Every economy needs to answer three basic questions: what to produce, how to produce the goods and services, and for whom to produce. Keep in mind that resources like land, labor, capital are limited or scarce. We simply cannot have everything; we will have to make choices. Which ones would be best? For allocative efficiency we should select the mix of services and products which produces the most value or utility.
Which products should be manufactured and in what quantities? The products that do not command positive prices in the market will not be manufactured. As a result just those goods with positive prices are to be produced and in such a manner that will clear the markets.
The quantity in which an item should be made is set at that level where demand equals supply. If quantity manufactured is more or less, then there will be disequilibrium in the marketplace and price will fluctuate. Hence, to keep stable equilibrium price it becomes essential to make supply and demand equal. This rule does apply for each commodity. By doing this, first central problem is solved.
Every choice we make has a cost associated with it. We simply cannot select one alternative without forfeiting another. Assume the selection is to produce either a travelling bag or a wallet. If we choose the travelling bag, we lose the wallet. If we opt for the wallet, we lose the travelling bag. To an economist, correct costs are what we have to give up to get something. In this example, the cost of the travelling bag is the lost wallet, and the cost of the wallet is the lost travelling bag. The professional jargon calls these opportunity costs. Opportunity cost is the value that needs to be sacrificed or given up. They are also the value of our next best option or opportunity. Why? Every time we make a selection, what we sacrifice is our next best alternative.
Figure: What to Produce? – Basic Economic Problem
Read Also: How to Produce?
This graph illustrates the trade off between travel bags and wallet. Due to scarcity, choices have to be made by consumers, businesses and governments. For instance, thousands of people travel into Delhi and they make selections about when to travel, if they should use the bus, the car, to walk or cycle – or whether to work from home. Countless choices are being made, quite a few are habitual.
Read Also: Three Basic Economic Problems