The Basic Economic Problem

In this guide, we'll explain the basic economic problem with clear examples, explainers, practice questions and exam tips, to ensure you're well-prepared for any questions on this topic this summer. This is a summary. Make sure to stop by each individual page in this unit to gain more depth and understanding.

What is the basic economic problem?

The basic economic problem is the problem of scarcity, which means that human wants and needs are unlimited, but the resources to satisfy those wants and needs are limited
This creates a situation where people must make choices about how to allocate their scarce resources, such as time, money, and labour, to satisfy their most urgent wants and needs

Three questions the basic economic problem forces every society to answer

In response to the basic economic problem, societies must answer three fundamental questions:

1. What to produce?

This question refers to the decision about what goods and services to produce given the limited resources available. Societies must decide which goods and services are most important to produce to meet the needs and wants of their people

2. How to produce?

This question refers to the decision about how to produce goods and services. Societies must choose the most efficient and effective methods to produce the goods and services they have decided to produce

3. For whom to produce?

This question refers to the decision about who should receive the goods and services produced. In a free market this is decided by who can afford to pay for the 

• Answering these questions requires societies to make trade-offs between different goods and services and to prioritise their production and distribution based on the needs and wants of their people
• The answers to these questions form the basis of a society's economic system (free market, mixed or planned) and determine how resources are allocated
  • They also determine how wealth and income are distributed within that society

The basic economic problem and opportunity cost

• The basic economic problem of scarcity requires individuals and societies to make choices about how to allocate their limited resources to satisfy their unlimited wants and needs
• Whenever individuals or firms choose to use their resources to produce or consume one thing, they are giving up the opportunity to use those resources for something else
• This is known as a trade-off
  • If a farmer decides to use his limited land and resources to grow wheat, he must give up the opportunity to use that land and those resources to grow other crops, such as corn or soybeans. This is the trade-off he must make in order to produce wheat
•  The opportunity cost is the value of the next best alternative that must be given up in order to choose a particular course of action. In the example of the farmer, the opportunity cost of growing wheat is the value of the crops he could have grown if he had used his land and resources differently, such as corn or soybeans
• Opportunity cost is important because it helps individuals or firms make better decisions by forcing them to consider the value of their choices in terms of what they are giving up
• Whenever a choice is made, the benefits of that choice must be weighed up against the costs of the next best alternative, in terms of both monetary costs and opportunity costs

Opportunity cost and production possibility curves

• A production possibility curve is a graphical representation of the trade-offs and opportunity costs faced by an economy that produces only two goods
• The curve shows the maximum possible combination of the two goods that can be produced with the given resources and technology, assuming that all resources are used efficiently
• The slope of the production possibility curve represents the opportunity cost of producing one good in terms of the other
• A movement along the curve demonstrates that producing more of one good requires sacrificing some of the production of the other good
• The production possibility curve demonstrates the concept of opportunity cost by showing the trade-offs that must be made when producing two goods
• It shows that producing more of one good requires sacrificing some of the production of the other good
  • The opportunity cost of producing one good is the value of the next best alternative that must be given up

Moving along the curve or shifting the entire curve?

• The production possibility curve (PPC) represents the maximum amount of two goods that can be produced with a given set of resources and technology
• A movement of the entire PPC can be caused by changes in factors such as the availability of resources, improvements in technology, changes in the size of the labour force, and changes in capital investment
• An increase in the availability of resources, such as more fertile land or a larger labour force, can shift the entire PPC outward. This means that more of both goods can be produced with the same level of technology and resources
• The invention of new farming techniques, such as the use of tractors or genetically modified seeds, can increase agricultural productivity and shift the PPC outward.
• Capital investment, such as building new factories or improving infrastructure, can also shift the entire PPC outward by increasing the productive capacity of an economy.
• Any factor that increases the availability or efficiency of resources, or increases the productive capacity of an economy, can shift the entire PPC outward, leading to an increase in the maximum amount of goods that can be produced
• Conversely, any factor that reduces the availability or efficiency of resources can shift the entire PPC inward, leading to a decrease in the maximum amount of goods that can be produced

Exam Tip

Paper 2 frequently asks you to analyse the impact of certain changes on the production possibility curve of an economy. If it is indicated that an economy is not using its resources efficiently, then the economy will be producing inside its existing production possibility curve. However, if it is indicated that that the resources available to an economy have changed in some way, then there is likely to be a shift of the entire curve (outward or inward, depending on the scenario)

Paper 1 frequently tests your knowledge of opportunity cost in MCQ. Remember that opportunity cost is not about money. It is about the loss of opportunity - the next best alternative

Basic Economic Problem Practice Questions

Recently a series of earthquakes in one country destroyed farming land, factories and residential homes. Analyse, using a production possibility curve diagram (PPC), the effect of the destruction of some of its resources on an economy. (6 marks)

A Nigerian oil monopoly is reallocating resources from producing oil to producing more environmentally friendly liquid petroleum gas (LPG). Analyse, using a production possibility curve (PPC) diagram, the effect of reallocating resources from kerosene to LPG. (6 marks)

Basic Economic Problem Key Terms

• Scarcity
• Economic good
• Free good
• Wants and needs
• Resources
• Land, labour, capital and enterprise
• What to produce?
• How to produce?
• For whom to produce?
• Opportunity cost
• Trade off
• Production possibility curve

Finally, don't forget the importance of consistent practice. Regularly work through practice questions and past papers to refine your exam technique and identify any areas where you may need additional support. With dedication and the right resources, you'll be well-prepared to achieve top grades in your CIE IGCSE Economics exam. Good luck, and happy revising!