MICROECONOMICS

LESSON 3: ECONOMIC PROBLEM

Economic Systems

A country’s economic system is made up of institutions and decision-making structures that determine
economic activity.

An economic system is the combination of the various agencies and entities that provide the economic
structure that defines the social community. These agencies are joined by lines of trade and exchange
goods. Many different objectives may be seen as desirable for an economy, like efficiency, growth,
liberty, and equality. An economic system may involve production, allocation of economic inputs,
distribution of economic outputs, landlords and land availability, households (earnings and
expenditure consumption of goods and services in an economy), financial institutions, firms, and the
government.

Alternatively, an economic system is the set of principles by which problems of economics are
addressed, such as the economic problem of scarcity through allocation of finite productive resources.

Types of Economic Systems

• Planned systems
• Free market systems
• Mixed economies

Today the world largely operates under a global economic system based on the free market mode of
production.

Planned Systems

In a planned system, the government exerts control over the allocation and distribution of all or some
goods and services. The system with the highest level of government control is communism.

In theory, a communist economy is one in which the government owns all or most enterprises. Central
planning by the government dictates which goods or services are produced, how they are produced,
and who will receive them. In practice, pure communism is practically nonexistent today, and only a
few countries (notably North Korea and Cuba) operate under rigid, centrally planned economic
systems.

Under socialism, industries that provide essential services, such as utilities, banking, and health care,
may be government owned. Other businesses are owned privately. Central planning allocates the
goods and services produced by government-run industries and tries to ensure that the resulting
wealth is distributed equally. In contrast, privately owned companies are operated for the purpose of
making a profit for their owners. In general, workers in socialist economies work fewer hours, have
longer vacations, and receive more health, education, and child-care benefits than do workers in

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capitalist economies. To offset the high cost of public services, taxes are generally steep. Examples of
socialist countries include Sweden and France.

Free Market System

The economic system in which most businesses are owned and operated by individuals is the free
market system, also known as ”capitalism.”

In a free market, competition dictates how goods and services will be allocated. Business is conducted
with only limited government involvement. The economies of the United States and other countries,
such as Japan, are based on capitalism.

In a capitalist economic system:

• Production is carried out to maximize private profit.
• Decisions regarding investment and the use of the means of production are determined
by competing business owners in the marketplace.
• Production takes place within the process of capital accumulation.
• The means of production are owned primarily by private enterprises and decisions
regarding production and investment determined by private owners in capital markets.

Capitalist systems range from laissez-faire, with minimal government regulation and state enterprise,
to regulated and social market systems, with the stated aim of ensuring social justice and a more
equitable distribution of wealth or ameliorating market failures.

World map showing communist states: Formerly titled socialist states, led by communists (whether that be in title or in fact), are
represented in orange, currently titled socialist states are represented in red. It is of heavy dispute whether there are any actual
socialist or genuinely communist led states in the world today.

Mixed Economy

A mixed economy, an economic system is a system that combines aspects of

both capitalism and socialism. A mixed economic system protects private property and allows a level of
economic freedom in the use of capital, but also allows for governments to interfere in economic

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activities in order to achieve social aims. According to neoclassical theory, mixed economies are less
efficient than pure free markets, but proponents of government interventions argue that the base
conditions required for efficiency in free markets, such as equal information and rational market
participants, cannot be achieved in practical application.

Basic Economic Problem

• The fundamental economic problem is the issue of scarcity and how best to produce and
distribute these scare resources.
• Scarcity means there is a finite supply of goods and raw materials.
• Finite resources mean they are limited and can run out.
• Unlimited wants mean that there is no end to the quantity of goods and services people
would like to consume.
• Because of unlimited wants – People would like to consume more than it is possible to
produce (scarcity)

Fundamental economic question

Examples of The Economic Problem

Consumers
Households have limited income and they need to decide how to spend their finite income. For
example, with an annual income of £20,000, a household may need to spend £10,000 a year on rent,
council tax and utility bills. This leaves £10,000 for deciding which other food, clothes, transport and
other goods to purchase.

Workers
Householders will also face decisions on how much to work. For example, working overtime at the
weekend will give them extra income to spend, but less leisure time to enjoy it. A worker may also wish
to spend more time in learning new skills and qualifications. This may limit their earning power in the
short-term, but enable a greater earning power in the long-term. For example, at 18 a student could
go straight into work or they could go to university where they will hope to gain a degree and more
earning power in the long-term.

Producers
A producer needs to remain profitable (revenue higher than costs). So, it will need to produce the
goods which are in high demand and respond to changing demands and buying habits of consumers –
for example, switching to online sales as the high street declines. Producers will need to constantly ask

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the best way of producing goods. For example, purchasing new machines can increase productivity
and enable the firms to produce goods at a lower cost. This is important for fast-changing industries
where new technology is frequently reducing costs of production. Without firms adapting to how they
produce, they can become unprofitable.

Government
The government has finite resources and its spending power is limited by the amount of tax that they
can collect. The government needs to decide how they collect tax and then they need to decide whom
they spend money on. For example, the government may wish to cut benefits to those on low income
to increase incentives to work. However, cutting benefits will increase inequality and relative poverty.

