Basic Economic Problem & Opportunity Cost
All humans have psychological needs which must be satisfied in order to survive. Over time these have developed into wants.
The basic economic problem exists because our desire for wants is unlimited, but the resources to produce our wants is limited.
We say that resources are scarce, relative to our desire for the goods and services these resources can be used to produce. For example, at an individual level, you are unable to have everything you want as you don't have the resources to pay for it.
This is where the idea of opportunity cost comes in. This is what is given up as a result of making a choice in terms of the next best option. It is important to note that we all perceive things differently, and so that is why we make different choices, as we will get different amounts of economic welfare from our consumption of a product.
Rational thinkers always choose the option with the greatest net benefit for them.
Economic Systems & Markets
An economic system refers to the way in which society organises itself to deal with the basic economic problem of relative scarcity. There are 2 extremes of economic system, in addition to the mixed system:
This is where the government is in complete control of the economy, and they make all the decisions relating to it. A centralised system.
Free Market Economy
This is where individual markets, firms and consumers control the economy and make decisions. A decentralised system.
In a market economy, there are always an unlimited amount of wants that can be satisfied. Through the provision of these wants, there is an opportunity for money to be made. This leads to innovation and the production of products to fulfil these wants.
This mechanism is the SIR Function: Signals, Incentives, Resource Allocation.
Economic Resources (FoP)
This includes all natural resources including physical land (and water), natural energy and commodities. Primary sector resources which are usually finite.
This includes all human resources involved directly with the production of a good or provision of a service
This includes all man made resources such as machinery, buildings and computers which are used to produce a good or provide a service.
This includes the organisation of resources and their management, which usually involves taking risks. This is the resource that brings the others together in order to produce output
Basic Economic Questions
Because of the basic economic problem of scarcity, we have to make choices. We, as a society, must decide on a number of things.
- What goods and services to produce? What products, and what types of products should we produce with our resources? In what quantities should we produce them?
- How to produce these goods and services? What technique of production should be used: Capital intensive or labour intensive? Countries as a whole or individual firms will use the technique that best suits the resources they have available.
- Who is to receive goods and services? How are the products going to be distributed? In a market, this is simply anyone who has the ability to pay for them. Although this creates inequality (the poorer cannot afford some products), it does create incentives for work. This creates the problem of a clash between incentives and equity.
Society has different ways of managing resources to answer these questions. These are the economic systems.
This is when we concentrate on a specific product or task. Specialisation happens at all levels:
- The specialisation of tasks within extended families in many of the world’s poorest countries
- Within businesses and organisations
- In a country – Bangladesh is a major producer and exporter of textiles, Norway is a leading oil exporter and Ghana is one of the biggest producers of cocoa in the world.
- In a region of a country – for many years the West Midlands has been a centre for motor car assembly and there has been huge investment in recent years in the Mini plant at Oxford
Division of Labour & Limitations
This occurs when production is broken down into many separate tasks. Division of labour raises output per person as people become proficient through constant repetition of a task. This gain in productivity helps to lower cost per unit and should lead to lower prices for consumers. However, this method of production is not without its limitations.
- It is often unrewarding, repetitive work that requires little skill. This lowers motivation and can in the long term harm productivity. Workers begin to take less pride in their work and quality suffers. We often see dissatisfied workers becoming less punctual at work and so output will fall.
- Many people eventaully choose to move to less boring jobs creating a problem of high worker turnover for businesses. This not only creates frictional unemployment, but also results in lower total output.
- Some workers receive little training and may not be able to find alternative jobs if they find themselves out of work - they may then suffer structural unemployment.
- Mass-produced standardised goods lack variety for consumers, and so the market may lack innovation, creating a possible market failure from allocative inefficiency
Production Possibility Curves
A Production Possibility Curve (PPC) is a curve which shows the combinations of two or more goods and services which can be produced whilst utilising all factor resources efficiently.
As you move along the PPC, the extra output from allocating more resources to one product usually starts to fall, i.e. more of one product has to be given up in order to achieve the extra output of the other. This is known as the law of diminishing returns. This states that because not all factor inputs are equally suited to producing different goods and services, your output (returns) will decrease (diminish).
A point outside the PPC is unattainable with current resources - it requires an increase in quality (efficiciency/productivity of) of factor inputs or quantity of factor inputs to reach it.
Producing more of both products represents an improvement in economic welfare, provided that the products are satisfying the needs and wants of consumers, i.e. they are allocatively efficient.
By moving (or reallocating) resources, an opportunity cost is encountered - by moving from one point to another, the cost will be the fall in output of one product in order to produce more of the other. Moreover, the PPC does not 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.
What PPCs show
Combinations inside the PPC show inefficient use of resources, whereby production could be increased with no opportunity cost.
PPCs can be used to show scarcity because we do not have enough resources to be able to produce a level of output outside the PPC, i.e. our wants are greater than our resources available to satisfy them.
The PPC model is also used to show choice - should we continue with current levels of output, or increase output of one product at the expense of the other?
Types of Capital
Capital is broken down into five different types:
Capital goods - Goods used to produce other consumer products in the future
Fixed Capital - Machinery, equipment, technology and factories
Working Capital - Stocks of finished and semi-finished goods (or components) that will either be consumed in the future or made into consumer goods
Infrastructure - Road and rail networks, airports and docks, telecommunications etc. Anything that allows things to be moved
Financial capital - Money used to purchase products or any of the economic resources
Advantages of Specialisation
There are many advantages to specialisation, such as:
- Higher output - Total production of goods and services is raised and quality can be improved
- Variety - Consumers have access to a greater variety of higher quality products
- A bigger market - Specialisation and global trade increase the size of the market offering opportunities for economies of scale
- Competition and lower prices - Increased competition acts as an incentive to minimise costs, keep prices down and therefore maintains low inflation