Economic Problem and Resource Allocation

The Economic Problem That Every Society Must Solve

• Societies must answer three basic questions:
  • What goods and services will be produced?
  • How will the goods and services be produced?
  • Who will receive the goods and services produced?

What Goods and Services Will Be Produced?

• Individuals, firms, and governments decide what goods and services to produce.
• Increasing production of one good requires reducing production of another. This is a trade-off due to scarce resources.
• Opportunity cost is the highest-valued alternative forgone when choosing an action.
• For example, funding space exploration might mean forgoing cancer research.

How Will the Goods Be Produced?

• Firms have multiple methods to produce goods and services.
• A music producer might use a great singer with standard techniques or a mediocre singer with Auto-Tune for a comparable sound.
• As labor costs fluctuate, firms may adjust by:
  • Employing more machines and fewer workers (machine-labor tradeoff)
  • Relocating to a place with cheaper labor

Who Will Receive the Goods and Services?

• In the United States, goods and services are usually distributed based on income.
• Tax and welfare policies can redistribute income, though there are differing opinions on the level of redistribution desired.

Terminology in Economics

• Profit: The difference between revenue and costs.

  • Accounting profit: Excludes costs of some economic resources not explicitly paid for.
  • Economic profit: Includes opportunity costs of all resources used by the firm.
  • Economic profit = Total Revenue - (Total Explicit Costs + Total Implicit Costs)

• Household: All individuals residing in a home. They supply factors of production (labor) to firms and demand goods and services from both firms and governments.

• Factors of production: Resources firms use to produce goods and services:

  • Labor: Human effort used in production.
  • Capital: Manufactured goods used to produce other goods and services (e.g., computers, buildings).
  • Natural resources: Land, minerals, energy resources.
  • Entrepreneurial ability: The skill of combining other factors of production to create a business and make a profit.

• Human capital: The accumulated training and skills of workers, enhancing their productivity.

Appendix: Using Graphs and Formulas

• Economic models: Simplified representations of reality, like maps, to understand economic phenomena.

• Graphs of one variable: Bar graphs can display market share data.

• Showing three variables on a graph: A single graph can depict price, quantity demanded, and a shift in demand due to a change in a related good's price.

• Positive and negative relationships:

  • Positive relationship: Two variables increase together.
  • Negative relationship: One variable increases, the other decreases.

• Correlation vs. Causation: Graphs can show correlations, but not necessarily causation.

• Linear and nonlinear relationships:

  • Linear relationships are represented by straight lines.
  • Most economic relationships are nonlinear.

• Slopes of nonlinear curves: The slope of a nonlinear curve can be approximated by measuring the slope as if the section were linear or by using a tangent line to a point.

• Percentage change: (Value in the second period − Value in the first period) / Value in the first period x 100

• Area of a rectangle: Base x Height

  • Represents total revenue in economic graphs.

• Area of a triangle: 1/2 * Base x Height

  • Used in graphs to represent specific economic values.