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The Central Economic Problem - Coggle Diagram
The Central Economic Problem
Scarcity
Is the problem arising from limited resources and unlimited wants. That is, it is the excess of human wants over what can actually be produced with limited resources to fulfil these wants
Factors of production
Land
Labour
Capital
Entrepreneurship
Opportunity cost
The value of the next best alternative forgone when a choice is made
Note, opportunity cost is the next highest ranked alternative, not all alternatives summed together
Rational decision-making
one which maximise the self-interest of the economic agent
involves weighing
Marginal (incremental) benefit; against
the (incremental or) additional benefit gained from consuming or producing one more unit of the good/service
Marginal cost (incremental) of any activity
the (incremental or) additional cost incurred from consuming or producing one more unit of the good/service
If marginal benefit exceeds marginal cost, it’s rational to do more of the activity
If MC exceeds MB, it’s rational to do less of the activity
The adjustment process will reach equilibrium when MB = MC
This principle applies to consumers, firms & governments
Self-interest maximising behaviour of diff economic agents
Consumers
Aim to maximise utility / satisfaction
Utility: the benefit / satisfaction consumers receive when they consume a good or service, subject to their budget constraint (amt of money they have to spend)
Rational consumers only consider their
Private costs
Benefits in their decision making
When marginal private utility or marginal private benefit (MPB) is greater than marginal private cost (MPC) from the consumption of an additional unit of gd/service,
Consumer surplus is positive & consumer will increase consumption from Q1 to Qe
If MPC is greater than MPB from the consumption of an additional unit of gd/service,
Consumer will decrease consumption from Q2 to Qe
Consumer will consume up to the unit Qe where MPB=MPC, where
Consumer surplus is maximised (utility is maximised)
Workers
Aim to maximise their welfare at work
Try to get jobs that yield the highest income possible
Choose to work in industries where they’re rewarded the most for the hours of labour they provide and subject to the skills, qualifications & experience they possess
Firms
Aim to maximise profits
Profits: difference btw total revenue from selling goods or services and the total cost of producing them, given their limited resources like labour & capital
If marginal revenue is greater than marginal cost, firm’s profit will increase by producing the additional car
Eg, marginal benefit to a car manufacturer is the additional revenue earned from the sale of one more car to a car retailer *ie, marginal revenue
Marginal cost include the additional labour cost, raw material costs etc of producing one more car
If the additional car adds more to the manu’s revenue than to costs *ie marg revenue is greater than marg cost, the firm’s profit will increase by producing the additional car
Thus, firm will prod to the point where its marginal revenue is equal to its marginal cost to maximise profits
Government
Aim to maximise social welfare, subject to the gov budget constraint
This assumption, however, is debatable
Eg, gov make rational choices when deciding how much to spend on items like national defence / education
Decision making framework
To ensure that the decision made is best given their (eco agents) constraints,
they must factor in:
Cost & benefits of the decision made
Actively consider the info needed and
Diff perspectives of the issue in weighing the costs & benefits
Impact of such decisions is analysed in terms of:
Intended consequences
Unintended consequences
Economic efficiency:
situation where each good is produced at the minimum cost & where individual people & firms get the maximum benefit from their resources
Prod eff
Is achieved when the firms in an economy are producing the maximum output for the given amt of inputs, or producing a given output with the least cost combination of inputs
The economy achieves prod efficiency when all the avail resources are fully employed to cohesive the max output possible
Allocative efficiency: Is achieved when the current combination of goods & services produced & consumed allows the society to attain the greatest level of satisfaction
AE also refers to the allocation of resources such that the combination of goods & services prod maximise the welfare / satisfaction of society
Economy achieves AE when the value consumers place on a good (reflected in the price they’re willing to pay) equals the cost of the resources used up in production of that unit of good
Condition required for allo eff
When price offered for the last unit of a good equals the additional costs incurred in its production, P=MC
If the price consumers are willing to pay is > than the MC of producing an additional unit,
