THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY

THE BASIC ECONOMIC PROBLEM

The basic economic problem is scarcity. Scarcity arises because human wants for goods and services are infinite but the resources required to produce them are finite.

THE BASIC ECONOMIC PROBLEM

Resources are scarce but human wants are unlimited.

The central purpose of economic activity is the production of goods and services with these limited resources in order to try and satisfy as many of the unlimited needs and wants as possible. This is done in order to try and improve or maximise economic welfare. The level of prosperity and quality of living standards in an economy.

ECONOMIC WELFARE

THE PROBLEM OF SCARCITY Not all wants can be satisfied, therefore choices have to be made over which wants to satisfy, or how the scarce resources are allocated amongst competing wants. This leads to conflict and economics tries to relieve conflict. The problem of scarcity means that choices have to be made and therefore an allocative mechanism is needed to answer the basic economic questions of:

What to produce? How to produce? For whom to produce? The method by which resources are allocated between alternative uses.

ALLOCATIVE MECHANISM

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THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY

ECONOMIC WELFARE
Economic welfare is a concept which isnt easily defined; it refers to how well people within society are doing. Economic welfare is usually measured in terms of real income, real GDP. An increase in real output and real incomes suggests people are better off and therefore there is an increase in economic welfare. However, economic welfare will be concerned with more than just levels of income. For example, peoples living standards are also influenced by factors such as levels of congestion and pollution, levels of literacy and education, healthcare and social service provision etc. These quality of life factors are important in determining economic welfare. Real income is the income of individuals or nations after adjusting for inflation. It is calculated by subtracting inflation from the nominal income. Real gross domestic product (GDP) is a macroeconomic measure of the size of an economy after changes in inflation have been taken into account.

REAL INCOME

REAL GDP

OPPORTUNITY COST
The problem of scarcity and the fact that choices need to be made leads us to the very important concept of opportunity cost. Every choice involves a sacrifice or trade off in simple terms, choosing more of one thing means giving up something else in exchange. This is called opportunity cost, i.e. the sacrifice of the next best alternative. It is the direct result of scarcity and occurs every time a choice is made. The opportunity cost of a choice is what economists call a real cost the cost of an item in terms, not of money, but of the resource, good or service that has had to be given up to obtain that item. The benefits forgone of the next best alternative use of resources.

OPPORTUNITY COST

Opportunity Cost is the true cost of an economic decision. The true cost of an economic decision is always measured in terms of opportunity cost and never in monetary/financial terms. Opportunity cost is the benefits of something real which is actually given up. If we are talking about the opportunity cost of money it is the benefits of the alternative use of the money rather than the money itself which constitutes the true cost of a purchasing decision. For example the opportunity cost of spending 50m on a new warship is not the 50m itself but the benefits forgone of spending the 50m on a new hospital. Other opportunity cost examples:

The opportunity cost of the governments decision to fight the Iraq war is the benefit that would have arisen from building 10 new schools. The opportunity cost of spending my monthly income is the benefit I would have received from saving it.

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THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY

The opportunity cost of buying a new Range Rover is the benefits that would have arisen from buying a Land Rover.

THE BROAD NATURE OF ECONOMIC ACTIVITY

Economics takes a broad view of what economic activity is. Economics also includes many activities that may not initially be thought of such as economic activity such as:

Charity work DIY Subsistence farming, Car boot sales Housework

Barter Child-rearing Leisure activities, Illegal trades (e.g. drugs)

ECONOMIC SYSTEMS
A mechanism for determining the allocation of scarce resources in the face of unlimited and competing human wants.

ECONOMIC SYSTEM

The purpose of any economy is to deal with the economic problem; therefore it has to deal with and try and resolve the three key economic questions: WHAT - What is going to be produced with the limited resources on offer? HOW - How is the output going to be produced? FOR WHOM - Who gets the output that is produced? The fundamental economic problem facing all societies is what, how and for whom goods and services should be produced and this is what am economic system tries to resolve. There are three main types of economic system: 1. Free Market Economy 2. Command or Planned Economy 3. Mixed Economy

FREE MARKET ECONOMY

The term free market economy primarily means a system where buyers and sellers are solely responsible for the choices they make and thus the allocation of resources. The free market gives absolute power to prices to determine the allocation and distribution of goods and services. The role of the government is limited to controlling the law and order of a country and to ensure that a 'fair price' is charged by the sellers. Where the competitive interaction of many producers and consumers, without any intervention by government, provides the forces of demand and supply which allocate resources through the price mechanism.

FREE MARKET ECONOMY

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THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY

SUPPLY

The amount of a good which producers are both willing and able to sell at a given price. The amount of a good or service that a consumer is willing to buy at a particular price. The price mechanism is a term used to describe the means by which the many millions of decisions taken each day by consumers and businesses interact to determine the allocation of scarce resources between competing uses.

