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The resources available to produce goods and services are scarce compared to the unlimited wants of people. This is the central economic problem. According to Answers (2010), Finite resources can be termed as a source by which people have taken 100% advantage and further it cannot be utilized. Infinite wants are those that are unlimited.
Limited resources are those that are limited in supply and these include goods like oil and gas and the unlimited wants include goods like sports cars and jewellery. Scarcity means that economic agents (individuals, firms, government and international agencies) can only satisfy limited amounts of resources and more and more wants are being created but none can be satisfied due to scarcity so choice must be made. Choice is the deciding the different uses of scarce resources. Individuals can choose to go on a holiday or buy a house. A firm can decide to buy new equipment or recruit more workers. The government can decide to buy weapons. The real cost of choosing one thing over another is called opportunity cost. It is the benefit gained from the next best alternative. Opportunity cost occurs not only when we buy things but when we choose goods and services to produce. An example of opportunity cost: a person may have only enough money to buy just one pair of shoes - pumps or high heels. If she chooses to buy the pumps, then the opportunity cost is the benefit which would have been gained from consuming the high heels. An example of opportunity cost of the government: the state may decide to want to improve roads or provide more hospital beds but may only enough for one. If they choose the roads, then the opportunity cost is the benefit which would have been gained from providing the hospital beds. An example of opportunity in a business: a firm may want to buy new fax machines or increase the salaries of workers but can only choose one. If they choose the new fax machines, then the opportunity cost is the benefit which would have been gained from the salaries of workers.
Any organization or individual has to make 3 fundamental types of choices about how to allocate the scarce resources available for it. These choices are: What to produce, How to produce and for whom to produce.
Because all goods needs cannot be produced, decisions about what to produce must be considered for example whether to produce food or clothing.
The next stage after deciding what to produce is how to produce. Firms usually decide on what tools are needed to make these goods whether it is workers or machinery. They may decide to use more machinery than labour in order to make production faster (capital intensive) or use more workers than machines (labour intensive). Capital intensive refers to the process in which production is done by machinery while Labour is to do with the processes in which production is done manually (by people).
The decision of the distribution of goods and services must be made. This is called for whom to produce. This is to do with the distribution of goods and services. Firms may decide to give more goods to children than workers or pensioners or decide to give an equal share of all goods and services produced.
How a country decides what to produce, how to produce and for whom to produce is called its Economic System. It relies on producers and consumers to make these decisions. It allows for price mechanism or market mechanism. According to Wikipedia (2010) a market economy is an economy in which prices of goods and services are determined in the free market system set by demand and supply. There is limited government intervention which means that most decisions are taken from producers and consumers. What is produced depends on what consumers demand for and are willing to pay for that particular product. There are many characteristics of a market economy:
All resources are privately owned by the people and the firms. Nothing is owned by the government. Goods like buildings and resources are privately owned.
All firms will aim to make as much profit as possible and they do this by creating products that people will buy rather than ones people wouldn't buy. Businesses must respond to the consumers wants and desires in order to make profits.
Because it isn't controlled by the government there is freedom of entry and exit. They also produce standardized goods rather than low quality goods. If goods are cheaper and have better quality than others will makes competitors want to improve their product.
No government intervention
Most decisions are made by producers and consumers because there is no government intervention. There is freedom of what to produce because they make what is wanted by consumers.
Many demerits and merits are seen within a market economy. The advantages are as follows:
Because the consumers decide what they want, the market system responds quickly to their wants. If people want a good or a service and can afford them, resources are quickly sent to the market to produce these goods and services.
A wide variety of goods and services are produced so consumers can choose which one they prefer. It allows for new and better methods of production. New methods and machines often reduce cost of production allowing firms to increase profits.
Resources are allocated by market forces and price mechanism without government intervention.
The disadvantages are as follows:
Market economy may encourage the consumption of harmful goods for example tobacco and cigarettes. Some people may wish to purchase dangerous goods and if they buy them, the free market will find it profitable to provide such goods.
Free market system may fail to provide certain goods and services for example street lighting. Some goods and services are consumed by everyone but people wouldn't want to pay for them, they see the goods as public goods because everyone benefits from it.
The market system allocates more goods and services to those consumers who have more money than others. This shows an inequality of consumers between the rich and the poor.
The social effects of production may be ignored. These are pollution and noise from factories which will affect people who live nearby. They don't consider the social effects of their actions.
The market economy helps with solving the economic problem by providing a mechanism for deciding what, how and for whom production will take place.
In a free market system consumers are the ones to determine the allocation of resources. Profits acts like a signal for what is to be produced. For instance if firms are gaining excellent profit it means that consumers are willing to buy that product whereas if the firms are producing very low or no profit at all it means that consumers aren't interested in the product anymore.
The decision of lowering prices to beat other firms in order to gain profit is how the firms decide to produce. It results in productive efficiently because producers make products at the lowest prices possible in order to survive in the market.
The amount of money consumers spend is determined by wealth and income. People with high income tend to buy large amounts of goods and services and people with lower income tend to buy few goods and services.
Market forces help solve the problem of what, how and for whom to produce. The main aim of firms is to determine the allocation of resources that is, how factors of production are used.
The 3 basic problems of economics will always exist as long as factors like scarcity and infinite wants of man are present. These problems cannot be completely solved; however the market economy effectively manages with these problems.