The Fundemental Economic Problem

An economy and the central purpose of economic activity is to produce goods and services to provide what we need and want.

There are infinite wants and yet limited resources. As resources are scarce we must decide on the best way to allocate them to get maximum benefit. Each choice carries with it a cost. This is called the opportunity cost .

Opportunity Cost

For example, if a farmer decides to grow carrots his or her opportunity cost is the alternative crops and commodities that could have been grown instead (e.g. wheat, potatoes or cabbages).

Economic Resources

1) Land (minerals and the land itself e.g. forestry) Reward = Rent

2) Labour (Potential work force, not just physical people but also skills) Reward = Wage

3) Capital (Equipment used to make goods and services e.g. a hammer) Reward: Interest

4) Enterprise (Risk takers who bring together factors of production) Reward = Profit

Economic Objectives

The economic objectives of individuals, firms and government:

In an economy we assume each agent (person) tends to act in their own interest

Consumers

Their objective is to maximise their own well-being or economic welfare. Economic theory is based on the idea of the rational (sensible) consumers, who make decisions based on attempting to maximise their welfare.


Workers

We assume workers want to maximise their gains from working. They typically want higher wages, better working conditions and job security.


Firms

We assume firms’ objective is to maximise profits.


Government

We assume that the government represents the people and therefore acts in their best interest. However the interests of some are not always the same as others.

Functions of Price

Prices have three main functions:

1) Incentive function

An incentive motivates an agent to pursue a course of action or to change their behvaiour. For example higher price incentivises producers to supply more goods to the market.


2) Signalling function

Prices have a signalling function - they change according to when resources are needed and when they are not. For example if prices are falling due to low demand from consumers this signals to suppliers to produce less.


3) Rationing function

The rationing function serves to ration scarce resources when demand does not equal supply. For example when demand is greater than supply and there is excess demand, the price goes up.

Normative and Positive statements

Normative: Opinions that require a value judgement to be made

Value Judgement: Statements or opinions that are not testable

Positive: Statements that can be tested