The Fundamental
Economic Problem
What is Economics?
• Economics is the study of how we
make decisions in a world where
resources are limited.
• It is sometimes called the science
of decision making.
Needs vs. Wants
•Needs are things we
need for survival, such as
food, clothing, and
shelter.
•Wants are things we
would like to have.
What is the Fundamental Economic
Problem?
• The fundamental economic problem is
scarcity—we do not have enough
resources to produce all the things we
would like to have.
• Because of scarcity, we must make
choices among alternatives.
The Three Basic Economic
Questions that
Society Must Answer
What to Produce?
• Society must decide what to produce with its
limited resources.
• Basic Needs- food, clothing and shelter
• Problems in Modern Societies-
- How many resources do we devote to national
defense, education, public health, welfare,
consumer goods?
- What consumer goods should we
produce?
How to Produce?
•Society must decide how to produce.
•Although there are countless ways to create all the
things we want and need, all require land, labor and
capital.
•The factors of production can be combined in
different ways.
•Should we produce electricity with oil, solar power,
nuclear, water or coal?
For Whom to Produce?
• Society must decide for whom to produce. Who
will receive the goods and services?
• How do we distribute abundance?
• Who get to buy a luxury car and who can’t afford one?
Economic Models
• To study a part of the economy, economists use
economic models.
• These are simplified representations of the real
world, based on economic theories.
• Business and government often base decisions
on solutions that emerge from testing economic
models.
• The circular flow diagram is a model and as
such it is a simplification of economic reality
which shows only two sectors in the
economy.
• (i)Household and (ii) Firm
Households consist of individuals or groups of
people living together and firms are
organizations involved in the production of
goods and services.
We will assume that the goal of firms is to
maximize profits which means they
benefit from high prices.
On the other hand households have only
limited incomes for which they benefit
from low prices.
• So, markets are important co-ordinating
mechanisms to reconcile these conflicting
goals.
• There are two basic kinds of markets in the
economy: factor or input market which
means the market for inputs – land, labour,
capital and organization; and product
or
• output market which means the market for
goods and services.
• This circular flow diagram illustrates the
flow of income and expenditure in a two
sector economy.
• Households own the factors of production
and supply them in the factor market to earn
income in the form of rent, wage, interest and
profit and this income is used to buy goods
and services from the product market.
• On the other hand, firms buy these factors of
production for producing goods and services
to supply in the product market.
• Thus factor payments are determined by the
interaction of supply and demand of each
factor in the factor market.
• Similarly the price of goods and services is
determined by the interaction of supply and
demand of each good and service in the
product market.
• So the circular flow diagram shows the flow
of goods and services from producers to
households and the flow of factors of
production from households to business
farms.
Factors of Production
• 1. Land
• 2. Labour
• 3. Capital
• 4. Organization
• Land: All the gifts of nature that we use to
produce goods.
• Labour: The physical and mental effort people
use to produce goods and services.
Capital: The equipment, buildings, tools and
manufactured goods that we use to produce other
goods.
• Organization:Taking a risk to make a profit.
Goal- combination of the 3 other factors of
production to create something of value to make a
financial gain or profit