The main problem at the center of economics is how to fulfill unlimited wants with limited resources.
What it means is how you can meet the ever-changing, every growing cloud of desires with resources (basically your materials, time, capital, and machinery) that are limited in both capacity and time.
Therefore, the economy has to answer three questions:
1. What to produce?
(What goods and services to produce in order to maximize the amount of utility (satisfaction) gained from the product.)
2. How to produce?
(What methods of production should be used to produce the goods and services that are needed)
3. Where should the output go?
(How should the output be distributed to people)
In order to outline the economic problem, we need to learn about the factors of production with a down to earth example...
Land is basically all the natural resources that a business uses (water, fish, metal ores, and in our case, the soil the plant grows in)
Labour is the workers who use the natural resources to make a product (In this case, our out-of-shot gardener waters and takes care of our little plant.
Capital is the tools the workers use to create the product (In our case, the watering can and the plant pot is the tools used in growing our rocket)
And finally, enterprise is the idea that unites all of this together (In the case of the picture, it is to grow and sell rocket plants).
In an economy, we can map out how these factors of production are allocated with a production possibilities frontier.
This diagram shows all the combinations of two goods that can be produced within a single economy.
For our example, we will assume that our theoretical economy only produces two goods, CPUs and GPUs.
(In real life economies can produce more than two goods at the same time.)
An economy is productively efficient at point A on the red line. This is when the economy maximizes the use of all available factors to produce either CPUs or GPUs.
At point B inside the red line, the economy is not producing as many GPUs and CPUs as it could at the red line. This may be due to factors that prevent the economy from utilizing them efficiently (e.g. A rise in unemployment).
At point C outside the red line, the economy would have to use more factors of production than it currently has in order to reach this point.
There are two types of efficiencies: productive and allocative.
Productive efficiency is when the economy maximizes the output produced with the factors of production it has. (For this example, it means producing as many GPUs and CPUs as possible with the factors available at the red line.)
Allocative efficiency is when the economy maximizes the benefits everyone receives from a combination of two products. (Basically what combination of CPUs and GPUs gives people the greatest benefit)
While you can measure productive efficiency by moving to the red line, allocative efficiency is more difficult to find out as what is considered the most beneficial combination varies from person to person.
Let us say that instead of going to point A, you would like to produce point A1.
As we move from B to B1, we have to give up some GPUs in order to get the amount of CPUs we want.
This is the opportunity cost of our change from A to A1, what we have to give up in order to get what we want.
The only way to get to C is for the economy to increase the total amount of factors available, shifting to the right from A to C as a result.
If you have any questions, you can reply to this post or PM me.
See you next time!
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