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It is often said that the central purpose of economic activity is the production of goods and services to satisfy our ever-changing needs and wants.

The basic economic problem is about scarcity and choice. Every society has to decide:

  • What goods and services to produce? Does the economy uses its resources to build more hospitals, roads, schools or luxury hotels? Do we make more iPhones and iPads or double-espressos? Does the National Health Service provide free IVF treatment for childless couples?
  • How best to produce goods and services? What is the best use of our scarce resources? Should school playing fields be sold off to provide more land for affordable housing? Should we subsidise the purchase of solar panels for roofs?
  • Who is to receive goods and services? Who will get expensive hospital treatment – and who not? Should there be a minimum wage? Or perhaps a living wage? What are the causes and consequences of poverty in societies across the globe?

Scarcity

We are always uncovering of new wants and needs which producers attempt to supply by using factors of production. For a perspective on the achievements of countries in meeting people’s basic needs, theHuman Development Index produced by the United Nations is worth reading. The economist Amartya Sen(Winner of the 1998 Nobel Prize for Economics) has written extensively on this issue.

Scarcity means we all have to make choices

Because of scarcity, choices must be made by consumers, businesses and governments. For example, over six million people travel into London each day and they make decisions about when to travel, whether to use the bus, the tube, to walk or cycle or work from home. Millions of decisions are taken, many of them are habitual – but somehow on most days, people get to work on time and they get home too in safety if not in comfort!

Key Point: Trade-offs and Choices

Making a choice made normally involves a trade-off – this means that choosing more of one thing can only be achieved by giving up something else in exchange.

“Every purchase is a trade-off, of course. If you decide to spend $120,000 on a new car (including COE), you’re saying that’s worth more to you than 240 bicycles or twelve vacations to Europe or the down payment on a house. Every choice involves opportunity costs; when you choose one thing, you’re giving up others. Plus, what you’re giving up isn’t always financial.Or obvious.”

 

  1. Housing: Choices about whether to rent or buy a home – both decisions involve risk. People have to weigh up the costs and benefits of the decision.
  2. Working: Do you work full-time or part-time? Is it worth your while studying for a degree? How have these choices been affected by the introduction of university tuition fees?
  3. Transport and travel: The choice between using Euro-Tunnel, a low-cost ferry or an airline when travelling to Western Europe.

Key Point: The Cost Benefit Principle

  • In many decisions where people consider the costs and benefits of their actions – economists make use of the ‘marginal’ idea, for example what are the benefits of consuming a little extra of a product and what are the costs?
  • Rational decision-makers weigh the marginal benefit one receives from an option with its marginal cost, including the opportunity cost.
  • This cost benefit principle well applied will get you a long way in economics!
  • But keep in mind that behavioural economics questions the rationality of many of our decisions!

Factors of Production

Land:

  • Land includes all natural physical resources – e.g. fertile farm land, the benefits from a temperate climate or the harnessing of wind power and solar power and other forms of renewable energy.
  • Some nations are richly endowed with natural resources and then specialise in the their extraction and production – for example – the high productivity of the vast expanse of farm land in Canada and the United States and the oil sands in Alberta, Canada. Other countries are reliant on importing these resources.

Labour:

  • Labour is the human input into production.
  • An increase in the size and the quality of the labour force is vital if a country wants to achieve growth. In recent years the issue of the migration of labour has become important. Can migrant workers help to solve labour shortages? What are the long-term effects on the countries who suffer a drain or loss of workers through migration?

Capital:

  • Capital goods are used to produce other consumer goods and services in the future
  • Fixed capital includes machinery, equipment, new technology, factories and other buildings
  • Working capital means stocks of finished and semi-finished goods (or components) that will be either consumed in the near future or will be made into consumer goods

New items of capital machinery, buildings or technology are used to boost the productivity of labour. For example, improved technology in farming has vastly increased productivity and allowed millions of people to move from working on the land into more valuable jobs in other industries.

  Infrastructure – a crucial type of capital

Examples of infrastructure include road & rail networks; airports & docks; telecommunications e.g. cables and satellites to enable web access.

The World Bank regards infrastructure as an essential pillar for economic growth in developing countries. India is often cited as a country whose growth prospects are being limited by weaknesses in national infrastructure.

