Topic Three

Basic or Central Economic Problem and Resources Allocations

2.1 Meaning and nature of economic problems

There is no single individual or country in the whole world that can satisfy all his wants. This shows
that wants are unlimited and means (resources) are limited. Thus, this scarcity of means in relation to
wants brings forth before us the problem that how much resources should be used in satisfying different
wants. In this way, one has to choose certain set of wants from among unlimited wants, which are to be
satisfied by his limited resources. In Economics, this very problem of choice making is called economic
problem. Explaining it Prof. Friedmen has also said that whenever limited resources are used to satisfy
different ends, economic problem arises. According to Prof. Eric Roll, ‘‘the economic problem is
essentially a problem arising from the necessity of choice; choice of the manner in which limited
resources with the alternative uses are disposed of. It is the problem of husbandry of resources’’. In
brief, the problem of choice making arising out of limited means and unlimited wants is called
economic problem.
2.2 Why do Economic Problems Arise?
The basic economic problem arises because resources are scarce, but human wants are unlimited.
Economic problems arise due to following facts of economic life:
A. Unlimited wants: Human wants are unlimited. As we satisfy one want, many more new wants
come up. Besides this, one cannot satisfy even one particular want for all times to come. As we
fulfil a particular want at a particular time, after a certain time it crops up again. This is why, it is
said that wants are not only unlimited but they are recurring in nature also. Similarly, with the
development of education, knowledge, scientific advancement and economic growth wants go on
increasing.
B. Different priorities: All wants are not equally important. Some are more important and some are
less important. So, a man can satisfy his different wants in order of his priorities.
C. Limited means: If means would have also been unlimited to satisfy unlimited wants, there would
have been no economic problem. The reality of the life is different i.e., the existing supply of
resources is inadequate in relation to the known desires of individuals. This gives rise to the
problem of scarcity which is the basis of all economic problems.
D. Means having alternative uses: Means are not only limited but they can also be used for different
alternative uses. For example, wood may be used for fuel, furniture, house construction and many
other uses.

In summary, it is necessary to make efforts to make adjustments between limited means having
alternative uses and unlimited wants having different priorities. This gives rise to the problem of
 choice. It means that we have to choose, which wants should be satisfied and in what quantity. In a
nutshell, we can say that multiplicity of wants and scarcity of means are the two foundation stones of
Economics. This is why, it is said that scarcity is the mother of all economic problems.
2.3 Basic or Central Problems of Economy
Human wants are unlimited but resources to meet these wants are limited and scarce. These
resources can also be put to alternative uses. Satisfaction of unlimited wants with limited means creates
problem of choice making. In every economy, economic resources are limited, whereas demands are
unlimited. This is why, every economy has to face and solve the following basic problems:

A. Allocation of resources: Since the resources are limited in relation to the unlimited wants of
human. The available resources of the society may be used to produce various commodities for
different groups and in different manners. Any individual, organization or nation has to make three
fundamental types of choices about how to allocate the scarce resources available to it. It has to
decide on the following:
1. What to produce? (Types and amount of commodities to be produced)
The resources such as land, labour, capital, machines, tools, equipment and natural means are
limited. Every demand of every individual in the economy cannot be satisfied, so the society has
to decide what commodities are to be produced and to what extent. Goods produced in an
economy can be classified as consumer goods and producer goods. It is fundamental to every
economic system that if we produce one commodity, it will mean that we are neglecting the
production of the other commodity. In free enterprise economies, most decisions concerning the
allocation of resources are made through the price system.
2. How to produce? (Problem of the selection of the technique of production-choice between
labour-intensive and capital-intensive techniques)
After the decision regarding what to produce has been settled, the next problem arises as to what
techniques should be adopted to produce commodity. Goods can be produced with either a
labour-intensive or capital-intensive system of production. The economy has to decide about the
technique of production on the basis of the cost of labour and capital. The questions related to
factor intensity in production are answered under the “Theory of production”.
3. For whom to produce? (Problem of distribution of income)
This has to do with how goods and services produced are shared among individuals and groups
in the economy. The individuals may belong to economically weaker sections or rich class of
people. Actually, this is a problem of distribution. Answers to such questions on for whom to
produce are found under the “Theory of Distribution”.
 4. Fuller Utilization/Employment of Resources (Efficient use)
Having realized that the means and resources are limited and scarce, ensuring proper utilization of them
is essential. So they can be properly used. There should not be the wastage of these resources. The
problem with the economy is how to use its available resources i.e., land, labour, capital and other
resources, so that maximum production with minimum efforts and wastages be made possible.
Economic development will suffer, if certain resources remain idle. Since 1930’s after the great world
depression we have started thinking of fuller utilization of limited resources. It has been accepted that
the under-utilization or unemployment of resources is a waste, so the economy must ensure that the
available resources are efficiently and effectively utilized. Problems regarding fuller utilization of
resources and efficiency are studied under “Welfare Economics”.

