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BASIC ECONOMIC CONCEPTS
The Economic Problem
How do we sum up the basic economic problem? We all suffer from it and spend most of our lives
trying to resolve it. Essentially, the economic problem stems from the fact that as humans, we have
unlimited wants and needs.
A NEED is something that can be seen as being essential to survival, such as food, water, shelter and
warmth.
A WANT is something that we would like to have but which is not essential to survival - a car, the
latest version of the PlayStation, the cell phone with all the latest gadgets etc.
The problem is that the world and every individual in it have LIMITED resources but UNLIMITED
wants and needs, in other words everyone and every nation in the world faces the problem of
SCARCITY. We never have enough money to get what we 'want'. There are never enough resources to
make sure the health service works properly; teachers and doctors will always moan about how they
never have enough resources to do their job properly. In recent times, we have heard much about the
problems faced by the police force 'not having the resources to get the job done'. The government
has limited funds from taxes, which have to be spent on a wide range of things - if we diverted more
funds to the police force, there would have to be cuts elsewhere in the government's spending
programme - or a rise in taxes.
All these things are symptomatic of the tension between scarce (limited) resources and infinite
(unlimited) wants and needs. That is what the economic problem is all about.
At this stage, you might point to the fact that countries like the United States produce massive
amounts of waste every year. You might look at the food that is wasted in restaurants, fast food
outlets and even the school canteen every day to wonder why there is so much wasted food, with so
many people in the world hungry and on the verge of starvation.
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Part of the problem is the fact that resources are not distributed evenly between countries and
societies. The terms 'wants' and 'needs' are also relative terms. 'I really, really want a Ferrari' might be
the comment of a pupil at
Bishops; 'I really, really want
to be able to walk only two
miles to get the daily ration of
water for my household'
might be the cry of a child in
the Sudan. To each individual,
they are both important - we
might be able to point out
that the Ferrari is not really
that necessary; a 1997 Golf
will do just as well!
Activity
Categorise Wants and Needs into segments with examples of each category
Research Abraham Maslow and his Hierarchy of Needs
Resources (Factors of Production).
Resources are a specific term used a great deal in ECONOMICS. It describes all the things available at
our disposal that can be used to satisfy our needs and wants.
In ECONOMICS, these resources are normally classified into four categories. These are:
Land - all the natural resources of the earth. This includes the fish in the sea, all the minerals found in
the earth; metals, sand, stones, rocks, timber, food from the soil and so on. Economists have a name
for the reward for the income from 'land' which is rent.
Labour - all the human mental and physical effort that goes into production. This will include people
who work as street cleaners, people who are interior designers, teachers, the police, doctors,
bricklayers, architects and so on. The financial reward for labour is referred to as salaries and wages.
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Regardless of the task, the human resource of labour comes in many different forms. Labour offers its
services in exchange for a reward or price - wages.
Capital - all the equipment, machinery and buildings that are not used for its own sake but for the
contribution it makes to production. This includes things like office desks and chairs, computers,
lorries, cranes, specialist machinery in a factory, the humble office coffee machine and so on. The
'price' of acquiring capital is referred to as interest.
Enterprise – the skills needed to organise the other resources into some form of production. Some
people would put enterprise as a specialist skill within labour but enterprise does have some
distinctive characteristics (e.g. risk taking) that merit its own category. The return for enterprise is
called profit.
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If we had an unlimited supply of resources at our disposal we would be able to meet any want or
need. The problem is, we do not have unlimited resources at our disposal. We therefore have to make
choices. Economics, could, therefore, be described as the science of CHOICE.
Choices are made at many different levels.



