1. What is the ‘economic problem’?
The fundamental economic problem is related to the issue of scarcity. Scarcity means that resources are limited and short in supply in the world (e.g. diamond). Because of limited resources and unlimited demands, society needs to decide how much to produce and distribute these relatively scarce resources. The basic economic problem can be define as what to produce, how much to produce and for whom to produce. Some countries are lucky to have great natural resources, whilst others do not. For example Africa and South America have little marketable resources. That means there are uneven distributions of resources. Sometimes suppliers have issues with shortage and surplus. A shortage is to do with the relationship between the amount the supplier are willing to supply and the given price in a specific time period. On the other hand, surplus is when an amount (such as an amount of goods) that is more than the amount that is needed. These concepts can be shown in a diagram:
A central concept in Economics is that of opportunity cost. This means if we do one thing, we cannot do another without losing something in the process. Choices have to be made by consumers, businesses and governments because of scarcity. For example, over six million people travel into London each day and they make choices about when to travel, whether to use the bus, the tube, to walk or cycle – or whether to work from home. A Production Possibility Frontier is a curve or a boundary used to show opportunity cost between two or more goods and services that can be produce. It represents the economic concept of choices and opportunity cost as it shows allocation of resources within an economy: The diagram shows that an economy is productively efficient at point A, B and C but an economy is not productively in point X since resources are not being used efficiently in the production of both goods. Point Y represents the goals that the economy cannot attain with its present levels of resources:
Furthermore, each country has different economic system to allocate resources. There’re three kinds of economic system: Planned economy, Free market economy and mixed market economy. 2. How can the price mechanism solve the ‘economic problem’? The benefit of the price mechanism is the invisible hand of price described by Adam Smith. A price mechanism is the system/ concept where the market focus of demand and supply decide the price. The decisions are made by consumers and producers. The price mechanism plays three important functions in a market: Signalling function, rationing function and incentive function. Prices perform a signalling function. They adjust to demonstrate where resources are required, and where they’re not. Which mean prices rise and fall to reflect scarcities and surpluses. If there is excess supply in the market, the price mechanism will help to remove a surplus of a good by allowing the market price to fall.
The second is rationing function. It is whenever resources are particularly scarce, demand exceeds supply and prices are driven up. The effect of such a price rise is to discourage demand and save resources. The greater the scarcity, the higher the price and the more the resource is rationed. This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this discourages demand and leads to more oil being saved than at lower prices. The rationing function of a price rise is related with a contraction of demand along the demand curve.
The third one is incentive function. An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to existing producers to supply more because they provide the possibility or more revenue and increased profits. The incentive function of a price rise is associated with an extension of supply along the existing supply curve....
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