5. Economic Growth
Is the economy’s capacity to produce goods and services growing from year to year or is it remaining
static? These questions have to do with economic growth. They are questions that have attracted the
attention of economists for several years and are problems studied under the “Theory of Economic
Growth”
Economic System and Resources Allocation under Different System

Limited Resources Unlimited Wants

Scarcity

We Must Make Choice About

1. What to Produce?
2. How to Produce?
3. For whom to Produce?

Economic System
The Choices We Make Will Be Determined By

Centrally Planned Economy Mixed Economy Market Economy

2.4 Economic System
Economic system is the mode of production and distribution of goods and service within which
economic activity takes place. In a broader sense, it refers to the way different economic elements
(individual workers and managers, productive organizations such as factories or firms, and government
agencies) are linked together to form an organic whole. The term also refers to how the different
economic elements will solve the central problems of an economy: what, how, and for whom to produce.
Having discussed what economic system is, we now explain different economic system we have.

1. Centrally Planned Economy (Socialism)

Centrally planned economy (also known as Command economy or socialism) is an economic
system in which the means of production are owned and regulated by the state. So, command
economy is one where all economic decisions are made by the government. The government decides
what to produce, how it is to be produced and how it is to be allocated to consumers. This involves a
great deal of planning. Planned economies tend to be run by governments who, in theory at least, want
to see greater economic equality among consumers. By state planning, goods and services can be
produced to satisfy the needs of all the citizens of a country, not just those who have the money to pay
for goods.
Socialism is more in theory than reality. Rather we assume places or countries where government
participation in business is more pronounced or noticed. Socialism is practiced by second world
countries like former Soviet Union (Russia), Poland, Romania, Hungary, China etc. However, China
is a perfect example of a country that practices socialism. State (government) owns all means of
production. Individuals are not permitted to own any property. Government + government
planners make choices about What, How and For whom to produce.
- What to produce is answered by government planners, they make assumptions about consumers` needs
and the mix of goods and services
- How to produce is answered by the government planners according the input-output analysis.
- For whom to produce – for consumers through state outlets. Prices can’t change without state
instructions. (Restrictions)
Roles of government
1. Government makes the most economic decisions with those on top of the
hierarchy giving economic commands to those further down the ladder.
2. Government plans, organizes and coordinates the whole production process in
most industries.
3. Government is the employer of most workers and tells them how to do their jobs.
Advantages:
- There is more equal distribution of wealth and income.
- Production is for need rather than profit.
- Long-term plans can be made taking into account a range of future needs such as
population changes and the environment.
Disadvantages:
- Vast bureaucracies employing – supervisors, coordinators
- People are poorly motivated
- Planners often get things wrong – shortages of surpluses of some goods
- Poor standard of living
2. Market Economy (Capitalism):
Capitalism is also a political and economic ideology which has its origination from America
(USA). It is the direct opposite of Socialism. Capitalism is also known as Laissez Faire Economy or Free
market or Capitalist State. This is an economic system in which each individual in his capacity as a
consumer, producer and resources owner is engaged in economic activity with a large measure of
economic freedom. All factors of production are privately owned and managed by individuals. It is also
called free-market economy and is the system where decisions are made through the market (price)
mechanism. The forces of demand and supply, without any government interference, determine how
resources are allocated. What to produce is decided upon by the level of profitability for a particular
product. How production should be organized is equally determined by what is most profitable. Firms are
encouraged through the market mechanism to adopt the most efficient methods of production. For whom
production should take place, production is allocated to those who can afford to pay. Consumers with no
money cannot afford to buy anything.
One unique feature of capitalism is price mechanism. Price mechanism is also known as price system. It is
defined as the allocation of scare resources through the determination of market forces or the invisible
hand (demand and supply).
Capitalism causes social imbalance because it encourages private acquisition of wealth, so the few
get richer and the many poor get poorer. Capitalism is gradually becoming a global trend. Even Nigerian
