The Economic Problem: Scarcity and Choice
I
Important Terms and Concepts
Opportunity cost 48
Cost-benefit approach 50
Production possibility (p-p) schedule 51
Production possibility (p-p) curve 52
Law of increasing opportunity cost 53
Productive efficiency 54
Productive inefficiency 54
Free lunch 55
Economic growth 56
Aggregate output 59
Business cycles 59
II
Unemployment 59
Inflation 59
Cost of living 60
Circular flow 61
Households 61
Firms 61
Market 61
Factor market 62
Product market 62
Real flows 62
Money flows 63
Objectives
After studying this chapter, students should be able to:
LO 2.1
Explain the relationship among scarcity, choice, and opportunity cost.
LO 2.2
Discuss and use the concepts of production possibilities schedules and production
possibilities curves.
LO 2.3
Discuss and illustrate graphically shifts in the production possibilities curve.
LO 2.4
Explain the fundamental economic questions and classify them as microeconomic or
macroeconomic issues.
LO 2.5
Construct a circular flow model and explain the flow of goods and services and
resources in the economy.
III
An Overview of the Chapter
One of the difficulties that students face is to view choice not only as taking, but also, and more
importantly, as giving up something. Once students grasp this way of looking at choice, it is a
relatively easy to establish a link between choice and opportunity cost. If students can see the
importance of incorporating the concept of opportunity cost in their own decision making, they
will likely be more receptive to the practicality of the concept and its relevance to their own lives.
The concept of an economic model was introduced in Chapter 1. The introduction of the
production possibility diagram here in chapter 3 is an opportunity for students to see how an
economic model is constructed and used. The approach used here is to present the simpler though
less realistic case of constant opportunity cost. The more realistic case of increasing opportunity
cost should be easier to grasp once students understand the concept of constant opportunity cost.
Students at this level clearly understand that inflation, unemployment, how to organize
production, how to price output, etc. are economic problems and issues. What has to be brought
to their attention is that all these problems stem from one fundamental economic problem—the
problem of scarcity. Once the problem of scarcity is understood, it is probably a good idea to
explain how an economic system like the Canadian economy attempts to deal with this enduring
economic problem.
The circular model has proved its worth as an excellent device for explaining the flow of resources,
income, and goods and services, and expenditures in an economy. The concepts of product market
and factor market are also easy to describe within a circular flow framework. Students should be
encouraged to provide real world examples of product markets and factor markets.
IV
Teaching Tips
The chapter includes some of the major economic concepts that are useful for understanding the
decision of households, firms, and governments: scarcity, choice, and opportunity cost. To help
students understand the economic way of thinking—the trade-off in decision making—we
strongly suggest that instructors spend some time providing students with examples of real
situations. One of the problems that beginning students face is that economics has taken
commonly used words and has given them a different meaning. One such word is “scarcity”.
Scarcity for most students taking economics for the first time means a low availability of a
product or a service. In introducing the concept of scarcity one instructor starts his lecture by
asking his class the question, “who is the richest man?” Many would answer, “Bill Gates”. And
then he follows his question, “Can Mr. Gates do everything he wishes to do?” Some students
would reply by saying that since he is the richest man, yes he can buy anything he wants to buy
and can do almost everything he wants to do. Other students would qualify the response by
adding the proviso that what he wants to buy or do has to be legal. The instructor follows his
question by asking, “Can he attend a symphony concert in Vienna and play golf in Kingston
Jamaica at the same time”. By this time most students realize even the richest people face the
scarcity of time, and have to decide how best to use their time.
The discussion about Mr. Gates’ limited time can lead to drawing a curve on the trade-off
between time spent on productive activities and leisure or between two types of leisurely
activities, a time allocation “production possibilities” curve for a typical student. Since many
students work part time, the time allocation trade off is relevant for students. An hour a student
spends surfing the Internet or watching TV is an hour not spent studying economics. Assuming
that all students have eight hours of free time, you can ask students to draw the “time budget
line”, starting with the maximum amount of time they can spend on watching TV and the
maximum amount of time they can spend studying economics. From this exercise, you will be
able to demonstrate to the students about:
-
Scarcity (in this case time)
Trade off, the adage that “ there is no free lunch”
Choice
Opportunity cost of watching TV
Differences in individual choice between watching TV and other activities
This simple exercise can partially demonstrate the idea of “thinking like an economist” and the
relevance of economics in explaining the trade off in the decisions of individuals, decision even
as mundane as watching TV.
V
Lecture Notes
A.
