The fundamental economic problem

The fundamental economic problem is related to the issue of scarcity. Because of limited resources and infinite demands, society needs to determine how to produce and distribute these relatively scarce resources. Of course, it is possible humans could limit their demands and be satisfied with the basic necessity's of life. In some tribal society's / spiritual communities you could argue there is no economic problem because the limited resources are more than adequate to meet all their wishes.
However, society is mostly dominated by people wishing to consume more goods and services than are available. Because there is a shortage of resources, economics considers:

• What to produce?
• How to produce?
• For whom to produce?

Opportunity cost

A key issue in this fundamental economic problem is the issue of opportunity cost. If we devote resources to building guns, then the opportunity cost is that we can't use these resources (land, labour) for growing vegetables. More on opportunity cost

How much should the government intervene in the economy?

From these three key questions there are numerous alternatives and theories about the best way to proceed. One of the fundamental questions has been the extent to which governments should intervene in the production and distribution of resources.

• How much should the government intervene in the economy?

Market forces and the economic problem

Some economists suggest the free market is the best way to deal with this economic problem. The free market can distribute resources according to consumer preferences; firms have an incentive to provide goods and services in demand.

However, other argue that a free market creates many problems; notably inequality of distribution. Therefore, because of this it is necessary for the government to intervene in the economic decision making process.

The market mechanism  dealing with the economic problem

Good becomes more available

In this diagram above, the good becomes more abundant. This causes the supply curve shifts to the right. This leads to a lower price and increase in quantity.

Therefore, if a good becomes more abundant, the market mechanism makes it cheaper and people buy more. For example, when steel became cheaper in the nineteenth century, it started to be used in many more applications

Fall in supply

In this diagram we have a fall in supply. In this case the opposite happens. Because this good is in shorter supply, the price goes up. This increase in price causes a fall in demand.
For example, as we run out of oil, we should expect the price to go up. This increase in the price of oil will cause demand to fall and people to look for alternatives.

Diagram showing increase in price

In this diagram, we have rising demand (D1 to D2) but also a fall in supply. The effect is to cause a large rise in price. For example, if we run out of oil, supply will fall. However, economic growth means demand continues to rise.

Related

• Supply and demand diagrams