You might go into a shop and see two great-looking pairs of jeans but you only have enough
money (resources) to buy one of them.
A hospital manager may have 50 patients all wanting to have an operation immediately but
there might only be sufficient resources (doctors, nurses, equipment, rooms, beds etc.) at that
time to treat 20 of them.
A business might have received a major order for its products and wants to increase
production but does not have the staff or the equipment and raw materials to meet the order
in full.
All these examples highlight the problem of scarce resources in relation to wants and needs. When
we are faced with these choices, we have to go through some quite sophisticated decision making.
We might not always be aware that we are making sophisticated decisions but in reality we are. Such
decision making is at the heart of the subject of economics and tells us something about how humans
try to tackle the economic problem.
Opportunity Cost
Opportunity cost is one of the most important and fundamental concepts in the whole of economics.
Given that we have said that economics could be described as a science of choice, we have to look at
what sacrifices we make when we have to make a choice. That is what opportunity cost is all about.
The definition of opportunity cost is:
The cost expressed in terms of the next best alternative foregone or sacrificed.
The language used here is a bit technical but it expresses a very easy but often misunderstood
principle. We need to unpick the definition to help get the understanding right. Cost implies
something is being sacrificed or involves having to give up something. We often use the term 'cost' in
the wrong way. How many times have you used 'cost' when you mean 'price'? Take the following
example:
Say you recently bought a new pair of shoes which cost R900. The cost here is
being expressed in terms of the amount of money you had to give up to acquire
those shoes. Because we all have a common understanding of 'money' as being
notes and coins that we use to exchange for the things we want, we can pretty
much understand this sentence.
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What statements like this fail to convey, however, is the true picture of what you are sacrificing by
choosing to buy the shoes. It is more accurate to say something like 'the price you paid for those
shoes were R900.' To get an idea of the true 'cost', we would really need to know something of the
sacrifice you made in giving up that R900.
R900 can buy a number of things - let us assume that it can also buy the following:
Five CDs
A new sweater
A meal out for four.
A flight from Cape Town to Durban.
When thinking about how to dispose of your money, you have to make choices and these represent
the choices at this moment in time. These choices represent different aspects of value. Each of the
items might represent some value to you but they may be different. It is important to remember that
you might, in an ideal world where there were no scarce resources, want all these things.
It might be possible to order the value of each of these items – for example you might value the items
in the following way:





Shoes: 9/10 (because my existing shoes have a hole in the sole)
5 CDs: 6/10 - I do have plenty of other CDs but there are new releases by my favourite artists –
but they will still be around next month.
The sweater: 2/10. - Not bad but nothing better than I have already got.
A meal out for four: 5/10 - nice but not essential at the moment
Flight to Durban: 4/10 - a luxury but one I can manage without at the moment.
Having gone through the mental process of attaching a value to your choices, it is clear that there is
only one choice to make - the shoes. In buying the shoes you have had to sacrifice the opportunity to
purchase one of the other items in your choices list. What is the next best alternative foregone? It will
be the item that gives the next highest value - the 5 CDs in this example.
The cost of the shoes, therefore, is better expressed as the 5 CDs sacrificed. We can assume from your
decision that you value the benefit or satisfaction you will gain from the shoes at this point in time
higher than the value you place on the CDs.
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Looking at cost in this way enables us to make some interesting insights into the behaviour of
individuals, international institutions, the government and businesses, and helps us to comprehend
decision-making at all levels.
Basic economic decisions
No two economies are organized in exactly the same way, but all have to solve three fundamental
problems:
1. What should be produced in the economy?
What quantities of food, mobile phones or banking services should be produced by the economy?
How many trees need to be felled to meet the demand for pulp for newspapers and magazines?
Should we spend extra money on national defence or should more resources be devoted to health
care and education?
2. How should production be organised?
Should a firm use labour or machinery to produce their goods? How many workers should be
employed? Should production take place in Port Elisabeth or Cape Town or in South Africa or
Botswana? Should Ford buy its components from the USA or Australian suppliers? These are all
examples of important production decisions.
3. For whom should production take place?
Should everybody be entitled to an identical share of production, or should some receive more than
others? We know that the distribution of income and wealth in South Africa and every other economy
is not equal. There are large-scale inequalities in people's living standards. Indeed the gap between
rich and poor world-wide has increased considerably over the last twenty years.
Economic systems
Let’s see how these different systems answer the three basic economic questions. There are four
main types of economic system:
1. Traditional or subsistence economy.
A subsistence economy is one where:


There is little specialisation and trade within the economy and with other countries
The productivity of workers tends to be low leading to low incomes and a poor standard of
living
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People tend to live in family groups, and grow most of their own food, make their own houses,
gather their own fuel and provide their own leisure activities i.e. to a great extent they are
self-sufficient
Few goods and are marketed and command a price or value - there is little surplus production
to export
2. Free market economy
A free market economy is one where:

Nearly all of the country’s factors of production are owned privately. Although it might make
sense to argue that firms own some of the resources, it is private individuals, or groups of
individuals, who own the resources. They then rent them out to the firms so that they can
produce the goods and services. This brings into play one of the government’s limited roles.
Through the legal system, the government must uphold the property rights of these private
individuals.

Everyone in this system is motivated by pure self-interest. Consumers maximise welfare, firms
maximise profits and the private individuals, who own the factors of production, aim to maximise
rents (on land), wages (on labour), interest (on capital) and profit (on enterprise).

Firms can sell anything they want. They effectively respond to the consumers, who are allowed to
buy anything that is sold by the producers. Workers can take on any job they want (this may seem
obvious, but wait and see what happens in the command economy).

