Chapter 1: Basic economic ideas and resource allocation

The Economic Problem

The economic problem arises due to scarcity – the competition between unlimited wants and limited resources. People have unlimited wants but there are insufficient resources to provide these goods and services.

Because of the fundamental economic problems that exists, the following questions arises that needs to be confronted:

  1. What to produce?
  2. How to produce? And
  3. For whom to produce?


Factors of Production

A factor of production is defined as those things useful in the production of goods and services; they are of four types:

  • Land – all natural resources in the economy. The reward for owning land is the income that is generated.
  • Labour – human resources available in an economy. The reward for labour is wages.
  • Capital – investment in man-made aids to production. They improve the output from land and labour. The reward for capital is interest.
  • Entrepreneurship – individual who organizes production and is willing to take risk. The reward is profit.

Opportunity Cost

Given the limited resources and an infinite number of choices, we must pick which desires to satisfy. Economists use the concept of opportunity cost to convey the true cost of any choices we make between alternatives. Opportunity cost can be defined as the cost expressed in terms of best alternative that is forgone.

The Margin

Individuals, businesses and governments make decisions based on marginal choices; that is, once behavior has been optimized, any changes will be detrimental as long as conditions remain the same.

Positive and Normative economics

Positive statements are those that are based on actual evidence.

e.g.; a fall in supply of petrol will lead to an increase in its price.

Normative Statements are those that are subjective about what should, would or ought to happen.

e.g.; “We should redistribute wealth from rich to poor.”


Specialisation and Exchange

 Specialisaion is the process by which economies concentrate on producing specific goods and services. Wit specialization comes exchange and by speciaisation and exchange the firm and individuals can create surplus.


Division of Labour

Division of labour is a special type of specialization where manufacturing process is split into a sequence of individual tasks. Division is done by; Specialisation of people in professions, specialization by process and specialization by area.

  • Advantages
  1. Makes the beat use of natural abilities
  2. Reduction in costs because people work faster
  3. Time saving


  • Disadvantages
  1. Immobility of labour
  2. Mental disadvantages on workers


Classification of Economic Structure

The way in which an economy is organized in term of sectors:

  • Primary sector – deals with raw materials.
  • Secondary sector – processing, manufacturing and assembling raw materials into goods
  • Tertiary sector – deals with service.


Production Possibility Curve

Product possibility curve shows a simple representation of the maximum level of output that an economy can achieve when using its existing resources in full.

  • The production possibility frontier (PPF) shows all the possible combinations of two products using all the available resources.
  • PPFs can be used to show opportunity cost. A moves from A to B on the curve increasing the quantity of consumer goods has an opportunity cost drop in capital goods.
  • Since we are using all the available resources, increasing the production of one of the goods means decreasing the production of the other goods.
  • With a production possibility curve, the only efficient points are on the production possibility curve itself; a point inside the production possibility curve is inefficient.


Classification of Goods and Services

    1. Private Goods: Those goods which are bought and consumed by individual consumers or firms for their own benefits.
    2. Public Goods: Those goods which are non-excludable and non-rival and for which it is usually difficult to charge a direct price.
    3. Quasi-public Goods: Goods which have some but not all of the characteristics of public goods.
    4. Merit Goods: Those goods which has a good side effect when consumed.
    5. Demerit Goods: Those goods which has worse effect when consumed.