is gradually becoming a capitalist state (partially with the presence of privatization). However, USA is a
perfect example of countries that practices capitalism. Others are Britain, Germany, France, Canada etc.
 Private firms or individuals own means of production. They make choices about: what to
produce, how to produce, and for whom to produce.
- What to produce is answered by consumers according their demand for goods & services
- How to produce is answered by the businessmen. They will choose the production method, which
reduces their costs to reach the higher profit.
- For whom to produce – firms produce goods & services which consumers are willing and able to buy.
Roles of government
1. To pass laws to protect businessmen & consumers
2. To issue money
3. To provide certain services – police
4. To prevent firms from dominating the market and to restrict the power of trade unions
5. Repair and maintain state properties
Advantages:
- Goods and services go where they are most in demand and free market responds quickly to people’s
wants plus wide variety of goods and services.
- No need for an overriding authority to determine allocation of goods and services.
- Producers and consumers are free to make changes to suit their aims.
- Competition and the opportunity to make large profits, greater efficiency, innovation
Disadvantages:
- It mis-allocates resources (to those with more income)
- It creates inequality of incomes
- It is not competent in providing certain services
- It leads to inefficiency (market imperfection)
- It can encourage the consumption of harmful goods - drugs
There are no pure free market economies or pure command economies. Because of: command economies
are impossible to regulate all markets; while free market economies can’t provide public goods (defence)
and can’t provide merit goods in sufficient quantity.
3. Mixed Economy: It is the last of the three economic systems. It has elements of socialism and
capitalism embodied in one. Most economists also call it WELFARE economy. It is an economic system
where what, how and for whom to produce, means of production and distribution are jointly determined
by government and individuals as well as firms. In essence, this is an economic system where the price
mechanism and economic planning are used side by side. So, virtually all the features of both capitalist
and socialist economies are present in mixed economic system. It is a mixture of a pure free-enterprise
market economy and a pure command economy. The ownership of means of production and distribution
are collectively owned and managed by both private and public enterprises. Some resources are allocated
via the market mechanism and some via the state. Countries such as Nigeria, India, e. t. c. practice mixed
economy. Decisions as touching what to produce? How to produce? And for whom to produce? Are taken
by both the state and private enterprises.
In a nutshell, the private sectors (firms and individuals) and the public sector (government and its
agencies) determine what how and for whom to produce. Nigeria and a host of other African and third
world countries practice mixed economy; besides, all Western European countries.
Public Sector – is responsible for the supply of public goods & services and merit goods. These goods
are provided free when used and are paid by taxes e.g., roads, healthcare, street lighting. The central or
local government makes decisions regarding resource allocation in the public sector. In public sector, the
state owns a significant proportion of production factors.
Private Sector – firms in response to the demand or consumers’ needs and wants make production
decisions. In the private sector individuals are allowed to own the factor of production. Businesses are set
up in this system by individuals to supply a wide variety of goods and services. Competition exists
between these firms.
The Role of Government in a Market (Mixed) Economy
There are various opinions of various economic thoughts about the role of government interventions.
Governments are generally argued to have four main macroeconomic goals:
- to maintain full employment
- to ensure price stability
- to achieve high level of economic growth
- to keep exports and imports in balance
2.5 Production Possibility Frontier (Curve)
Production possibility curve or frontier is an analytical tool which is used to illustrate and explain
the problem of choice in economics. It can also be referred to as “product transformation curve” or
“production possibility boundary”. Specifically, it is defined as a graphical representation that shows the
various combinations of amounts of two commodities that an economy can produce per unit of time using
its existing resources to full extent and in the most efficient way. Likewise, Production Possibilities
Frontier (PPF) refers to graphical illustration of the various maximum combinations of goods and services
that an economy can produce efficiently using its available resources and technology within a given
period of time. It explains the boundary between the goods and services that can be produced from those
that cannot.
2.5.1 The Basic Assumptions of Production Possibility Frontier
The production possibility curve is based on the following key assumptions