Scarcity, opportunity cost, and choice
a) Scarcity: It was stated earlier that scarcity is a fundamental problem that households, firms,
and governments face because of limited resources and unlimited wants. Even extremely rich
people face the problem of scarcity since their time is limited.
b) Opportunity cost: many economists use the common adage, “there is no free lunch” to
explain the concept of opportunity cost. Because resources are limited and because they have
alternative uses, we have to decide how best to use them. We have to choose the best way of
using our resources, and once we decide to use a resource in a certain way, that resource
cannot be used for another purpose. Opportunity cost is the cost of using a resource in terms
of its alternative use.
B.
Cost-benefit analysis
a) Any decision involves costs and benefits. These costs and benefits can be monetary and
non-monetary. We assume that when individuals make decisions, they weigh the costs and
benefits of their decisions, especially important decisions. A decision is considered rational
when its benefits outweigh its the costs.
b) Marginal benefits and costs: what is considered is not the total benefits and total costs, but
rather the marginal benefits and marginal costs, the addition to total benefits and to total costs
as a result of undertaking a unit of something.
C.
The production possibilities: the maximum combinations of two products that could be
produced when resources are used efficiently and fully, under the existing technology. The
relationship can be shown in a table or a curve: the production possibilities schedule (PPS) and
the production possibilities curve (PPC).
a.) The PPC can be used to illustrate the following concepts.
i. Choice: a movement along the curve
ii. Productive efficiency: a point on the curve.
iii. Productive inefficiency: a point inside the curve
iv. Unemployment: a point inside the curve
v. Full employment: a point in the curve
vi. Opportunity cost: the slope of the curve
vii. Economic growth: an outward shift of the curve
viii. Scarcity: a point outside the curve
b) Linear production possibilities curve: since a linear curve has a constant slope, the rate of
change between the two goods remains unchanged, irrespective of the level of production of
either product. The opportunity cost of switching from producing one product to the other
remains constant, as the production of one product increases. This situation assumes that
resources are equally efficient in producing both products.
c) A concave production possibilities curve: since it has an increasing slope, as the production
of one of the products increases, the rate of change between the two products increases. The
opportunity cost of switching from producing one product to the other increases. More and
more of one product must be given up, to obtain a unit increase in the production the other
product. This is sometimes known as the law of increasing opportunity cost. The reasons
behind the increase in opportunity cost are the heterogeneity of resources and existence of the
law of diminishing returns.
d) Shifts in the PPC
i. Economic growth: The curve shifts outward, to the right. Technological change
affecting both products equally, results in a proportional increase in the production of the
two products. Technological change affecting only one of the products increases the
intercept of that product, while keeping that of the other product unchanged. A
technological change that affects one product more than the other results in
disproportional increases in the two products.
ii. Disasters: man-made disasters (wars, riots) and natural disasters (earthquakes, floods,
droughts, and tsunamis) shift the curve to the left, towards the origin.
D.
The fundamental microeconomic questions
a) What is produced? Answers the types and quantities of goods and services produced. In a
market economy, the interaction of consumers and firms, influenced by government
regulations, settles this question.
b) How are the goods produced? The level of technology, the relative availability of resources,
and intuitional arrangements determine how resources are combined to produce a product or a
service.
c) For whom are the goods produced? The distribution of what is produced among the
different income groups in society, between workers and other groups, depends on the
productivity of each resource, the relative bargaining position of each group, and institutional
arrangements.
E.
The fundamental macroeconomic issues
a) Aggregate output: the total amount of goods and services produced in an economy over a
period. It is also known as GDP.
b) Business cycles: periodic changes in total output in the short run. Periods of economic
upturns and downturns.
c) Unemployment: an economic situation in which people who are willing and ready to work
cannot find jobs.
d) Inflation: an increase in the average price level over time.
e) Economic growth: an increase in the goods and services produced by an economy over time.
An increase in real GDP.
f) International balance of payments: the net flow of goods and services and capital between
Canada and the rest of the world.
F.
The circular flow of income: a simplified model showing the flow of goods and services and
income between households and firms. The model shows a real flow and a corresponding
opposite monetary flow. The model incorporates:
a) Households
Individuals living under the same roof constitute households. It is assumed households
maximize their well-being, their utility, by selling the factors of production they own,
including their labour services in the factor market, and by buying goods and services from
firms in the product market.
b) Firms
A business organization that sells goods or services for the purposes of making profit. There
are different forms business organizations. Firms are assumed to maximize profits by buying
factor services in the factor market and selling goods and services in the product market.
c) Factor market: the market where factors of production are bought and sold. Households sell
the services of their factors to firms.
d) Product markets: the market where goods and services are bought and sold. Firms sell
goods and services to households.
VI
Answers to Reading Comprehension Questions
LO 2.1
1.
Explain the relationship among scarcity, choice, and opportunity cost
What is the relationship among scarcity, choice, and opportunity cost?