Opportunity Cost and The Economic Problem

The economic problem can be illustrated with the concept of opportunity cost.
Opportunity cost is the next best alternative foregone. A consumer with a limited income of $20,000
year continually faces choices, if they spend $3,000 on a new car, then that is $3,000 they cannot
spend on food and drink

Economic Choice?

Economic choice - is deciding between different uses of scarce resources

Opportunity cost - is the benefit that is lost

in making a choice between two competing
uses of scarce resources.
.

Economists use a special language to analyze issues, prepare forecasts and render opinions regarding
the economy. One very important concept that they use frequently is opportunity cost.

These are different than explicit costs that are visible costs and are commonly used in our daily lives
such as rent, salaries, etc. Explicit means there is an actual payment that takes place, these are the
costs that accountants use in their books. Economists add implicit costs to this list, the opportunity
costs. These are costs that are not as evident, for example if a student gives up a salary of $10,000 per
year to start a business the student has to consider the salary as an implicit cost.

Every cost is an opportunity cost, the money/time/resources could have been used elsewhere. For a
student the opportunity cost of going to the movies may include the time spent going to the movies,
watching the movie, time to return home plus all the explicit costs involved. The firm may look at
resources used to produce a truck as opposed to producing a car, produce a laptop as opposed to a
desktop computer; in any case resources are limited and economists thrive to account for all possible
costs.

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At the national level opportunity costs maybe very large - the cost of a war takes away resources from
building freeways, the cost of new regulations may drive corporations out of the country, and so
on. Both at the microeconomic level or at the macroeconomic level there is always an opportunity
cost. On the chart below we will calculate the opportunity cost of going to Palomar College for Jane
Studious. Jane is currently working full time (40 hrs/week) and makes $12/hr. The cost per unit at
Palomar is $26 per unit. What is the total cost of going to college if Jane quits her job and becomes a
full-time student?
Opportunity Costs of going to College
Let's look at the data provided: Total costs
Gives up $480 x 16 weeks = $7,680 (Opportunity
Jane makes 40 x 12 = $480 per week
cost)
She will attend Palomar 16 weeks & take 4 classes 12 units x $26 = $312
Books, fees and parking $500 approximately $500
Other School Expenses (food, supplies, etc.) $600
Total Cost $9,092
As you can see from above the total cost - opportunity cost is $1,412. Of course, the returns are great
as well.
Production Possibilities Curve
• Production Possibilities Curve - the first model that most economics students are exposed too.
The Production Possibilities Curve is a graph that shows what is feasible to produce given the
current resources -for a student the resources maybe time to spend studying, dancing or
working.
• The Production Possibilities Frontier represents outcome or production combination that can
be produced within a given amount of resources.

Example (in Government)

A government may have choices on how to spend limited resources. In this simple model, they have a
choice between health care and military spending. If they increase spending on the military, the
opportunity cost is less spending on health care.

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The table below represents possible outcomes from each various combinations of time studying each
subject:

# of hours spent # of hours spent calculus economics

studying calculus studying economics grade grade
0 4 0 60
1 3 30 55
2 2 55 45
3 1 75 30
4 0 85 0

Notice that each additional hour spent studying either calculus or economics results in smaller
marginal improvements in the grade. The reason for this is that the first hour will be spent studying the
most essential concepts. Each additional hour is spent on the "next-most" important topics that have
not already been mastered. (It is important to note that a good grade on an economics examination
requires substantially more than four hours of study time.) This is an example of a general principle
known as the “law of diminishing returns”. The law of diminishing returns states that output will
ultimately increase by progressively smaller amounts as additional units of a variable input (time in this
case) are added to a production process in which other inputs are fixed (the fixed inputs here include
the stock of existing subject matter knowledge, study materials, etc.).

Let's consider why the production possibilities curve has this concave shape. As the diagram below
indicates, a relatively large improvement in economics grade can be achieved by giving up relatively
few points on the calculus exam. A movement from point A to point B results in a 30-point increase in
economics grade and only a 10-point reduction in calculus grade. The marginal opportunity cost of a
good is defined to be the amount of another good that must be given up to produce an additional unit
of the first good. Since the opportunity cost of 30 points on the economics test is a 10-point reduction
in the score on the calculus test, we can say that the marginal opportunity cost of one additional point
on the economics test is approximately 1/3 of a point on the calculus test. (If in doubt, note that if 30
points on the economics exam have an opportunity cost of 10 points, each point on the economics test

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must cost approximately 1/30th of 10 points on the calculus test -- approximately 1/3 of a point on
the calculus test).

The increase in the marginal opportunity cost of points on the economics exam as more time is
devoted to studying economics is an example of the law of increasing cost. This law states that the
marginal opportunity cost of any activity rises as the level of the activity increases. This law can also be
illustrated using the table below. Notice that the opportunity cost of additional points on the calculus
exam rises as more time is devoted to studying calculus. Reading from the bottom of the table up to
the top, you can also see that the opportunity cost of additional points on the economics exam rises as
more time is devoted to the study of economics.