There are high levels of competition. It is assumed that nearly every market is a perfectly
competitive one, with numerous buyers and sellers and no barriers to entry or exit. Firms are
competing desperately for customers and the consumers are competing with each other for the
goods on offer.

The price mechanism allocates the economy’s resources. The reason why it is called the ‘price’
mechanism is because the price acts as a signal and an incentive for producers to act in the
required way so as to maximise their gain, which, in turn, optimises the allocation of resources in
the whole economy.
In a free market economy:

What will be produced?
You might think that the firms decide what is finally produced. Actually, in a free market economy,
it is the consumers who have all the power. Consumer sovereignty exists. In a free market, a firm
will only produce a good if the consumer is prepared to buy it. Through their purchases (or money
‘votes’) consumers effectively dictate to the firms what should be produced. If consumers, on
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mass, stop buying Fanta Grape (perhaps they prefer drinking Fanta Orange) then the producers
would stop making it. So the answer to the question is, “whatever the consumers want.”

How will it be produced?
The simple answer is, “by the firms.” But there is more to this question than that. “How” also
means “how well.” Due to the highly competitive environment that exists, there will be pressure
on firms to produce the goods as efficiently and cheaply as possible.

For whom will it be produced?
In other words, who actually ends up consuming the goods that are produced? Well, we said
earlier that consumers’ money votes determine what is actually produced. But it will also
determine what consumers can actually buy. Those with more money will be able to consume
more of the goods produced. Who has the most money? The rich, of course, but why are they
rich? For some, it is inherited wealth, earning high incomes from the sales of the factors of
production that they own (renting land and making interest and profit from capital and
enterprise).
For others, who inherited nothing, their wealth may come from the successful sale of their labour
services. David Beckham came from nothing, but he is able to sell his labour services (kicking a
football!) for tens of thousands of pounds a week!
Of course, in this system, if you have nothing and you do not have marketable labour skills (for
most people this will be a good education), and then you will remain poor. The free market
system tends to create an unfair distribution of income. The wealthy consume a
disproportionately large share of what is produced.
3. A command economy
A command economy is one where:

Nearly all of the country’s factors of production are owned publicly by the government (or the
state). The only factor over which the government does not have total control is labour, but as you
will see, they certainly have indirect control over the workers.

There is the complete opposite of the pure self-interest of the free market system. No one (in
theory) thinks of himself (or herself). Consumers, workers and the government are all assumed to
be working for the ‘common good’. This system is often associated with communist Soviet Union
(as it was before 1989), but the fascist Hitler ran a ‘planned’ economy, albeit rather dictatorially.
Democratic countries often attempt a less severe form of planned economy via socialism.

There is no free enterprise.

There is very little competition.
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
There is no competition, so there is no price mechanism. The authorities set the prices. It is
because they set prices at low levels to make sure that everyone can afford the goods that excess
demand occurs causing long queues for goods outside shops. Another inevitable consequence is
the creation of black markets.

There is a planning system: This is an extra characteristic of the command economy. The other five
has tried to follow the five given in the ‘free market economy’ section. As the government runs
the system, they have the job of planning how all the resources should be used. They have to
decide what should be produced and in what quantities. They must decide how the goods are to
be made. What labour should be used and where? What techniques of production shall we use?
How will the completed goods be divided between the workers (or consumers)? The key point is
that they directly set the output levels and price levels.
In a command economy:
The answers to the questions of what, how and for whom are basically up to the planners
themselves.

What will be produced?
The consumer no longer has any control. The planners (or the government) decide what will be
produced. The question is, how do the planners know what the consumers want and need better
than the consumers themselves?

How will it be produced?
There are no such things as ‘firms’ in a planned economy. The planners direct the resources into
producing ‘units’. They are not really firms. They have no autonomy. So, as we said above, the
planners decide on the quantities of output and methods of production.

For whom will it be produced?
In the free market, the richer you were, the more you could buy. Of course, very poor people
could end up with very little. The planner tries to be fair in distributing the output of the economy.
Wages are determined by the planners, as are the prices of the goods produced. So the
government is, effectively, determining how much each consumer can consume.
4. A mixed economy
A mixed economy is one where:
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
The government owns some of the country's factors of production publicly and some are owned
privately.

Again, a combination of the two extremes. The market part of the economy will be motivated by
self-interest (Adam Smith). Firms will profit maximise, consumers will maximise their welfare and
the factor owners will maximise rent, interest and profit. The government, again, has the
‘common good’ goal. We will see what that entails later.