Because of the existence of scarcity, we are forced to choose. We cannot have as
much of everything as we would like to have. The act of choosing involves
giving up something and whatever is given up is the opportunity cost.
2.
Define opportunity cost and give an example to demonstrate your
understanding of the concept.
The point that students should note is that opportunity cost is not necessarily the
money spent to buy something. Instead, it is whatever is sacrificed when a choice
is made. If you chose to go to a hockey game with a free ticket instead of going
to a party with your friends, then the opportunity cost of going to the hockey
game is the party that you gave up.
3.
Briefly explain the cost-benefit approach to decision making. Give an
example of the practical use of this approach.
It is worth noting that the concept of cost here should include opportunity cost.
The cost-benefit approach involves comparing benefits and costs. If the benefits
outweigh the costs, then it is worth pursuing the activity. An example would be
attending class because in your estimation, the benefits of doing so exceed the
costs of being absent.
4.
Using the concept of opportunity cost, give a possible explanation for the
observation that most college students prefer late morning classes to early
morning classes.
One possible explanation is that college students like sleep. Late morning classes
afford them the opportunity of sleeping longer. The opportunity cost of early
morning classes is the extra sleep that they could have obtained.
LO 2.2
1.
Discuss and use the concepts of production possibilities schedules and
production possibilities curves
What does a linear p-p curve tell us about opportunity cost?
A linear p-p curve tells us that we are assuming that opportunity cost is constant.
2.
Explain why p-p curves are more likely to be concave than linear.
The key to this answer is to recognize that resources are not all equally efficient
in all uses. That being the case, opportunity cost is likely to be increasing rather
than constant. Thus, p-p curves are more likely to be concave than linear.
3.
State the law of increasing opportunity cost.
The law of increasing opportunity cost states that as an economy increases its
production of a commodity, the cost per unit of production rises.
4.
Define: a) Productive efficiency
b) Productive inefficiency
a) Productive efficiency refers to the condition that exists when it is impossible to
produce more of one commodity without producing less of some other
commodity.
b) Productive inefficiency is the condition that exists when it is possible to
produce more of one commodity without producing less of some other
commodity.
5.
In economics, there is no way of getting something for nothing (no free
lunch). Do you agree? Explain fully.
If resources are not fully employed, the economy can produce more goods and
services without sacrificing the production of anything. This is the case of a free
lunch. However, if the economy’s resources are fully employed, there can be no
“free lunch”.
LO 2.3
1.
Discuss and illustrate graphically shifts in the production possibilities curve
Give three examples of specific events that would cause Canada’s p-p curve
to shift out to the right.
Anything that increases Canada’s productive capacity will shift its p-p curve to
the right. Included will be increases in the quantity or quality of any resource
whether natural, human, or capital, and an increase in technology. An increase in
the use of existing resources does not shift the p-p curve.
2.
How can economic growth be illustrated on a p-p diagram?
Economic growth can be illustrated by a shift of the p-p curve to the right.
3.
Explain why a fall in prices will not shift an economy’s p-p curve.
Factors that will shift an economy’s p-p curve are factors that affect the
economy’s productive capacity. These include changes in the quantity or quality
of resources and changes in technology. Since a fall in price does not affect the
economy’s productive capacity, it follows that it will not shift the p-p curve.
4.
LO 2.4
1.
Explain why p-p curves are unlikely to shift in or out in a parallel manner.
It is unlikely that changes in the quantity or quality of resources or in technology
will affect the production of goods or services equally. Parallel shifts in the p-p
curve are therefore unlikely.
Explain the fundamental economic questions and classify them as
microeconomic or macroeconomic issues
What are the fundamental microeconomic questions?
The fundamental microeconomic questions are (1) What goods and services will
the economy produce and in what quantities? (2) What method of production will
be used to produce the economy’s output of goods and services? (3) How will the
economy’s output of goods and services be distributed among the various
members of the society? These questions are usually summarized into What?
How? and For whom?
2.
What do the microeconomic questions what? how? and for whom? refer to?
What refers to what goods and services should be produced and in what
quantities, how refers to the method of production that should be used, and for
whom refers to how the output of goods and services should be divided among
the citizens.
3.
Identify four important macroeconomic questions or issues and explain
briefly why each is important.
Among the macroeconomic questions that can be mentioned are inflation (cost of
living), output of goods and services (standard of living), unemployment, growth
of total output, economic fluctuations, and problems in the international
economy.
4.
Why would ordinary Canadians be interested in the cost of living?
The cost of living refers to the amount of money required to sustain a certain
level of living, including basic needs such as housing, food, and healthcare.
Canadians would be interested in the cost of living because it is directly related to
one’s quality of life.
