The Basic Economic Problem and its Solutions

 

The basic economic problem is scarcity.  All economies face this basic issue.  Scarcity arises because we can’t produce all we want.  Since we can’t have everything we’d like, things are “scarce” and choices need to be made.  Of the limitless range of things folks would like, we need to decide What to Produce, How to Produce These Things and For Whom we Produce These Products. 

 

There are three basic ways of dealing with the problem of What, How and For Whom to produce: by Tradition, by Command and by Markets.  Most people through time have lived in traditional economies.  In the traditional economy, the “what” question is answered simply by producing what has always (or traditionally) been produced.  How to produce is determined by tradition as well.  You make things the way they’ve always been made.  Finally, goods are distributed in the customary manner with shares being determined by the traditional values and rankings of the various members of the society.  Typically, a traditional economy tends to be predominately agricultural, with agriculture being done on a small scale, subsistence basis.

 

Command economies operate just the way the name suggests.  What, How and For Whom to produce are determined by government edict.  The Communist Block countries of the Soviet Union era were examples of command economies.  These countries were the Soviet Union, Poland, Yugoslavia, Czechoslovakia, East Germany, Albania, China and Cuba (I may well have forgotten one or two of them).  This sort of system is particularly effective where the government is interested in pursuing particular goals such as industrial development and military advancement.   It’s not terrifically good at achieving high efficiency levels or maximizing consumer well being.  Command systems tend to perform poorly as the economy becomes larger and more complex, since more and more choices have to be made.  It is notoriously difficult to devise incentives and rules that get people to do what the rule maker wants.  If a manufacturer is rewarded for the number of units produced, he will tend to make them the simplest way.  If this means that only one style of shoe is produced, for example, then consumers will have to content themselves with one style.  This will not, in the long run, prove popular.

 

The third method, the Market Economy, is the one we use and the one which microeconomics studies.  In our system, markets establish prices, and it is these prices that determine what shall be produced.  Again, not everything we want can be produced because of our ultimately limited producing powers.  The Production Possibility curve illustrates the limit we face with regard to production.

 

The production possibility curve represents the output capabilities of a hypothetical economy that produces only 2 products.  This is done so that we can easily graph the results.  Very commonly, the two products chosen are “guns” and “butter”, these being products that require significantly different kinds of inputs (guns being rather “industrial” and butter utilizing more “agricultural” resources). 

 

 

 

The curved line running from the Guns axis to the Butter axis represents all the combinations of guns and butter that this economy can produce.  At any point inside the curve, we can produce both more guns AND more butter—we can have, in short, absolutely more stuff.  This means we’re not producing as efficiently as possible.  When we’re on the curve, we can have more guns OR more butter.  To get more of one thing means we have to give up some of the other.  More guns are had at the cost of less butter.  Since, while on the curve itself, we can’t have an unambiguous increase in all goods, we are producing as efficiently as possible.  We simply cannot produce at guns and butter levels outside (to the right and above) the production possibility curve.  The curve shows the boundary of our productive capacity.  The curve can move over time.  If it moves outward, we are experiencing economic growth.  If it moves to the left, the capacity of the economy to produce is shrinking.  Economic growth results from population increase and technological change.  Shrinkage in the capacity to produce would result, probably, from some catastrophe such as a nuclear attack or plague. 

 

The shape of the production possibility curve (concave when looking out from the origin) reflects the fact that one product cannot be converted into the other at a constant rate, but rather the rate of trade off between the products changes constantly as we increase the production of one product (guns for example) at the expense of the other (butter, in this case).  As we produce more and more guns, we progressively draw resources out of butter production.  Gradually, resources that are drawn from butter production and applied to gun production will become less and less useful in increasing gun output, and more and more important for butter production.  Cows, for example, are of little use in producing guns (they might be used to turn a capstan which would power a machine tool, for example), but they are of obvious utility in the production of butter.  The movement of cows to gun production (which would be done only as a “last resort) would add little to gun output, but would have devastating effects on butter production.  Thus, as we move progressively toward production of one of the two products, we have to give up more and more of the other product to achieve the increases in that product whose output we are expanding.   

 

The curvature of the production possibility frontier reflects certain realities about the nature of production.  Inputs are not all equally substitutable in the production of various goods.  As such, expanded production of a given product will ultimately bring less and less desirable resources into play, doing less to increase the output of the product at hand, but doing a great deal to reduce the output of other products for which these resources might be more suited.  Were resources to be equally substitutable across all production processes, we would then have a production possibility curve that was a straight line, like the one below.

 

 

The straight-line production possibility curve is the line segment A-B above.  The straight-line segments labeled C and D are price lines.  A price line simply shows a ratio of exchange or trade off: in this case the trade off between guns and butter. 