1. Only two goods are produced in different proportions in the economy

 2. The supplies of resources are fixed. The same limited resources can be re-allocated for the
production of the two goods within limits.
3. The same resources can be used to produce either or both of the two goods and can be shifted
freely between them.
4. The production techniques are given and constant.
5. Full employment of resources. The economy’s resources are fully employed and technically
efficient
6. The time period is short

Note: These assumptions are to allow the use of simple graphical analysis. Note that these assumptions
are realistic for the short run but not for the long run.

2.5.2 The Roles of Production Possibility Frontier

The PPF is a fundamental tool in the hand of economists to perform some critical roles in an attempt to
illustrate the concepts such as scarcity, allocation of resources, choice and opportunity cost, efficiency and
economic growth. The roles are as follows:

1. It explains, with a model, the concepts of marginal cost and marginal benefit,
2. It explains the concept of efficiency (both in production and allocation),
3. It explains how to expand production by accumulating capital (resources) and improving
technology with a view to break the existing limits.
4. It also helps in explaining economic problem of allocating resources (making choices) in a
situation of scarcity.

The example of production possibility frontier or curve is presented in Figure 1 below.

Figure 1: Example of Production Possibility Frontier for Food and Machine

The PPF curve divides production space into 3 distinct areas which are as follows:

1. Points on the PPF curve (points like A, B, C, D, E, and F),

2. Points on the inside of the curve (points like X); and
3. Points outside the curve (points like Y)
 Points either on or inside the frontier are ATTAINABLE with the current level of resources and
technology
 Points outside the frontier are unattainable with the economy's current level of resources and
technology. We need more than the available resources and technology to reach there.
 Because scarcity forces the society to give up one choice for another, the slope of the PPF will
always be negative, reflecting the concept of trade off.
 Point A shows that all resources are devoted to produce machines and no resources are available to
produce food.
 Point F shows that all resources are devoted to produce food and no resources are available to
produce machine.
 Points (A, B, C, D, E and F) on the PPF represent the maximum production (output) we can get
when all resources are fully employed.
2.5.2 The Roles of Production Possibility Frontier
A. Full Employment and Unemployment
The PPF can be used to analyze and explain employment situation in production processes.
1. From the assumptions stated earlier, all resources must be fully employed in order for the
economy to be operating on the PPF.
2. If all available resources are not used (i.e., unemployment of some of the resources), country ends
up inside its PPF, producing less output than they could have produced.
3. A reduction in unemployment moves the economy’s point of production closer to the PPF. When
the society is closer to the PPF that means it is closer to full employment.
B. Efficiency and Inefficiency
All of the choices on PPF are efficient although they are not equally desirable.
 Efficiency means
1. Producing the maximum output from the available resources used in production.
2. The use of the least-cost methods to produce specific quantity of output.
3. Using the fewest resources to produce specific quantity of a good or a service
4. Using factors of production in the most productive way.
All points on the PPF are efficient points. We achieve production efficiency if we cannot produce more
of one good without producing less of some other good.
 With inefficient production, we end up on the inside of the PPF
1. Inefficiency is a result of some unemployed (unused) resources or misallocation (waste, under-
use) of the resources, or both. Misallocation means assigning resources not to their best use.
2. Point X in the graph above means that the country's resources are not being used efficiently. At
such a point it is possible to produce more of one good without producing less of the other good.
C. Trade-off
Operating on the PPF shows that one good has to be sacrificed in order to have more of the other
1. Every choice along the PPF involves a tradeoff. Changes in production from one point on the
PPF to another involve a tradeoff. Some of one good must be forgone (given up) to gain more of
the other good.
2. On this PPF, we must give up some machines to get more food or give up some food to get more
machines. Thus, PPF has a negative slope. Thus, a country that must decrease production of one
good in order to increase the production of another must be producing on its PPF
3. There is no tradeoff when production points are inside the PPF because it is possible to get more
both goods without producing less of some other goods and services.
4. All tradeoffs along the PPF involve a cost – an opportunity cost.
D. Opportunity Cost
The opportunity cost of any action or choice made is the highest value of the alternative forgone. The
concept of opportunity cost could be made more precise using the PPF. All points (A, B, C, D, E and F)
on the PPF involve opportunity cost; this is because to produce more of Food, you need to produce less of
Machine. The opportunity cost is calculated as follows:
quantities of the good youmust giveup
Opportunity cost of producing one more unit =
quantities of the good you will get