LO 2.5
1.
Construct a circular flow model and explain the flow of goods, services, and
resources in the economy
Explain the roles of households and firms in the factor market and the
product market. Give one example each of a product market and a factor
market.
Most students will probably think of households only as buyers of goods and
services and of firms only as sellers of goods and services. In other words, they
tend to consider only the product market. It is the case that households also sell
resources and that firms also buy resources. We should not ignore the factor
market.
2.
In the real world, earning a profit is associated with firms. Why, in the
circular flow model, do households earn profits?
The reason is that in the circular model, we assume that households own all the
resources. Profit is the income derived from the resource called entrepreneurial
services. Thus households earn profits.
3.
Distinguish between real flows and money flows. Give an example each of a
real flow and a money flow in the circular flow model.
The distinction between real and monetary is important in economics. The
circular flow model provides a way to see the difference. Real flows are what can
be bought with money. In the circular flow model, the money flows are wages
and salaries, interest and dividends, rent, profits and households expenditures.
The real flows are resources and goods and services.
VII
Solutions to Problems and Exercises
BASIC
1. The issue here is that choice involves giving up something, and the thing given up is the
opportunity cost.
2. A possible opportunity cost is:
(a) Summer employment that you could have had
(b) Other things that you could have bought with $8 000, including a Caribbean cruise
(c) A better grade on your economics test
(d) The book that you could have bought instead
(e) The money you could have earned during that time.
3. _________________________________________________________
Combinations
Books (000)
Cartons (000)
_________________________________________________________
A
0
10
B
1
9
C
2
7
D
3
4
E
4
0
_________________________________________________________
(a)
(b)
(c)
(d)
(e)
The opportunity cost is 1 000 cartons
The p-p curve would be concave
Any point below the p-p curve would suffice
Any point on the p-p curve would suffice
Any point above the p-p curve would suffice.
4. (a) The p-p curve will shift to the left because the country has lost resources
(b) The p-p curve will shift to the right because the country now has more resources
(c) The p-p curve will still shift to the right even though the method has not yet been
implemented. The fact is, the country is not capable of producing more.
(d) The p-p curve will not shift because the economy’s productive potential has not changed.
However, actual production will increase toward a point closer to the p-p curve.
5. (a)
(b)
(c)
(d)
(e)
(f)
False. Households sell resources to the firms.
False. The firms’ income is derived from the sale of goods and services
True
True
False. Households also operate in the factor market, selling resources
True
6. In this problem, it is important to note that the p-p will be concave because of increasing
opportunity cost.
(a) The ability to produce apples will increase but the ability to produce butter will be
unchanged. A non-parallel shift will result.
(b) This will result in a parallel outward shift in the p-p curve.
(c) The ability to produce butter will increase but the ability to produce apples will be
unchanged. A non-parallel shift will result.
7. Exchange
A. A book publisher sells books to students
B. A book publisher buys paper from a firm
C. The government buys furniture from a firm
Market
P
F
P
D. Businesses borrow money from banks
E. A government employs new civil servants
F. Households buy electrical appliances
INTERMEDIATE
1. (a) Wages and salaries
Rent
F
F
P
Interest and dividends
Profits
(b) A = Goods and services
B = Goods and services
C = Resources
D = Resources
E = Income of firms (revenue)
F = Firms’ expenditures
G = Households’ income
H = Households’ expenditures
2. The economy should operate at point A. With more capital goods, the economy will
experience a faster rate of economic growth.
3. Here is an excellent example of the use of the concept of opportunity cost. During periods of
high unemployment and job shortages, the opportunity cost of attending college is relatively
low. If you cannot find a job, then what you are giving up in terms of lost wages and salaries
is negligible. Since the cost of attending college is low, more people might opt to attend
college.
CHALLENGING
1. This is an application of the concept of opportunity cost. The question to ask here is this:
What is the opportunity cost for the executive compared with the opportunity cost for the
executive assistant? In terms of salaries, the executive’s time is worth more than the
executive assistant’s time. If the executive earns $100 per hour while the assistant earns $20
per hour, then ten minutes in the line cost the executive $16.67, while the cost for the
assistant is only $3.33.
2. The p-p curve for the country with high capital formation will shift out more than that for the
country with low capital formation.
VIII Answers to Assess Your Knowledge Questions
1. When you decided to go to college, you gave up the opportunity to go to work. The cost (i.e.,
opportunity cost) of going to college is the income you could have earned by going to work.
2. The correct choice is a. A country’s workforce is one of its resources. An increase in a
country’s workforce will increase its productive capacity.
3. A firm is the economic entity that converts inputs into outputs for sale at a profit.
4. Economic growth is an increase in the total output of goods and services produced by a
country.