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Chapter 1: The economic problem (Spanish)

By Lic. Gabriel Leandro, MBA.

Main concepts developed in this topic:

Economic activity Goods
Capital goods Consumer goods
Economic goods Intermediate goods
Free goods Capacidad empresarial
Capital How to produce?
Opportunity cost Transformation curve
Economics Mixed economy
Scarcity Production boundaries
Capitalist model Circular flow model
Models of economic organization Socialist model
Needs To whom should one produce?
Economic problem Economic reasoning
Resources What to produce?
Land Work


Economics is part of everyone’s life. This is because any individual can consume, save, work, produce, invest, acquire debts, and pay taxes, among many other activities studied by economics. That’s why information regarding economics appears in newspapers, television, the internet and other media which is associated with fundamental variables in order to take proper decisions. Some of these variables relate to prices, interest rates, salaries, jobs, exchange rates, etc. Being able to know and understand these variables is even more important for people who manage businesses since their success is based on an appropriate understanding of the present and future economic environment.

This chapter tries to describe the economic problem, which gives origin to economics, and also studies some models that will illustrate this problem and the way in which society organizes itself to solve it.

ECONOMICS: It’s the science that studies the way in which limited resources are assigned among the diverse uses that compete for them, with the purpose to satisfy part of the individual’s unlimited desires.

The Economic Activity

The economic activity is the interaction between production units, consumers, and interchange. In this sense it’s possible to point out three basic elements of the economic activity: the resources, the needs and the goods.

Now, each of the components of the economic activity will be analyzed: recourses, needs and goods.

  • Resources: are all the means used for the production of goods and services.

Resource classification:

Classic Version

  • Land: It refers to all the means of production that are found in nature, such as terrains for agriculture, mineral reserves, rivers, etc..
  • Work: Consists of the time and effort (physical or mental) that people assign to the production of goods and services.
  • Capital: It refers to the means created by human beings and work for production, such as machinery, a physical plant of a company, production equipment, among others.

Alternate Version

  • Natural resources of value: It refers to the factors that intervene in the production, and are obtained from nature, such as land, rivers, etc.
  • Economically active population or labor force: It refers to the work that can be accomplished by the total of workers with physical and mental capacity, included occupied and unoccupied.
  • Capital: refers to the means created by human beings and work for production, such as machinery, physical plant of a company, production equipment, among others.
  • Technology: Any method to produce a good or service.
  • Business Capacity: consists of a group of abilities and skills that allow coordination for the rest of recourses (land, work, capital and technology). In other words, the capacity to design and create new products, to develop new production processes, etc.

Characteristics of resources:

  1. Limited: resources are not enough to supply all the possible requirements and needs of the individuals.
  2. Changeable: resources may have more than one possible use. For example: a piece of land may be used to plant coffee or build a factory.
  3. Partially replaceable: in determined circumstances, a resource may replace another in the production of a good or service. For example: in an industrial plant, tasks may be carried out manually, but they can also be done automatically by certain machinery. In this case work is substituted by capital.
  • Needs:

A need is “any internal state that makes certain results seem attractive.” (Robbins)
It’s that which can’t be disregarded. It manifests a lack of something.

Types of needs:

  • Primay
  • Secundary
  • Essential
  • Non essential
  • Individual
  • Collective
  • Physiological
  • Safety
  • Social
  • Esteem
  • Fulfillment

    This is the so-called Maslow’s Pyramid of Needs

Characteristics of needs:

  1. Unlimited
  2. Satiable
  3. Intensity
  4. Temporality

On the contrary of resources, which are scarce, needs are unlimited (and more on the desires) since in a lifetime we need to supply our needs of food, clothing, transportation, communication, housing among many other.

 Goods: A good is anything that satisfies needs.

