Chapter 3
The Fundamental Economic
Problem: Scarcity and Choice
Our necessities are few but our wants are endless.
INSCRIPTION ON A FORTUNE COOKIE
Scarcity, Choice, & Opportunity Cost
• Resources are scarce
– People have less resources than they
would like
• Choices
– Must be made among limited set of
possibilities
– Have more one thing means have less
something else (trade-off)
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Scarcity, Choice, & Opportunity Cost
• Labor – scarce
– Time limitations
– Number of skilled workers – limited
• Economics – study
– Use limited means to pursue unlimited
ends
• Opportunity cost of any decision
– Value of next best alternative - forgone
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How much does it really cost?
• Principle of opportunity cost economics
– Options available
• Households & businesses
• Governments & entire societies
– Given - limited resources
– Study logic of
• How people can make optimal decisions
• From among competing alternatives
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How much does it really cost?
• With limited resources
– Decision - have more of one thing
• Have less of something else
• Relevant cost of any decision
– Opportunity cost
• Value of next best alternative - given up
• Optimal decision making
– Based on opportunity-cost calculations
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Opportunity Cost and Money Cost
• Market - functions well
– Goods with high opportunity costs have
high money costs
– Goods with low opportunity costs have
low money costs
– Might not be identical: Forgone wage of
college education
• Optimal decision
– Best serves objectives of decision maker
– Selected by explicit or implicit comparison
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with possible alternative choices
Scarcity and Choice for a Single Firm
• Outputs – produced by firm or economy
– Goods & services it produces
• Inputs - used by firm or economy
– Labor, raw materials, electricity, other
resources
– To produce outputs
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Scarcity and Choice for a Single Firm
• Example: One business firm – Farmer
– Fixed supply of inputs
– Given technology
– Produce two outputs
• Produce more of one output
– Produce less of the other
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Table 1
Production possibilities open to a farmer
Bushels of Soybeans
Bushels of Wheat
Label in Figure 1
40,000
30,000
20,000
10,000
0
0
38,000
52,000
60,000
65,000
A
B
C
D
E
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Scarcity and Choice for a Single Firm
• Production possibilities frontier (PPF)
– Different combinations of various goods
– Given
• Available resources
• Existing technology
– Slopes downward to right (Why?)
– Points: on or inside
• Attainable
– Points: outside
• Cannot be achieved
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Figure 1
Production possibilities frontier for production by a
single farmer
Soybeans
40
A
B
30
20
Attainable
region
Unattainable
region
C
D
10
E
0
10 20 30 38
52 6065
Wheat
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Scarcity and Choice for a Single Firm
• Production possibilities frontier
– Bowed outward
• Resources (inputs) – specialized
• Slope of production possibilities frontier
– Opportunity cost
• Principle of increasing costs
– As production of a good expands
– Opportunity cost of producing another unit
• Generally increases
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Figure 2
Production possibilities frontier with no specialized
resources
50
A
Black shoes
40
B
30
C
20
D
10
0
10
20
30
40
50
Brown shoes
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Scarcity and Choice for a Single Firm
• Concentrate more of productive capacity
– On one commodity
– Employ inputs
• Better suited to making another commodity
– Vary proportions of inputs
• Limited quantities of some inputs
– Bowed outward
• Production possibilities frontier
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Scarcity and Choice for Entire Society
• Economy – constrained by
– Resources
– Technology
• Production possibilities frontier – society
– Position & shape
– Determined by economy’s
• Physical resources, skills, technology
• Willingness to work
• Past: construction of factories, research, &
innovation
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Scarcity and Choice for Entire Society
• Production possibilities frontier
– Civilian consumption (automobiles)
– Military strength (missiles)
– Downward slope - Choices
• Increase civilian consumption
• Decreasing military expenditure
– Bowed outward
• As defense spending increases
– More expensive - “buy missiles”
» Sacrifice civilian consumption
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Figure 3
Thousands of Automobiles per Year
Production possibilities frontier for the entire economy
700
B
600
D
500
E
400
G
300
F
200
100
C
0
100
200
300 400
Missiles per Year
500
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The Concept of Efficiency
• Efficiently produced output
– Given current technology
– Cannot increase output production
• Without increasing amount of inputs
• Or giving up a quantity of other output
• Efficiency = absence of waste
• Efficient economy
– Wastes none of available resources
– Produces maximum amount of output
– Given technology
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Three Coordination Tasks - Any Economy
• Allocation of resources
– Society’s decisions
– Divide scarce input resources
– Among different outputs produced
– Among different firms / organizations
• Produce outputs
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Three Coordination Tasks - Any Economy
1. How to utilize resources efficiently
– Reach production possibilities frontier
2. What
– Which combination of goods to produce
– Select one point on production
possibilities frontier
3. To whom?
– Total output - distributed to each person
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1. Market - Efficient Resource Allocation
• Division of labor
– Break up a task
• Smaller, more specialized tasks
• Each worker – more adept at a particular job
• Example: Adam Smith’s pin factory
• Law of comparative advantage
– One country - production of particular good
• Relative to other goods
– If it produces that good less inefficiently
• Than it produces other goods
– Compared with other country
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Adam Smith’s Pin Factory
• ”One man draws out the wire, another
straights it, a third cuts it, a fourth points it, a
fifth grinds it at the top for receiving the head:
to make the head requires two or three
distinct operations: to put it on is a particular
business, to whiten the pins is another ... and
the important business of making a pin is, in
this manner, divided into about eighteen
distinct operations, which in some
manufactories are all performed by distinct
hands, though in others the same man will
sometime perform two or three of them.”
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Principle of comparative advantage
• Determine most efficient
– Patterns of production and trade
– Comparative advantage – matters
• Country - gain by importing a good
– Even if - produced more efficiently at home
– Enable country – specialize
• Produce goods – more efficient
• Less efficient country – specialize
– Export goods – least inefficient
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2.Market Exchange& How Much to Produce
• Comparative advantage & division of labor
Creates greater productivity
• Need system of exchange to increase
standards of living
– Trade
• Goods for other goods
• Common item: money
• Market decides
– How much of each good to be produced
– More pin produced than consumed, price
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down, firms produce less
3. How to Distribute Economy’s Outputs
• Market system
– Form of economic organization
– Resource allocation decisions
• Made by Individual producers and consumers
• Based on their own best interests
• Without central direction
• Example 1: Vegetarians would not spend
money on beef in Safeway
• Example 2: demand for Hawaiian
pineapples in Vermont ↑ → more
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pineapples in Vermont supermarkets
Summary
• Opportunity cost
• PPF: single firm vs. society
• Three tasks
– How (Production)
– Which (Exchange)
– To Whom (Distribution)
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