DEMAND

PRICE MECHANISM

The free market system answers the three key economic questions in the following way: WHAT - generally there is an economic incentive for the firm to choose to produce the most profitable goods and services and these will be those which are in highest demand. HOW there is an incentive for firms to choose the production method which is the least costly and therefore is the most profitable. FOR WHOM - the people who get the goods and services produced in a free market are those who are willing and able to pay the price for them.

ADVANTAGES OF A FREE MARKET ECONOMY

A free market economy or an economy which leans towards the free market system has a number of advantages: INNOVATION The ability to earn profit within a free market gives firms the incentive to innovate; therefore free markets are wrought with inventions and the money to research them. Countries classified as having a free market have been responsible for the vast majority of inventions since the 19th century. HIGH INCOME MOBILITY - Under a free market system it is easier to move around income brackets. It is just easier to become rich or poor when as opposed to a command economy where resources are allocated by the government. EFFICIENCY AND PRODUCTIVITY - This happens because of the survival of the fittest aspect of free markets. Firms that have higher costs than others (by producing inefficiently) will go out of business as those that are more efficient prosper. Thus, firms are always looking for cheaper ways to do things which drive costs and prices down. HIGHER GDP - Free market-leaning countries have higher GDPs than command marketleaning economies. This is because they tend to be more efficient and produce more. PRODUCTIVE TAX SYSTEM - Due to the generally higher wealth level larger tax revenues can be generated within market-leaning economies. This large amount of tax revenue results in

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THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY

more money being spent on social programs. Free market nations generally spend more or have more efficient social programs.

DISADVANTAGES OF A FREE MARKET ECONOMY

A free market economy or an economy which leans towards the free market system has a number of disadvantages: MERIT GOODS Lack of provision of merit goods like education, health and social housing. The poor may be deprived of merit goods. In this way the rich may become richer and the poor become poorer. Goods which can be of benefit to society that are under produced and under consumed in a free market economy.

MERIT GOOD

PUBLIC GOODS - Non provision of public goods (bus stops, parks, street lighting, army, police, fire services) as they are not profitable to produce as consumers are not willing to pay for them. DEMERIT GOODS - Over consumption of demerit goods (drugs, cigarettes, alcohol etc.) if consumers have a desire for these goods, then they will be provided as they are profitable to produce, even though it may not be desirable from the point of view of society for them to be over consumed. Goods which can be of harm to society that are over produced and over consumed in a free market economy.

DEMERIT GOOD

EXTERNALITIES Private firms will ignore externalities such as air, water and noise pollution as it will reduce their profit levels if they do take these factors into account. They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid.

EXTERNALITIES

SOCIAL INJUSTICE There may be high levels of social injustice in a free market economy, where the economically strong get richer and the economically weak get poorer.

COMMAND or PLANNED ECONOMY

Where the means of production are state controlled and the allocation of resources is managed centrally.

PLANNED ECONOMY

In a Command Economy or Planned Economy, the central or state government regulate the use of resources. The government is the final authority to take decisions regarding production of goods and services, the distribution of goods and services and the allocation of the revenues earned from their distribution.

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THE NATURE AND PURPOSE OF ECONOMIC ACTIVITY

China and former USSR and are perhaps two of the best instances of Command Economy. Though many countries now-a-days are switching off from Planned Economy to Market or Mixed Economy. However nations like North Korea and Cuba are some countries where Planned Economy still exists in full form. In the case of a Command Economy, both state-owned and private enterprises receive guidance and directives from the government regarding production capacity, volume, modes of production and course of their actions. The planned economic system answers the three key economic questions in the following way: WHAT - The goods and services produced in a command economy are those which the government chooses to produce. HOW - The government chooses the method of production. It can direct resources, including labour, to whatever activity it chooses. FOR WHOM - The output of the economy is distributed in whatever way the government sees fit, e.g. it may try to distribute goods and services equally in order to minimise inequality. Once again a planned economy has a number of advantages and disadvantages but these are basically the reverse of the advantages and disadvantages of a free market economy.

MIXED ECONOMIES
Where resources are allocated by a mixture of free markets and government intervention.

MIXED ECONOMY

In reality all economies are mixed economies and are a mixture of elements from the free market and planned economic systems. Simply in such a type of economy there is the presence of private economic freedom and centralised planning with a common goal of avoiding the problems associated with both economic systems.

TRANSITIONAL ECONOMIES
A transition economy or transitional economy is an economy which is changing from a centrally planned economy to a free market.

TRANSITIONAL ECONOMY

Transitional economies undergo or are undergoing economic liberalisation. During this process market forces take over setting prices rather the government. There is privatisation of government-owned enterprises and resources, and the creation of a financial. The process has been applied in China, the former Soviet Union and Communist bloc countries of Europe, and many third world countries.

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