Economic Systems and Production Possibility Curves: Question 3

Worked solution

Part (a): The three fundamental economic questions

Because resources are scarce relative to human wants, every economic system (market, planned, or mixed) must answer three fundamental questions:

• What to produce? Which goods and services should be produced, and in what quantities, given that producing more of one thing means fewer resources are available for something else.
• How to produce? Which methods and combination of the factors of production (land, labour, capital and enterprise) should be used to produce those goods and services.
• For whom to produce? How the goods and services that are produced should be distributed among the different members of society.

Part (b): The price mechanism and the coffee price rise

A rise in the world price of coffee beans works through the price mechanism to change the behaviour of coffee farmers in a market economy:

• Signalling function: the higher price signals to coffee farmers (and to potential new entrants) that coffee is now relatively more valuable/scarce than before, compared with other crops they could grow instead.
• Incentive function: because the price farmers can sell their coffee for has risen, the potential revenue and profit from growing coffee increases. This higher potential reward is a direct incentive for existing coffee farmers to expand production, for example, by planting more coffee bushes, using more labour to harvest, or switching land previously used for another crop into coffee.

Because these adjustments happen automatically through the profit incentive facing individual farmers, rather than through any central government instruction, more of the economy’s resources move into coffee production purely as a market response to the price signal. This is a movement along the market supply curve for coffee (a response to a price change), rather than a shift of the supply curve itself.

Part (c): Why national defence needs the public sector

National defence has two key characteristics that mean the private sector, left alone, is unlikely to supply it:

• Non-excludable: once a country is defended, it is essentially impossible to prevent any individual citizen from benefiting from that protection, even if they refused to pay for it. If a private firm tried to sell national defence, people could simply “free-ride”, enjoying the protection without paying, so the firm could not collect enough revenue from individual customers to cover its costs, and so it would not be profitable for it to supply the good at all.
• Non-rival: one person benefiting from national defence does not reduce the amount of protection available to anyone else, unlike a private good, where one person’s consumption does reduce what is left for others. This means the additional (marginal) cost of extending protection to one more citizen is effectively zero, so charging a per-person price, even if it were possible, would not be an efficient way to allocate the good.

Because the free-rider problem prevents a private firm from profitably supplying national defence, and because rationing it by price would be inefficient in any case, it is instead normally provided directly by the public sector, funded out of general taxation rather than through individual charges.

Final answers

• (a) The three fundamental economic questions are what, how, and for whom to produce
• (b) The higher coffee price raises farmers’ potential profit, incentivising them (via the price mechanism) to grow more coffee
• (c) Non-excludability and non-rivalry mean the private sector would under-supply (or not supply) national defence, so the public sector provides it, funded by taxation