By their abundance or relative shortage
  • Free goods: They are so abundant that no one would be willing to pay for them. For example: air.
  • Economic goods: they are relatively scarce and therefore, have a more elevated cost, such as a book, a pant, etc.
By their destination
  • Consumer goods: Final goods destined for a buyer and found in the market. Such is the case of a finished shirt ready to be worn by someone.
  • Production or capital goods: they are goods that are used to produce other goods, for example a sewing machine.
  • Intermediate goods: are goods used in any of the different stages of production and are partially finished such as cloth, string, etc.
By their degree of elaboration
  • Finished goods: products that have reached the final stage of production and are ready to be consumed. For example an automobile, a shirt, etc.
  • Unfinished goods: are the ones that need other stages of production to be concluded. For example only having the sleeves of a shirt.
By their nature
  • Tangible good: goods that represent material objects: a compact disc or a notebook.
  • Intangible goods: it refers to the services we use but can’t be perceived, as a doctor’s appointment or an economics class.
By their possession
  • Private goods: their use is limited to its owner or producer. For example an automobile.
  • Public goods: they can be consumed by everyone in a simultaneous manner, even without paying for the good and no one can be excluded from their use. This is the case of street lighting, roads, etc.

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The Economic Problem:

As mentioned before, the resources are limited and the needs unlimited. Therefore the economic problem will consist of:

How to use the limited resources to produce enough goods and services in order to satisfy unlimited needs?

That’s why ECONOMICS is the science that studies the way in which the limited resources are assigned among the different uses that compete for them.

Key questions of economics: The economic problem may be expressed by three basic questions that must be answered by any system of economic organization:

  1. What to produce and how much? In other words: What goods and services must be produced and in what amounts? Due to the existence of needs and that these must be satisfied accordingly, it’s necessary to determine what needs are going to be fulfilled and what goods satisfy these needs. This question is of economic nature.
  2. How to produce? Meaning, How to produce goods? This question is of technical nature and it refers to what technology will be used in the production, what are the necessary materials, what type of workforce, the production process, etc..
  3. For whom should one produce? Meaning. Who obtains what’s being produced? This question is of social nature and its solution depends on the model that the social organization follows, for example, in a market economy it will depend on the buying capacity of the different consumers.

Model of the Transformation Curve:

Due to the shortage of resources, it’s necessary to choose the resource distribution according to the needs, likes and preferences. This is why the model of transformation curve or production frontier is presented.

A model in this context is a simplified representation of reality and its behavior. In order to build the model, it’s necessary to formulate hypothesis since reality is regularly more complex.

Assumptions of the model of curve transformation:

  1. Society produces two goods or goods basket.
  2. Economics is autarkic.
  3. The curve is traced by a time unit.
  4. Technology is given and it’s the best.
  5. Production factors are given.
  6. Production factors are versatile, but are not equally productive in different activities.
  7. There is full use of factors.
  8. Individuals act rationally

Definition of production frontier or curve transformation

Curve transformation or production frontier can be defined as:

The group of all the different maximum alternative combinations of two goods or services that might produce in a determined period, when there’s an unlimited availability of factors and technology.

For example, imagine an economy that produces coffee of shirts according to the following data, where the amount of coffee is given in thousands of sacks per month , and the shirts in thousands of units:

Quantities by time unit

Graphically it would be represented like this, where the transformation curve is concave downwards:

It’s of great importance to point out some of the conclusions obtained from this model which are:

  • The curve illustrates the shortage problem and by that, it explains the economic problem. If there were no lack, then a frontier or maximum limit wouldn’t exist.
  • It illustrates the OPPOURTNITY COST: this is because shortage implies the need of choice, therefore obtaining the highest production requires a reduction in the production (chance loss) of one or more goods. The cost of an opportunity in a determined action is the value of the best sacrificed alternative. In the example, if the economy is in point A and whishes to be transferred to point B, then to opportunity cost is 1, since it scarifies one unit of coffee to obtain one unit of shirts. Shifting from B to C scarifies two units of coffee and obtains another of shirts; therefore the opportunity cost is 2.
  • Law of growing opportunity cost: the highest obtaining of a good in equal amounts requires giving up higher quantities of the alternative good. This is because the resources are not equally productive in different areas. The graph illustrates the opportunity cost (O.P.) of moving point A to B, then B to C and so on until it reaches F:

  • All the points in the curve are equally efficient (there’s a full use of factors and the best technology possible is used), it all depends on the combination that wants to be made.
  • Any point in the interior’s frontier means that the resources are not fully used or are used in an ineffective manner. For example in the following graph, points M and N are equally efficient, but point Q is not, because it’s producing less than the maximum as for coffee or shirts.

