In this short and sweet post, we explain in simple and clear terms - What is the Central Problem of Economics?
Human wants are unlimited.
However, resources that can be used to produce goods and services to meet these unlimited human wants are limited.
These limited or finite resources which are used to produce goods and services are called the factors of production.
There are four main factors of production – they are land, labour, capital, and entrepreneurship (or enterprise).
Land refers to all gifts of nature, such as land, natural resources, and water.
Labour refers to human intellect, effort, hours, and expertise. Human capital refers to skilled labour.
Capital refers to goods that can be used to produce other goods.
Entrepreneurship refers to risk-taking behaviour to coordinate the factors of production of land, labour, and capital, to bring an increase in output from given inputs.
The situation of unlimited human wants against the realities of limited resources is the central problem of economics.
This central problem of economics is the problem of scarcity, where the factors of production are limited but human wants are unlimited.
Scarcity necessitates rational choice among competing uses for the resources, which means that a rational choice has to be made about what to produce, how to produce, and for whom to produce.
Choosing one option over another, or choosing one use of a scarce resource against another competing use for the same resource, leads to the concept of opportunity cost.
Opportunity cost is defined as the cost of the next best alternative forgone.
To address the problem of scarcity, there have been many mechanisms developed or evolved over the years to solve this allocation problem.
One example is the command economy, where a central planner will decide what to produce, how to produce, and for whom to produce, and the central planner will allocate the factors of production to the areas of production deemed necessary, and then allocate the goods and services to the population according to certain principles (for example, socialist or communist principles).
Another example is the free market economy, or capitalistic economy, where the price mechanism in the free market will allocate resources to competing uses.
Assuming the conditions of perfect competition and perfect information, the unfettered free market allocates scarce resources efficiently to their best uses.
According to Adam Smith, the father of economics, the free market operates like an “invisible hand”, coordinating the factors of production and goods and services.
However, most economies in the world are actually mixed economies.
Mixed economies refer to economies that are partly centrally run, and partly free market, or economies that generally utilise the price mechanism subject to some government intervention, to varying degrees.
The study of economics generally assumes that the price mechanism is the most efficient way of allocating resources, given certain assumptions, and also allows for a certain degree of government intervention, especially to cure market failures, situations where the free market does not allocate resources most efficiently.
Source: An abridged and adapted chapter from the powerful and simple concise economics guide - Success in Microeconomics (https://payhip.com/b/Az5w) For more information, do get a copy of the e-book. Do support this economics guide, please. Thank you very much!
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