 

 

For example, in the graph above, we have a price line showing a trade off of 1 unit of guns for 3 units of butter.  This is like saying that (if butter costs $100 a unit) that the price of a gun is $300—it costs you three units of butter (at $100 a unit) to get a gun (which costs $300).  The slope of the price line (1/3) is the inverse of the price of guns vis-à-vis butter.  The “flatter” the price line is, the more expensive guns are (in terms of butter, in this example).  Referring to the graph above this one, we can see that there are only 3 possible production mixes.  Should the price of guns be greater (segment C) than the constant rate of technical trade-off as shown in segment A-B,  only guns will be produced, since they are more valued than the cost (trade off) of making them.  If the price (or desirability) of butter is higher than it’s cost (segment D), then only butter will be made.  The third outcome is where the price line for guns and butter has exactly the same slope as the cost of transforming guns into butter (segment A-B) then it make no difference where we produce on the production possibility frontier since all combinations will be at points where the relative desirability of guns vs. butter is the same as the cost of producing them (the technical trade off ration). 

 

The curved production possibility frontier yields an infinite number of unique solutions as to the most desirable mix of guns and butter to produce.  As we rotate a price line around the production possibility curve, we will see a locus of tangencies (points where the price line just touches the production possibility frontier).  At each point of tangency, the ratio of transformation (cost of production) will exactly equal the price of guns vs. butter, a price which represents the degree to which people prefer guns to butter.  The tangency is always the point where the cost of an incremental unit of guns or butter exactly equals the cost of producing the incremental unit.  See if you can tell yourself why this solution is optimal.

 

In the market model, consumers spend their limited incomes in such a way as to maximize their material well being, which we economists call their “utility”.  We can maximize our utility because the enjoyment or utility we can get from any product (over any defined time period) is not infinite.  I do not make myself infinitely happy by eating an infinite number of cheeseburgers in rapid succession.   At some point, the utility (enjoyment) I get from an incremental cheeseburger begins to decline.  This decline in enjoyment (or utility) is called “diminishing marginal utility”, and is the basis for the appearance of the demand curve.

 

Observe that the demand curve above (D-D) slopes downward to the right.  This downward slope means that in order to induce people to consume more of a product, its price must be reduced.  This phenomenon reflects the fact that as people consume more of a product in a given time period, they eventually get less and less additional utility from each successive unit—and so will only buy the successive unit if it costs less than the preceding one.   In other words, the price people are willing to pay is a reflection of the incremental utility (enjoyment) they are getting from the product in question.  Since, because of diminishing marginal utility, that incremental enjoyment (or utility) decreases as more is consumed, people are willing to pay less and less for succeeding units of the product in question.

 

As people spend their limited incomes to maximize their utility, they create a matrix of prices which tell producers what products consumers value the most.  It is these most valued products that producers will focus their attention on, and they will focus this attention with an eye to producing these items in the most profitable manner possible. 

 

 

The supply curve, above, slopes upward revealing that producers will supply more at higher prices than at lower ones.  This behavior reflects the fact that it costs increasingly more per unit to supply greater levels of output.  This seems to fly in the face of the historical reality of lower prices resulting from the adoption of mass production and other increasingly powerful techniques of production.  In reality, however, the declines in cost resulting from modern manufacturing techniques are what we call long run phenomena.  They occur because, over long periods of time, we can replace our factories with newer, more efficient ones.  However, in reality, all of us live in the short run, a period of time during which we are stuck with the factories and technologies that we have at hand. 

 

When we are stuck (as we always are) with the tools, technology and resources we currently have at hand, we find ourselves faced with the following kind of production costs: as we begin to produce products from our (let’s say) widget factory, we find that the first widget we produce is quite costly.  This makes sense since our widget factory was designed to produce many widgets per day, producing just one is quite inefficient.  The next widget we produce costs quite a bit less.  This falling cost of the incremental (or marginal) good continues until we reach the engineering optimum for the plant.  At that point, we’ve produced a string of widgets each of which has cost less than the preceding one, until we reach the minimum marginal (or incremental) cost point.  Beyond this engineering optimum, each successive widget is going to cost more than the last one.  Since we’re a small firm that simply takes the market widget price as a given, we have been quite happily expanding output to the engineering optimum point since each successive widget is more profitable than the previous (assuming that the price we get for widgets is greater than our marginal cost).  Once we reach the minimum marginal cost point (the engineering optimum) we can no longer happily expand output without a care.  At this point, each successive widget is going to cost more than the last, so we must pay attention to not producing a widget that costs more than what we’ll get for it.  For this reason, the supply curve, shown above, is the rising portion of the marginal cost curve.  The falling portion of the marginal costs curve is a “no brainer” as far as decision-making is concerned.  As long as price is above cost, we’ll produce every falling cost widget.  The supply decision becomes real when the cost of the next widget starts to rise.

 

 

When we combine the choices made by consumers are represented by the demand curve in the graph above with the production determinations made by suppliers as shown on the supply curve we reach an equilibrium price and quantity.  The equilibrium price and quantity is shown at the intersection of the demand and supply curve.  At this price, there is no tendency for the price or quantity to change since the amount people want to buy at this price equals the amount producers are willing to supply.  Finally, this is the point where the cost of  producing an additional unit exactly equals the amount people enjoy an additional unit as reflected in the price (sacrifice) they are willing to pay to have it.  Producing just to this point assures that neither any units that cost more than they will be valued are produced, and that every unit that is valued at least as much as it cost to produce will be made.  This is an optimal outcome.  Think about it.