Hey there, future economist! Welcome to the very first chapter of your syllabus. This section, The Economic Problem and Methodology, is the absolute foundation of everything you will study in Economics.
We are going to tackle the biggest, most universal problem in the world:
Why can't we have everything we want?
If you understand the concepts of scarcity and choice here, the rest of the course will make much more sense. Don't worry if this seems abstract at first; we will break down the big ideas into simple steps!
3.1.1.1 The Nature and Purpose of Economic Activity
The Central Purpose of Economics
The core goal of all economic activity, whether conducted by individuals, governments, or businesses, is simple:
- To organize the production of goods and services (G&S) in order to satisfy needs and wants.
A need is something essential for survival (e.g., food, shelter, water).
A want is something desirable but not essential (e.g., a luxury car, a holiday, a designer shirt).
The Three Key Economic Decisions
Because satisfying every single want is impossible (as we will see with scarcity), every economy must answer three basic questions:
- What to produce?
(Should we build more hospitals or more rockets?) - How to produce?
(Should we use more machinery (capital-intensive) or more human workers (labour-intensive)?) - Who is to benefit?
(How are the goods and services distributed among the population? This relates directly to economic welfare – how well-off people are.)
Quick Takeaway: The purpose of economic activity is production to meet needs and wants. Economic welfare depends both on what is produced, and critically, who gets it.
3.1.1.2 Economic Resources (Factors of Production)
To produce goods and services, we need resources. Economists classify these resources into four categories, known as the Factors of Production (FOPs).
Memory Aid: C.E.L.L.
- C: Capital
The man-made aids to production (e.g., machinery, factories, roads, computers). Note: Money is *not* capital in Economics, it is just a medium of exchange. - E: Enterprise (or Entrepreneurship)
The willingness and ability to take risks, organise the other three factors, and initiate production (e.g., the person who starts the business). - L: Land
All natural resources (e.g., physical land, forests, mineral deposits, oil, water). - L: Labour
The human input into the production process (e.g., the workers, their skills, and their effort).
The Environment and Resource Scarcity
The natural environment is vital because it provides resources (Land) and absorbs waste. Resources can be:
- Renewable Resources: Can be replenished naturally within a lifetime (e.g., timber if replanted, solar energy).
- Non-Renewable Resources: Are used up faster than they can be replaced (e.g., oil, coal, natural gas).
The key point here is that the environment is a scarce resource. Our economic activities (production and consumption) can negatively affect the environment, reducing its availability and quality for future generations (e.g., pollution, deforestation).
Key Takeaway: All production requires the four Factors of Production (Land, Labour, Capital, Enterprise). The environment is a crucial, scarce resource that economic activity can damage.
3.1.1.3 Scarcity, Choice and Allocation of Resources
The Fundamental Economic Problem: Scarcity
The central challenge that gives rise to the entire field of Economics is scarcity. It is caused by the combination of two facts:
1. Limited Resources: We only have a finite amount of FOPs (Land, Labour, Capital, Enterprise).
2. Unlimited Wants: Human wants are infinite; as soon as one is satisfied, new ones appear (the ‘more, better’ mentality).
Scarcity = Limited Resources + Unlimited Wants.
The Consequence: Choice and Opportunity Cost
Because resources are scarce, we cannot satisfy all wants. This forces us to make choices.
If we choose to produce Product A, we must sacrifice the resources that could have been used to produce Product B. This sacrificed alternative is the opportunity cost.
Opportunity Cost: The cost of the next best alternative forgone (given up) when a choice is made.
Example: You have enough money to buy either a new phone or a gaming console. If you choose the console, the opportunity cost is the new phone you gave up.
Resource Allocation Systems
The fundamental problem of scarcity means societies must decide how resources are allocated (distributed) between different uses. We look at three main types of economic systems:
- 1. Free Market Economy (Capitalism):
Resources are allocated primarily by the price mechanism (supply and demand). Individuals and private firms own most resources and make the key decisions. Government intervention is minimal. - 2. Centrally Planned Economy (Command Economy):
Resources are allocated by the government, which makes all the key economic decisions (What, How, For Whom). State ownership is dominant. - 3. Mixed Economy:
A combination of the above. Some resources are allocated by the market (private sector), and some are allocated by the government (public sector). Most modern economies (including the UK and China) are mixed economies.