Entrepreneurship

An entrepreneur is an individual who supplies products to a market to make a profit.

Entrepreneurs will usually invest their own financial capital in a business and take on the risks. Their main reward is the profit made from running the business.

Renewable and Finite Resources

Renewable resources are commodities such as solar energy, oxygen, biomass, fish stocks or forestry that is inexhaustible or replaceable over time providing that the rate of extraction of the resource is less than the natural rate at which the resource renews itself. (This is important!) This is a key issue in environmental economics, for example the over-extraction of fish stocks, and the global risks of permanent water shortages resulting

Finite resources cannot be renewed. For example with plastics, crude oil, coal, natural gas and other items produced from fossil fuels, no mechanisms exist to replenish them.

production possibility frontier (PPF) is a curve or a boundary which shows the combinations of two or more goods and services that can be produced whilst using all of the available factor resources efficiently.

We normally draw a PPF on a diagram as concave to the origin. This is because the extra output resulting from allocating more resources to one particular good may fall. I.e. as we move down the PPF, as more resources are allocated towards Good Y, the extra output gets smaller – and more of Good X has to be given up in order to produce the extra output of Good Y. This is known as the principle of diminishing returns. Diminishing returns occurs because not all factor inputs are equally suited to producing different goods and services.

Diminishing returns occurs because not all factor inputs are equally suited to producing different goods and services

Combinations of output of goods X and Y lying inside the PPF occur when there are unemployed resources or when the economy uses resources inefficiently. In the diagram above, point X is an example of this. We could increase total output by moving towards the production possibility frontier and reaching any of points C, A or B.

Point D is unattainable at the moment because it lies beyond the PPF. A country would require an increase in factor resources, or an increase in the efficiency (or productivity) of factor resources or animprovement in technology to reach this combination of Good X and Good Y. If we achieve this then output combination D may become attainable.

Producing more of both goods would represent an improvement in our economic welfare providing that the products are giving consumers a positive satisfaction and therefore an improvement in what is calledallocative efficiency

Reallocating scarce resources from one product to another involves an opportunity cost. If we go back to the previous PPF diagram, if we increase our output of Good X (i.e. a movement along the PPF from point A to point B) then fewer resources are available to produce good Y. Because of the shape of the PPF the opportunity cost of switching resources increases – i.e. we have to give up more of Good Y to achieve gains in the output of good X.

Because of the shape of the PPF the opportunity cost of switching resources increases – i.e. we have to give up more of Good Y to achieve gains in the output of good X.

The PPF does not always have to be drawn as a curve. If the opportunity cost for producing two products is constant, then we draw the PPF as a straight line. The gradient of that line is a way of measuring the opportunity cost between two goods.

The PPF does not always have to be drawn as a curve. If the opportunity cost for producing two products is constant, then we draw the PPF as a straight line. The gradient of that line is a way of measuring the opportunity cost between two goods.

Explaining Shifts in the Production Possibility Frontier

The production possibility frontier will shift when:

  • There are improvements in productivity and efficiency perhaps because of the introduction ofnew technology or advances in the techniques of production)
  • More factor resources are exploited perhaps due to an increase in the size of the workforce or a rise in the amount of capital equipment available for businesses

In the diagram below, there is an improvement in technology which shifts the PPF outwards. As a result of this, output possibilities have increased and we can conclude (providing the good provides positive satisfaction to consumers) that there is an improvement in economic welfare.

In the diagram below, there is an improvement in technology which shifts the PPF outwards. As a result of this, output possibilities have increased and we can conclude (providing the good provides positive satisfaction to consumers) that there is an improvement in economic welfare.

Technology, prices and consumer welfare

Improved technology should bring market prices down and make products more affordable to the consumer. This has been the case in the market for personal computers and digital products. The exploitation of economies of scale and improvements in production technology has brought prices down for consumers and businesses.

External Costs

In the case of air pollution there is an external cost to society arising from the contamination of our air supplies. External costs are those costs faced by a third party for which no compensation is forthcoming. Identifying and then estimating a monetary value for air pollution can be a very difficult exercise – but one that is important for economists concerned with the impact of economic activity on our environment. We will consider this issue in more detail when we study externalities and market failure.

Free Goods

Not all goods have an opportunity cost. Free goods are not scarce and no cost is involved when consuming them.