Marginal Benefit and Marginal Cost

When economists discuss the costs and benefits associated with alternative activities, the discussion
generally focuses on marginal benefits and marginal costs. The marginal benefit from an activity is the
additional benefit associated with a one-unit increase in the level of an activity. Marginal cost is
defined as the additional cost associated with a one-unit increase in the level of the activity.
Economists assume that individuals attempt to maximize the net benefit associated with each activity.
If marginal benefit exceeds marginal cost, net benefit will increase if the level of the activity rises.
Therefore, rational individuals will increase the level of any activity when marginal benefit exceeds
marginal costs. On the other hand, if marginal cost exceeds marginal benefit, net benefit rises when
the level of the activity is decreased. There is no reason to change the level of an activity (and net
benefit is maximized) at the level of an activity at which marginal benefit equals marginal cost.

Consider, for example, an employer's decision to hire a new worker. The employer must determine the
marginal benefit of hiring the additional worker as well as the marginal cost. The marginal benefit of
hiring the worker is the value of the additional goods or services that the new worker could produce.
The marginal cost is the additional wages the employer will have to pay the new worker. An economic
analysis of the decision to hire the new worker involves weighing the marginal benefits against the
marginal costs. If the marginal benefits are greater than the marginal costs, then it makes sense for the
employer to hire the worker. If not, then the new worker should not be hired.

Calculation of Marginal Benefit

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Below is a table that presents the estimates of benefits of hiring security guards at a large department
store, measured in terms of the value of theft deterred every month. What is the marginal benefit of
hiring the second, third, and fourth security guard?

Total number of Total benefit, Php

guards
1 4,300
2 7,100
3 9,000
4 10,000

Hiring one guard is likely to reduce theft worth Php4,300. Therefore, the marginal benefit of first guard
is Php4,300. Adding one more guard increases the benefit to Php7,100. That is, the marginal benefit or
additional theft deterred by the second guard is Php2,800 (Php7,100 minus Php4,300). Below are the
estimates of marginal benefits of each additional guard, calculated by using the following formula:
MBn = TB n − TB n −1 , where MBn denotes the marginal benefit of the nth guard, TBn stands for total
benefit from n number of guards, and TBn-1 stands for total benefit from (n – 1) number of guards.

Total number of guards Marginal benefit, Php

1 4,300
2 7,100 – 4,300 = 2,800
3 9,000 – 7,100 = 1,900
4 10,000 – 9,000 = 1,000

What happens to marginal benefit as more guards are hired? The marginal benefit progressively
diminishes. In other words, the estimates above exhibit the law of diminishing marginal returns.

Rule of Economizing Behavior

As we explained earlier, economizing behavior is an attempt to derive maximum possible amount of
net benefits from use of scarce resources. In the above example of hiring security guards, how many
guards should the department store hire if a guard has to be paid a monthly wage of Php2,400?

Should a guard be hired? The answer would be yes, because the marginal benefit (Php4,300) exceeds
the marginal cost (Php2,400). Actually, the department should evaluate whether it should hire two
guards.

Should two guards be hired? The answer again is yes, because the marginal benefit of the second
guard is Php2,800 and the marginal cost is Php2,400 (the second guard also has to be paid the same
wages).

Should three guards be hired? The answer is now no, because the marginal benefit of the third guard is
Php1,900, whereas the marginal cost is Php2,400. The third guard does not deter enough theft to
justify paying Php2,400 to the guard. Thus, two guards are the optimal number of guards to be hired;

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optimal, because the total net benefit is maximum. The amount of total net benefit from hiring only
one guard or from hiring more than two guards is lower (see the table below).

Total Total Marginal Total cost, Marginal cost, Total net benefit
number of benefit, Php benefit, Php Php Php (total benefit –
guards total cost), Php
1 4,300 4,300 2,400 2,400 1,900
2 7,100 2,800 4,800 2,400 2,300
3 9,000 1,900 7,200 2,400 1,800
4 10,000 1,000 9,600 2,400 400

If for some reason the department store had employed three guards, the above analysis suggests that
it should lay off one guard. On the other hand, if the store had only one guard, it should employ more
guards. In other words, the store needs to keep hiring guards until marginal benefit does not drop
below marginal cost. Based on this example, the rule of economizing behavior (the rule of maximizing
total net benefit) can be stated as:
• Do more of an activity if its marginal benefit exceeds marginal cost.
• Do less of an activity if its marginal cost exceeds marginal benefit.
• Choose the level of activity where marginal benefit equals marginal cost.

Graphically, the above decision problem can be represented as:

MB and MC per guard (in thousand pesos)

4000

3000
MC
2000

1000 MB

0 1 2 3 4 Number of Guards

If guards can be hired part-time, the above graph suggests that additional net benefits can be obtained
by hiring a third guard part-time, where MB intersects (becomes equal to) MC. Note that the MB curve
is downward-sloping because of diminishing marginal returns.

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