Did you know? Understanding how markets and governments affect resource allocation is a core skill for any economist.
Key Takeaway: Scarcity forces choice, and choice always involves an Opportunity Cost (the next best thing you miss out on). How a society allocates resources depends on its economic system (market, planned, or mixed).
3.1.1.4 Production Possibility Diagrams (PPDs)
What is a PPD?
A Production Possibility Diagram (PPD), also called a Production Possibility Frontier (PPF), illustrates the maximum possible output combinations of two goods or services that an economy can achieve when all its resources are fully and efficiently employed.
Let’s imagine an economy can only produce two things: Cars (Capital Goods) and Food (Consumer Goods).
What the PPD Illustrates:
- 1. Trade-offs and Opportunity Cost: Moving along the PPD boundary means producing more of one good requires sacrificing some of the other. This sacrifice is the opportunity cost.
- 2. Resource Allocation: Any point on the curve represents a specific distribution of resources between the production of Cars and Food.
- 3. Unemployment/Inefficiency: Any point inside the boundary (like point X) means resources are being used inefficiently or are unemployed (e.g., workers are laid off, factories are idle).
- 4. Economic Growth: An outward shift of the entire boundary occurs when the economy’s productive capacity increases (e.g., due to new technology or more resources).
Efficiency on the PPD
We use two types of efficiency:
- Productive Efficiency:
This occurs when production takes place at the lowest possible cost, meaning no more output can be produced from the given inputs.
On a PPD, any point on the boundary is productively efficient. - Allocative Efficiency:
This occurs when resources are allocated in a way that maximises satisfaction for society, meaning we are producing the specific combination of goods that people want most.
Not all points on the PPD boundary are allocatively efficient—only the single best point that matches society's wants.
Common Mistake Alert: Remember, if an economy is producing *on* the curve, it is productively efficient, but if people hate the goods being produced, it’s still allocatively inefficient.
Key Takeaway: The PPD is a powerful tool illustrating scarcity, choice, opportunity cost, and the two types of efficiency (Productive and Allocative).
3.1.1.5 Economic Methodology
Economics as a Social Science
Economics is classified as a social science because it studies human behaviour and society's use of resources. This means its methodology (the way it studies things) has both similarities and differences compared to natural sciences (like Physics or Chemistry).
- Similarities: Economists use scientific methods, creating models, testing hypotheses using data, and attempting to establish general laws (like the law of demand).
- Differences: It is impossible to run controlled laboratory experiments on a national economy. Economic outcomes are influenced by unpredictable human psychology, politics, and culture, making accurate predictions difficult.
Positive and Normative Statements
This is a fundamental distinction in methodology. It determines whether a statement is objective fact or subjective opinion.
- Positive Statement:
A statement that is objective and can be tested, proven, or disproven by referring to evidence/data.
Example: "Raising the minimum wage by 10% will cause unemployment to increase." (This can be tested.) - Normative Statement:
A statement that is subjective and contains a value judgement (an opinion). It often includes words like "ought," "should," "better," or "unfair."
Example: "The government should raise the minimum wage to improve fairness." (This is an opinion about what is morally right.)
Memory Trick: Think Positive = Provable. Think Normative = Not provable (an opinion).
The Influence of Value Judgements
Economic policy decisions are never purely based on positive statements (facts). They are always influenced by value judgements.
- Policy Making: When governments decide whether to build a new road (What to produce) or increase taxes (Who benefits), they look at the positive consequences (the facts and predicted outcomes, e.g., this road will increase GDP by X%).
- But: The final decision is also heavily influenced by moral and political judgements (e.g., Is it fair to tax the rich more? Is it better for the environment?). These are normative considerations.
Key Takeaway: Economists aim for positive (provable, objective) analysis, but policy decisions inevitably involve normative (opinion-based, subjective) value judgements.