem.

Example 1: The Fundamental Economic Problem Which of the following are the two root causes of the fundamental economic problem? Scarcity of resources Maximizing profit Social welfare Unlimited human needs Answer In this example, we need to identify the root causes of the fundamental economic problem. Recall that the fundamental economic problem states the following: human needs are diverse and continuously increasing, while resources to satisfy them are limited. The first part of the statement addresses the unlimited and diverse human needs, option IV, while the second part of the statement refers to the scarcity of resources, option I. Hence, the root causes of the fundamental economic problem are the scarcity of resources and unlimited human needs, which are I and IV.

In the previous problem, we identified the scarcity of resources and unlimited human needs as the root causes of the fundamental economic problem. Let us now consider how we, as individuals or as a society, can address the fundamental economic problem.

Definition: Economic Choices Individuals or economic entities can address the fundamental economic problem by making economic choices. The objective of any economic choice is to allocate the limited resources to maximize their utility.

In the definition above, the term utility refers to the total satisfaction derived from the consumption of resources. Hence, when an economic entity, that is, an individual, a firm, or a government, makes economic choices, it considers how to maximize the benefits of the existing resources.

Making economic choices requires the entity to set priorities of different needs so that some will be satisfied before others. For instance, an individual can choose to satisfy the need to tour Italy, or a government can choose to fund the construction of a new school. These are examples of economic choices where an individual or a government decides to satisfy a specific need over others. Since making a choice inevitably means that we are not choosing the other options, we leave other needs unsatisfied when an economic choice is made.

Definition: Opportunity Cost Opportunity costs are the effects or consequences of alternative options in an economic choice. If the effects are financial, which include profits and losses, the opportunity cost, or the cost of foregone options, can be written as a difference between the alternate and chosen options.

The relationship between the fundamental economic problem, economic choices, and opportunity costs are represented in the following diagram.

Opportunity costs are also known as missed opportunities. Let us consider possible opportunity costs of the economic choice to tour Italy. An example of nonfinancial opportunity costs may be the missed opportunity to visit relatives during that time. On the other hand, the cost of travel is a financial opportunity cost, which is measured in terms of the difference between the travel costs incurred by the tour and the savings that could be made by not undertaking the tour. Before making economic choices, the opportunity costs of all available options should be considered in order to maximize the benefit.

In the next example, we will examine the relationship between economic choices and opportunity costs.

Example 2: Economic Choices and Opportunity Costs Which of the following correctly describes the relationship between opportunity costs and choices? Opportunity cost refers to the financial implications of making choices. If two individuals make the same economic choice, the opportunity cost for the two individuals is the same. Every economic choice is accompanied by an opportunity cost. Opportunity cost is always positive. Opportunity cost is always negative. Answer In this example, we need to identify the correct statement regarding the relationship between opportunity costs and choices. Recall that choices are necessary because of the scarcity of resources and that the purpose of an economic choice is to allocate the limited resources to maximize benefits. We also recall that opportunity costs are the effects or consequences of alternative options in an economic choice. Let us consider each option. Option A: This option could be appealing since the word cost has a financial connotation. However, the opportunity cost does not have to be related to financial implications. Instead, it may represent the qualitative effects of foregone options. Hence, this statement is inaccurate. Option B: Let us consider an example of opportunity cost in order to determine whether this statement is accurate. Say that two different individuals make the choice to tour Italy over summer. For one, the opportunity cost could be the missed opportunity to visit relatives, while for the other, the opportunity cost could be the missed opportunity to take courses over the summer to further their education. As this example demonstrates, opportunity costs of the same economic choices could vary between different individuals due to the different availability of alternative options. Hence, this statement is inaccurate. Option C: Opportunity costs are inevitable in economic choices since there are always alternatives to consider. This is a true statement. Options D and E: If the effects are financial, the opportunity cost is written as the difference between the alternate and chosen options. Since it is a difference, the opportunity cost may be positive or negative depending on which quantity is larger. Hence, this statement is inaccurate. Option C is the only accurate description of opportunity costs and choices since every choice is accompanied by opportunity costs.