There is free enterprise in the market part of the economy (the private sector).

The private sector can be quite competitive. It depends on the market structure that prevails in
the various industries. In the real world few industries are perfectly competitive. Governments do
tend to set up bodies, though, whose job is to make sure that industries do not become too
uncompetitive (The Competition Board).

The price mechanism operates in the private sector. Its efficiency depends on how competitive
the market structures are. The government run activities, like the health and education, which
tend to be provided free for the poorer sectors of the community.
Real world examples
In the real world it is fairly easy to assess how ‘mixed’ an economy is. Economists simply look at the
percentage of a country’s Gross Domestic Product (GDP) that is devoted to government spending.
The USA is often thought of as the economy with the most capitalist or ‘free market’ model. The
statistics bear this out – the government spend just over 30% of GDP. This is one of the lowest figures
in the world, and yet the government is still a huge player in the economy. Even in the capitalist
centre of the world (the land of the free!), there is a need for a defence system and a system of law.
There is a health system and a system of welfare payments, but they are only used as a last resort, or
by the poor who have no choice. Those who can afford it have health insurance.
Many European governments spend up to 50% of their GDP (France, for example), but the largest
percent is Sweden, whose government spend almost 60% of its GDP (it was as high as 70% in the mid90s!) State benefits and pensions are generous; the health service is of a good quality and is free at
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the point of use; there is automatic retraining for those who lose their job and free child minding
facilities for women wanting to go back to work. There are no student loans either!
The question that governments have to ask themselves is, “Do I want our economy to be like the USA
or more like Sweden?” It is difficult to get the mix right. A government never manages to please all
the people all of the time. If I was an unemployed person with little spare cash, I think I’d rather live in
Sweden, where I’d get free health care and training for a job. If I were rich I’d rather live in the USA; I
could afford good health care and a private pension, etc., from my post-tax income and still have
money over to enjoy as I wished.
The advantages of a free market economy (and the disadvantages of command economies)

Efficiency. We said earlier that free market economies are very competitive. As a result they tend
to allocate their resources more efficiently. Decisions about what to produce are made by the
people who will actually consume the goods. Planners from command economies are less likely to
make the correct decisions across the whole economy.

Choice. Firms will produce whatever consumers are prepared to buy. Remember that the
consumer is sovereign. Due to free enterprise, there are no restrictions on what the firms can
produce. It is of no surprise, therefore, that there will be a much larger choice of goods and
services in a free market economy compared with a command economy. The planner will be more
concerned with making sure there are enough essential goods to go around rather than providing
all the goods consumers want.

Innovation. Firms will always be looking to produce something new to get ahead of their
competitors. We said earlier that, even though the government’s role is limited, one of its jobs is
to protect property rights. This will include intellectual property rights through patents. Hence,
there are incentives in the free market system for firms to be innovative and produce better
quality products. Obviously there is no incentive for the planner to be innovative. As long as
factories produce the essentials the planners will be happy.

Higher economic growth rates. One does not have to be an expert economic historian to see that
countries whose economic system has been nearer to the free market model have grown much
faster than those with a command economy since the Second World War. The most successful
economy in the world (in terms of size) has been the USA, and they have been one of the freest
economies in the world (China has also grown very rapidly recently as a result of moving towards
a free market economy). Given the three factors above, it is not surprising that this is the case.
The disadvantages of a free market economy (and the advantages of a command economy)

Public, merit and demerit goods. Some goods (public goods and merit goods) are not provided or
are underprovided in the market economy. Other goods (demerit goods) like cigarettes, drugs and
alcohol are over provided. In a command economy this should not occur.
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
Unequal distribution of income. For many, this is the big disadvantage of a free market economy.
In a free market with very limited government, benefits will be low, the health service poor and
schools under funded. If you start life with very little, and do not even get a good education, then
there will be very little protection from poverty. A command economy might not have the
efficiency and enterprise for the successful to make millions, but at least the strong government
will try to make sure that nobody falls through the safety net. It will be a fairer economy, even
though it is likely to be less successful overall.

The environment. Free market economies are likely to produce more pollution, which is bad for
the environment. Command economies can make sure that the production processes that they
chose are as environmentally friendly as possible. They should be able to make sure that the level
of output is the socially optimal level of output. Governments can try to force firms into producing
the socially optimal level of output through the use of taxes, but governments with a limited role
will not be keen to use taxes. Having said all that, the command economies of the 80s had
notoriously poor records on the environment. In theory, they should have been able to monitor
pollution levels closely, given that they had control of production, but this simply did not happen.
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