Consumers valuation of the last unit of the good (satisfaction derived from it) is > than the oppo cost of prod it ➔ social welfare’ll still increase by prod more of the gd
If price consumers are willing to pay is < than the MC of prod an additional unit of good,
Consumers valuation of the last unit of the good is < than the opp cost of prod it ➔ welfare’ll increase by prod less of the gd as too many resources have been allocated to that good
Thus, maximum welfare is achieved when the consumers’ valuation of the last unit of the good (P) is equal to the oppo cost of prod the last unit of the good (MC) ie. P=MC
Production possibility curve:
Shows the maximum attainable combination of 2 goods & services that can be produced in an economy, when all the available resources are used fully & efficiently, at a given state of technology
When drawing PPC, we assume that:
The economy only prod 2 goods / services
Production is observed over a specific time period, Eg 1 year
The quantity & quality of the resources used remain the same over a specific time period
Resources are fully employed & efficiently utilised
There is no change in the level of technology
What does the PPC illustrate:
Scarcity
Is illustrated by the unattainable combinations outside the PPC
Can thus be partially (the part on limited resources) illustrated by unattainable combinations that lie outside the PPC e.g. points J, K, L
Constraint
Constrained by its current amount of resources and its current state of technology
The economy can only prod any combination of gds & services that is within / on the PPC
Thus points J, K, L can’t be achieved even if society desires them, because the economy has limited resources
Thus they’re unattainable as PPC’s boundary is max pt
Choice
Illustrated by the fact that society has to choose among the attainable combinations of the 2 goods
The economy can only by producing at one point at any given time
Eg, economy can’t be producing both points - G & H at the same times
Thus there’s a need for the society to choose which production point it wishes to be at
Scarcity can also be partially illustrated by the need to make choices given the unlimited wants
Opportunity cost
Illustrated by the downward (negative) slope of the PPC
When the limited amt of resources have been fully & efficiently employed in the economy, in order to produce more unit(s) of one good, the economy has to produce less of the other good
If concave to origin gets steeper, it shows that there’s increasing opportunity cost
Productive efficiency
Illustrated by production pts D, E, F, G, H, I, where all the available resources are fully & efficiently employed to achieve / produce the maximum output possible
Thus, all points on the PPC are productive efficient
Unemployment & underemployment
Pts inside the PPC - A, B, C are productive inefficient as resources are either:
Unemployed
Situation where not all the avail resources are used in the prod of gds & services (some resources aren’t utilised) or;
Underemployed
Situation where although the resources are engaged in prod/employed, they are operating below their full/potential capacity ie,
Even when all resources are fully used, the resources aren’t efficiently utilised
Thus, the economy isn’t producing the maximum output possible w the given resources
At pt B, it’s possible to use the unemployed / underemployed resources to increase the prod of one good won’t decreasing the prod of the other good
That is, opportunity cost incurred in zero
Eg, movement from pt B to G
Allocative efficiency
Illustrated by one of the pts along the PPC
Diff combination of gds along PPC would yield diff levels of satisfaction, depending on: Tastes & preferences of the society
Production pt that achieves allocative efficiency for the society is
The combination of gds & services that maximise its welfare
It’s possible that diff society may have diff allocative efficiency pts
A society’s allocative efficient prod pt may also change over time as
Taste & preferences change or;
Distribution of income changes
Only 1 productive efficient pt / 1 pt on the PPC (E or F or G or H or I) is allocative efficient
Economic growth & shifts of PPC
Potential eco growth
Known as long-run eco growth
Is defined as an increase in the productive capacity of the economy (ie, the ability of the economy to produce)
Is illustrated by an outward shift of the PPC
Main sources of long run eco growth are
Increases in the quantity of resources
Improvements in the quality of resources
Technological advancement
Actual eco growth
Is related to the concept of short-run growth
Is measured by the percentage annual change in national output actually produced
On PPC diagram, it can be illustrated by
An outward movement from a production pt within the PPC to a production pt closer to or on the PPC
As long as there is an increase in one good wout the fall in the other, it can be considered actual economic growth
AEG occurs w better utilisation of existing resources by reducing unemployment and under-employment.