  • The highest points in the curve are desirable, but unreachable according to the present conditions.
  • The frontier’s expansion occurs when there is a higher income of resources (capital accumulation, workforce increase, better technology) or an increase in their productivity, which triggers an economic growth, therefore reaching points that were not possible to reach before. It’s also possible that the curve may move left. This could happen in a natural disaster, war, or any other situation that may reduce the maximum capacity of economic production..

Applications of the model of curve transformation: Commercial interchange and the corporate advantage.

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  • Market mechanisms (capitalist model): the offer and demand determine the price. The owners assign the resources to obtain the highest monetary rewards.
  • Centralized Economy (socialist model): the central authority determines the price and assigns the resources for goal achievement.
  • Mixed: an economy that uses signs from the market and not, to assign goods and resources..

The following table summarizes the way in which each model of economic organizations answers to the three basic economic questions. It also shows the way in which production is organized and it establishes the properties’ regime for the resources:

Property regime The material resources are subject to the social property regime. The collective social property and the consumption social property coexist in some degree, with a relative freedom of hiring and with possibilities of employment. The regime of resource private property prevails. The resources acquired by the government would be relatively small compared to private property. Productive resources of state and private property exist. There are also companies where capital is co-owned by the state and regular businessmen.
Production Organization A planning entity designs an economic plan that contains general objectives and specific goals with a stock of available resources. The production units and the direction of technical bodies carry out the task. The market is the fundamental institution that acts as a coordinating mechanism for economic activity. As the market establishes the prices and amounts of interchange it determines the assignment of productive resources. The government does not control totally, but it actively participates as a producer, consumer and regulator of the economic activity. Free markets coexist with others with funding conditioned by state intervention.
What to produce? This decision is taken by the political high level, were the most important thing is how many resources will be meant for capital formation and then which ones will be destined for consumer goods. The consumer autonomy prevails, meaning that the consumers will seek the goods of there choice, according to their income. In this way, they will determine what goods should be produced and in what amounts.

The three following situations are presented: 1. Goods produced and exchanged in free markets. 2. Goods produced in markets intervened by the government. 3. Goods and services produced directly by the government.

How to produce? The decision is taken by the director of each production unit according to the resources and technology available. This decision is taken by the producer according to the present technical possibilities and the relative prices of the productive resources. The decision is taken by the producer, being a businessman or government, according to the technical criteria and the rice of resources.
For whom should one produce? Capital goods are assigned to the producers, while some consumer goods are offered freely and others rationalized. Production distribution is carried on according to the buying capacity, which depends on peoples’ income and the prices of goods. Some goods and services are offered freely by the government, while others are distributed according to the buying capacity of the individuals.


The model of circular flux of the economic activity illustrates how a market economy works. Supposedly, there are two economic agents in this economy: the consumers and the producers. The government will be excluded in this simple version. Also, the economy is closed and consumers spend all their income, in other words, they don’t save. There are two main markets: the market of goods and services, and the market of production factors. The model is illustrated in the following diagram:

This diagram is a schematic representation of how economies are organized according to the market. Both consumers (households) and producers (enterprises) need to make decisions. This will make agents interact in the market of goods and services (where consumers are buyers and producers are sellers) and in the market of production factors (where consumers are sellers, and the producers acquire services).

It’s of equal importance to highlight that within this scheme, an expense for one agent will result in income for another. For example, the acquisition of a chair results in an expense for homes, but at the same time it will become and income for the producer.


Economics is a social science; this means it obtains its knowledge from the scientific methods. The following diagram illustrates the way in which economic knowledge is formulated.


In economics it’s possible to talk about facts and reality, which is objective. This is what positive economics refers to. But it’s also possible to formulate judgments about facts. This is called normative economics. Positive economics uses math, statistics and econometrics to describe the different economic phenomena (descriptive economics). It explains these phenomena through the economic theory, which is divided in microeconomics and macroeconomics. Macroeconomics is the study of economic adds such as, national production and the price level. Microeconomics is the study of consumer and producer behavior that operates in the individual markets of economy.


Work on exercises about this Tepic: Economic problem and Models of Economic Organization.

View exercises on text book’s Website: Economic site of Parkin. Chapters 1 and 3.

View Interactive test on ECOMUR.COM. Topics 1 and 2.

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