In the previous example, we considered the relationship between economic choices and opportunity costs. We learned that opportunity costs are widely varied depending on available alternative options. Opportunity costs for financial costs and benefits are often considered more objectively since they can be expressed explicitly as a difference. Qualitative opportunity costs should also be considered, although it is more difficult to remain objective regarding these items.

In the next example, we will identify different opportunity costs associated with a specific economic choice made by a national government.

Example 3: Understanding Opportunity Costs After careful review, a national government decided to fund the construction of a bridge. Alternatives considered were the construction of a new high school and an increase in the wages of government employees. Which of the following is not an opportunity cost for the national government’s choice to fund the construction of the bridge? Improved morale among government employees due to the raise in pay Improvement in the quality of high school education Improved efficiency in traffic due to the new bridge Difference in financial cost between the construction of the bridge and the alternatives considered Answer The national government in this example decided to fund the construction of a bridge, where the alternative options considered were the construction of a new high school and an increase in the wages of government employees. We need to identify which of the given statements does not relate to opportunity costs. Recall that opportunity costs, also known as missed opportunities, are the effects or consequences of alternative options in an economic choice. Let us consider each option. Option A: Improved morale among government employees is an effect we can expect from the alternative option of an increase in the wages of government employees. This can be considered as a possible missed opportunity; hence, it is an example of an opportunity cost associated with the current choice. Option B: Improvement in the quality of high school education is an effect we can expect from the alternative option of the construction of a new high school. This can be considered as a possible missed opportunity; hence, it is an opportunity cost associated with the current choice. Option C: Improved efficiency in traffic is an effect we can expect from the chosen option, which is the construction of a bridge. This is not an example of missed opportunities; hence, it is not an opportunity cost. Option D: Recall that when opportunity costs are financial, they are expressed as the difference between the effects of the alternative and chosen options. Hence, the difference as mentioned here represents a financial opportunity cost associated with the current choice. Option C, which describes the effect of the chosen option, is not an example of opportunity costs.

In the previous examples, we learned about opportunity costs resulting from economic choices. Let us now consider the efficiency of an economic system.

The efficiency of an economic system is measured by the amount of resources wasted during their allocation. An economic system is efficient if few to no resources are wasted. Since the goal of any economic choice is to allocate the limited resources to maximize benefits, good economic choices will lead to an efficient economic system. Other than considering the opportunity costs, what other factors affect the ability for governing entities to make good economic choices?

For a government to make good economic choices, it needs accurate and detailed information about the population it serves. Information can greatly aid economic decision making by reducing wasted resources during their allocation. In other words, the efficiency of an economic system is, for a large part, determined by the ability to obtain accurate and appropriate information when making economic choices. For instance, accurate data on the number of children in different regions of a nation will enable the government to choose the optimal location to build a new school and to satisfy the need for education. Accurate information about the state of poverty will enable the government to deliver available resources where the need is the greatest.

We can also consider the importance of information for individuals and companies. An individual with a need for shelter should have accurate information about available public shelters to efficiently satisfy the need. A company producing goods should have accurate information about how many consumers have the need for the goods it is producing. As we can see, the availability of accurate and appropriate information enables the reduction of wasted resources in economic choices made by individuals or companies.

Conversely, the problem of missing or inaccurate information is known as information failure.

Definition: Information Failure Information failure is the deficiency in available information necessary for making economic choices.

Information failure often leads to bad economic choices, which lead to inefficient economic systems. For instance, inaccurate information about the number of children in different regions of a nation will likely cause the government to choose a site for a new school that is not optimal. This will produce wasted resources both from unnecessary transportation for children to get to school and some families deciding not to use the new school. This is an example of information failure in a government.

Information failure can occur for individuals as well. Incomplete information about harmful effects of certain ingredients may lead individuals to consume unhealthy food, which can worsen their health. This leads to wasted healthcare resources.

In the next example, we will identify an example of information failure.