∆ Food
Opportunity cost of producing one more unit of machines=
∆ Machine

∆ Machine
Opportunity cost of producing one more unit of food=
∆ Food

The slope of PPF depends on the concept of this opportunity. The slope of the production–possibility
frontier (PPF) at any given point is called the marginal rate of transformation (MRT). The slope defines
the rate at which production of one good can be redirected (by reallocation of productive resources) into
production of the other. It is also called the (marginal) "opportunity cost" of a commodity, that is, it is the
opportunity cost of Food in terms of Machine. It measures how much of Food is given up for one more
unit of Machine or vice versa. The slope of PPF relies on the opportunity cost of one good in term of
another. This opportunity cost by nature can be increasing, decreasing or constant; it all depends on the
shape of the PPF.

1. If the PPF is concave to origin (see Figure 1 for example); the opportunity cost will be increasing.

2. If the PPF is convex to origin; the opportunity cost will be decreasing.

3. If the PPF is a straight line, the opportunity cost will be constant as production of different goods
is changing.
Production Efficiency and Allocative Efficiency

1. All points (A, B, C, D, E and F) on the PPF represent production efficiency. Production
efficiency occurs when we cannot produce more of one good without giving up some of the other
good. But which point on the PPF gives the society the best allocation of resources on both goods
(i.e., which point has allocative efficiency)?
2. To determine the optimal (efficient) quantities of each good the society should produce, we should
compare marginal costs and marginal benefits. Allocative efficiency exists when marginal benefit
is equal to marginal cost.
3. It is of great importance to know that both Production efficiency and Allocative efficiency are
attained only when where marginal benefit of producing the two goods is equal to the marginal
cost of producing them.

2.6 Economic Growth

All output combinations outside the PPF are unattainable with the available resources and technology. At
these combinations, we could get more goods and services than what we are currently capable of
producing. To attain these combinations, the two key factors are
1. Capital accumulation is the growth of capital resources, which includes human capital
(increasing or improving the quality of resources)
2. Technological change (Improvement) is the development of new goods and of better ways of
producing goods and services.
Any of these changes will shift PPF outward to reach new points that is unattainable before the changes.
The new PPF would represent the new efficient allocation of resources and the country now has more of
its goods and services. This is what is called economic growth (or an increase in production capacity).
However, it to be noted that this economic growth can be balanced or unbalanced.

Balanced and Imbalanced Growth

If the capital accumulation and /or the advancement in the technology result in an increase in the
production in all sectors (that is the production of both Food and Machine as example) there will be a
balanced outward shift of the PPF (balanced economic growth).
 But if there is an increase in the resources and/or new advancement in the technology that lead to a
development of only one sector or one good the growth would be imbalanced. For example if a new
technology discovered that makes machine production more efficient and more productive the PPF
outward shift will affect only machine sector and will not affect the food sector, at least in the short run.
Inward Shift
When the PPF shifts outward, we know the economy is growing. Alternatively, when the PPF shifts
inward, it indicates that the economy is shrinking as a result of a decline in its most efficient allocation of
resources and optimal production capability. A shrinking economy could be a result of war or natural
disaster that results in a decrease in production or a deficiency in technology which might move the PPF
inward and to the left.
An Important Hint on Production Possibility Curve
It is very important to know that only points on or within a production possibility curve are actually
possible to achieve in the short run but the point outside the PPC is only achievable in the long-run. In the
long run, if technology improves or if the supply of factors of production increases, the economy's
capacity to produce both goods increases; if this potential is realized, economic growth occurs. That
increase is shown by a shift of the production-possibility frontier to the right.