The Economic Problem

Needs vs. Wants

To find out the answer to our question, let's first try to classify human desires into needs vs. wants. A need is defined as something necessary for survival. It may sound vague, but essential clothing, shelter, and food are usually classified as needs. Everyone needs these basic things to survive. It's that simple! What are wants then? A want is something that we would like to have, but our survival does not depend on it. You may want to have expensive filet mignon for dinner at least once, but it is definitely beyond what would be considered a necessity.

Three Basic Economic Questions

What are the three basic economic questions?

• The three basic economic questions:
• What to produce?
• How to produce?
• For whom to produce?

What do they have to do with the fundamental economic problem? Well, these questions provide a basic framework for allocating scarce resources. You may think, wait a minute, I scrolled all the way here to find some answers, not more questions!

Bear with us and look at Figure 1 below to see how our wants are connected to the three basic economic questions.

Now let's discuss each of these questions in turn.

The Economic Problem: What to produce?

This is the first question that needs to be answered if society is to allocate its resources efficiently. Of course, no society can sustain itself if all the resources are spent on defense, and none are spent on food production. This first and foremost question helps to identify a set of things that society needs to sustain itself in balance.

The Economic Problem: How to produce?

How should the factors of production be allocated to produce the required things? What would be the efficient way to make food, and what would be the efficient way to make cars? How much labor force is there in a community? How would these choices impact the affordability of the final product? All these questions are densely combined in one question - how to produce?

The Economic Problem: For whom to produce?

Last but not least, the question of who will be the final user of the things made is important. The choices made when answering the first of the three questions mean that the scarce resources were used to create a set of particular products. This implies that there may not be enough of one specific thing for everyone. Imagine a lot of resources were allocated for food production. This means that not everyone in that society can have a car.

The Economic Problem and the Factors of Production

Now, you may be wondering, what exactly constitutes these scarce resources we are trying to use to produce the things we need? Well, economists refer to them as factors of production. In simple terms, factors of production are the inputs used in the production process.

There are four factors of production, which are:

1. Land
2. Labor
3. Capital
4. Entrepreneurship

Figure 2 below shows an overview of the four factors of production.

Fig. 3 - The four factors of production

Let's briefly go over each of them in turn!

Land is arguably the densest factor of production. It contains the land for agricultural or building purposes, or mining, for example. Land, however, also includes all natural resources such as oil and gas, air, water, and even wind.Labor is a factor of production that refers to people and their work. When someone is employed producing a good or a service, their labor is an input into the production process. All the jobs and professions you can think about are classified as labor, from miners to cooks, to lawyers, to writers.Capital as a factor of production includes items like machinery, equipment, and tools utilized to produce the final good or service. Do not confuse it with financial capital - money used to finance a particular project or a venture. The caveat with this factor of production is that it has to be manufactured before it can be used as an input into the production process.

Entrepreneurship is a factor of production as well! It is distinguished from the other factors of production because of three things:

1. It involves the risk of losing money that the entrepreneur invests into the project.
2. Entrepreneurship itself can create opportunities for more labor to be employed.
3. An entrepreneur organizes the other factors of production in a way that would yield the most optimal production process.

We know that by this point, you have probably lost all hope of finding the answer to the questions of resource allocation posed above. The truth is, the answer is not that simple. To put it short, you have to study economics as a whole to be able to answer these questions, at least partially. Economic models like the most straightforward supply and demand model to the complex models of aggregate investment and saving all contribute to solving the problems of scarce resource allocation.

The Economic Problem Examples

Let's go over three examples of the fundamental economic problem:

• time allocation;
• budget allocation;
• human resource allocation.

The Economic Problem of Scarcity: Time

An example of an economic problem you may experience daily is how to allocate your time. You need to allocate your time to many things, from spending time with family to studying, to exercising, to doing chores. Choosing how to allocate your time between all these is an example of the fundamental economic problem of scarcity.

The Economic Problem of Scarcity: Opportunity Cost

Opportunity cost is the cost of the next best alternative foregone. Every decision involves a trade-off. Imagine you are deciding whether to eat pizza or quinoa salad for lunch. If you buy pizza, you won't be able to purchase quinoa salad and vice versa. A similar thing is happening with a multitude of other decisions you make daily, and they involve opportunity cost. Opportunity cost is a direct result of the fundamental economic problem and the need for rationing scarce resources.

Fig. 4 - The choice between pizza and salad involves opportunity cost

The Economic Problem of Scarcity: Spots at a Top College

Top colleges receive more applications than the places they have available each year. This means that a lot of applicants will, unfortunately, be rejected. Top colleges use advanced screening requirements to admit the students who will do well and reject the rest. They do this by looking not only at how high their SAT and GPA scores are but also at their extracurricular activities and achievements.

Fig. 5 - Yale University