Example 4: Understanding Information Failure Which of the following is a description of information failure? The government releases inaccurate unemployment numbers, causing the stock market to tumble. A company produces an oversupply of toys due to data from an inaccurate survey. An individual is undecided on which product to use due to too much available information from the Internet. Reporting of unemployment numbers by the government is delayed, causing uncertainties in the stock market. Answer We recall that information failure is the deficiency in available information necessary for making efficient economic choices. Hence, we need to identify which of the given examples are poor economic choices resulting from deficiency in available information. Let us consider each scenario. Option A: In this scenario, the government produced an inaccurate report, which resulted in falling stock prices. While inaccurate information is involved in this scenario, falling stock prices is not an example of bad economic choices. Hence, this is not an example of information failure. Option B: In this scenario, data from an inaccurate survey led a company to overproduce toys. Overproduction of toys is an example of an economic choice that resulted from the survey’s inaccurate information. This is an example of information failure. Option C: In this scenario, too much information has left an individual undecided on a type of product to use. No economic choices have been made by the individual, and the problem is the oversupply of information rather than the deficiency of information. Hence, this is not an example of information failure. Option D: In this scenario, the report of unemployment numbers is delayed, causing uncertainties in the stock market. The deficiency of information at this time has caused the problem, but there are no economic choices involved in this scenario. Hence, this is not an example of information failure. Option B, which describes a company making a bad economic choice based on inaccurate information, is an example of information failure.

We have learned about the fundamental economic problem and its components as well as the effects of economic choices. When only a small number of needs and resources are involved in the fundamental economic problem, the optimal economic choices appear to be within reach. However, economic issues in today’s society are complex and multifaceted. The diversity of human needs and interconnected networks of different economic systems make economic issues very difficult and profound, but they also make this subject interesting and exciting.

Definition: Economics Economics is a social science studying how individuals and societies use scarce resources to satisfy increasing and diverse needs.

In other words, economics seeks to solve the fundamental economic problem. Depending on the types of economic problems considered, economics can be divided into several branches.

In terms of the scale of economic problems considered, the subject is split into micro- and macroeconomics.

Macroeconomics studies economic behaviors of an overall economy or society. Economic choices examined here include the ones made by the national government as well as international organizations. Microeconomics considers economic problems in context of smaller entities, such as individuals or firms. Economic choices studied here concern behaviors of, and interactions between, consumers and producers of resources. The distinction between these two branches of economics is represented in the following diagram.

There are many other subdivisions in economics, which are specialized in the scope of economic problems considered. For instance, welfare economics studies various social welfare models, aiming to design an efficient economic system to deliver available resources to individuals in need. Development economics concerns developing countries and various priorities and strategies for these countries to achieve economic growth over time.

In our final example, we will consider what is studied in microeconomics.

Example 5: Distinguishing Different Fields of Economics Which of the following best describes what is studied in microeconomics? Behaviors of consumers and producers General levels of economic activity Evaluating the efficiency of economic decisions Improving economic and social conditions Answer In this example, we need to identify which phrase best describes the study of microeconomics. Recall that we have encountered several branches of economics: macroeconomics, microeconomics, welfare economics, and development economics. Let us match each subject with the topics in the options. Option A: Behaviors of consumers and producers lead to small-scale economic problems, which are studied in microeconomics. Hence, this option describes what is studied in microeconomics. Option B: General levels of economic activity describe the types and quantities of economic activities in a large population, which lead to large-scale economic problems. We recall that macroeconomics mainly deals with large-scale economic problems at regional, national, or international levels. Hence, this is a topic studied in macroeconomics. Option C: Efficiency of economic decisions involves reducing waste when allocating limited resources. This topic often arises when considering different social welfare models, where resources should be delivered to individuals in need with as little waste as possible. Such problems are studied in welfare economics. Option D: Recall that development economics addresses various priorities and strategies for developing countries to achieve economic growth. This involves improving economic and social conditions of developing countries; hence, this is a topic of development economics. Option A, behaviors of consumers and producers, best describes what is studied in microeconomics.

Let us finish by recapping a few important concepts from this explainer.

Economic system | History, Types, & Facts

Summary

economic system, any of the ways in which humankind has arranged for its material provisioning. One would think that there would be a great variety of such systems, corresponding to the many cultural arrangements that have characterized human society. Surprisingly, that is not the case. Although a wide range of institutions and social customs have been associated with the economic activities of society, only a very small number of basic modes of provisioning can be discovered beneath this variety. Indeed, history has produced but three such kinds of economic systems: those based on the principle of tradition, those centrally planned and organized according to command, and the rather small number, historically speaking, in which the central organizing form is the market.

