Cambridge IGCSE Economics

The basic economic problem

The basic economic problem is that human wants are unlimited while the resources available to satisfy them are limited. People always want more goods and services than can be produced from the land, labour, capital and enterprise that exist at any time. This shortage relative to wants is called scarcity, and it is the reason economics exists: because not everything can be had, choices have to be made and something is always given up.

Scarcity affects every kind of decision-maker, though it looks different for each.

The three basic economic questions

Because resources are scarce, every society has to answer three questions.

• What to produce: which goods and services, and in what quantities, for example more food or more cars, more hospitals or more roads.
• How to produce: which methods and which combination of resources, for example a labour-intensive method with many workers, or a capital-intensive one using machines.
• Who to produce for: how the output is shared out between people, which depends on how income and wealth are distributed and on who is able to pay.

Different economic systems answer these in different ways, through prices and private choices in some and through government planning in others.

Economic goods and free goods

An economic good is a good or service that is scarce, so it uses up resources to produce and has an opportunity cost. People have to pay for it or give up something to get it. Food, clothes, a haircut and a bus ride are economic goods.

A free good is one with no opportunity cost, because there is so much of it that using it does not take anything from anyone else, and no resources are used to supply it. Sea air on a beach and sunlight are standard examples. The line between the two can move: clean air in a polluted city, or drinkable water in a drought, may stop being free once it becomes scarce.

Factors of production

Factors of production are the resources used to produce goods and services. There are four, and each earns a reward for its owner.

"Capital" here means physical capital, not money. Money used to buy machinery is called financial capital, but only the machine is a factor of production.

Rent is the payment for the use of land, wages are paid to workers for their labour, and interest is paid to the owners of capital (or on the money borrowed to buy it). Profit is what is left of a firm's revenue after all costs, and it rewards the entrepreneur for taking the risk that the venture might fail.

Changes in the quantity and quality of factors

The amount of output an economy can produce depends on how many resources it has and how good they are, so changes in either can raise or lower its productive capacity.

Quantity of factors can increase through:

• discovery of new natural resources, such as oil or gas, or the reclaiming of land;
• a growing labour force, caused by a rising birth rate, immigration, more women or older people entering work, or a higher retirement age;
• investment in new machinery and buildings, which adds to the stock of capital;
• more people starting businesses, which increases enterprise.

Quantity can fall through the exhaustion of resources such as a mine running out, emigration of workers, an ageing population leaving the labour force, or the destruction of capital in a war or natural disaster.

Quality of factors can increase through:

• education and training, which make labour more skilled and productive;
• better health care, so workers are fitter and miss fewer days;
• improved technology, which makes capital goods more efficient;
• better farming methods and fertilisers, which raise what land can produce;
• better management and incentives, which improve enterprise.

Quality can fall if skills become out of date, if health worsens, if capital wears out without replacement, or if soil is degraded by over-farming.

A rise in the quantity or quality of factors increases the economy's capacity to produce, which is how economic growth is achieved over time.