The very paucity of fundamental modes of economic organization calls attention to a central aspect of the problem of economic “systems”—namely, that the objective to which all economic arrangements must be addressed has itself remained unchanged throughout human history. Simply stated, this unvarying objective is the coordination of the individual activities associated with provisioning—activities that range from providing subsistence foods in hunting and gathering societies to administrative or financial tasks in modern industrial systems. What may be called “the economic problem” is the orchestration of these activities into a coherent social whole—coherent in the sense of providing a social order with the goods or services it requires to ensure its own continuance and to fulfill its perceived historic mission.

Social coordination can in turn be analyzed as two distinct tasks. The first of these is the production of the goods and services needed by the social order, a task that requires the mobilization of society’s resources, including its most valuable, human effort. Of nearly equal importance is the second task, the appropriate distribution of the product (see distribution theory). This distribution not only must provide for the continuance of a society’s labour supply (even slaves had to be fed) but also must accord with the prevailing values of different social orders, all of which favour some recipients of income over others—men over women, aristocrats over commoners, property owners over nonowners, or political party members over nonmembers. In standard textbook treatments, the economic problem of production and distribution is summarized by three questions that all economic systems must answer: what goods and services are to be produced, how goods and services are to be produced and distributed, and for whom the goods and services are to be produced and distributed.

All modes of accomplishing these basic tasks of production and distribution rely on social rewards or penalties of one kind or another. Tradition-based societies depend largely on communal expressions of approval or disapproval. Command systems utilize the open or veiled power of physical coercion or punishment, or the bestowal of wealth or prerogatives. The third mode—the market economy—also brings pressures and incentives to bear, but the stimuli of gain and loss are not usually within the control of any one person or group of persons. Instead, the incentives and pressures emerge from the “workings” of the system itself, and, on closer inspection, those workings turn out to be nothing other than the efforts of individuals to gain financial rewards by supplying the things that others are willing to pay for.

There is a paradoxical aspect to the manner in which the market resolves the economic problem. In contrast to the conformity that guides traditional society or the obedience to superiors that orchestrates command society, behaviour in a market society is mostly self-directed and seems, accordingly, an unlikely means for achieving social integration. Yet, as economists ever since Adam Smith have delighted in pointing out, the clash of self-directed wills in the competitive market environment serves as an essential legal and social precondition for the market system to operate. Thus, the competitive engagement of self-seeking individuals results in the creation of the third, and by all odds the most remarkable, of the three modes of solving the economic problem.

Not surprisingly, these three principal solutions—of tradition, command, and market—are distinguished by the distinct attributes they impart to their respective societies. The coordinative mechanism of tradition, resting as it does on the perpetuation of social roles, is marked by a characteristic changelessness in the societies in which it is dominant. Command systems, on the other hand, are marked by their capacity to mobilize resources and labour in ways far beyond the reach of traditional societies, so that societies with command systems typically boast of large-scale achievements such as the Great Wall of China or the Egyptian pyramids. The third system, that in which the market mechanism plays the role of energizer and coordinator, is in turn marked by a historical attribute that resembles neither the routines of traditional systems nor the grandiose products of command systems. Instead, the market system imparts a galvanic charge to economic life by unleashing competitive, gain-oriented energies. This charge is dramatically illustrated by the trajectory of capitalism, the only social order in which the market mechanism has played a central role. In The Communist Manifesto, published in 1848, Karl Marx and Friedrich Engels wrote that in less than a century the capitalist system had created “more massive and more colossal productive forces than have all preceding generations together.” They also wrote that it was “like the sorcerer, who is no longer able to control the powers of the nether world whom he has called up by his spells.” That creative, revolutionary, and sometimes disruptive capacity of capitalism can be traced in no small degree to the market system that performs its coordinative task. (For discussion of the political and philosophical aspects of capitalism, see liberalism. For discussion of the political and philosophical aspects of communism and socialism, see communism and socialism.)

How to Answer the What, How, and Who Economic Questions

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:

What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?

We briefly discuss each question below.

1. What Goods and Services will be Produced?

How will society decide whether to produce more economics textbooks or more DVD players?

Should we fund more child care facilities or more university places?

To address the problem of declining rainfall, does society build more desalination plants or more dams?

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.