Chapter 3

The Fundamental Economic Problem: Scarcity and Choice

Our necessities are few but our wants are endless.

INSCRIPTION ON A FORTUNE COOKIE

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Scarcity, Choice, & Opportunity Cost

• Resources are scarce– People have less resources than they

would like

• Choices– Must be made among limitedlimited set of

possibilities

– Have more one thing means have less something else (trade-offtrade-off)

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Scarcity, Choice, & Opportunity Cost

• Labor – scarce– Time limitations

– Number of skilled workers – limited

• Economics – study – Use limitedlimited means to pursue unlimitedunlimited

ends

• Opportunity cost of any decision– Value of next bestnext 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 optimaloptimal 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

with possible alternative choices 6

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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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Production possibilities open to a farmer

Table 1

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Bushels of Soybeans Bushels of Wheat Label in Figure 1

40,00030,00020,00010,000

0

038,00052,00060,00065,000

ABCDE

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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 downwarddownward to right (Why?)

– Points: on or inside• Attainable

– Points: outside• Cannot be achieved

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Production possibilities frontier for production by a single farmer

Figure 1

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10 20 300

Wheat

6065

10

20

Soy

bean

s

30

40A

E

D

Unattainable

region

Attainable

region

38 52

C

B

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Scarcity and Choice for a Single Firm

• Production possibilities frontier– Bowed outwardBowed 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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Production possibilities frontier with no specialized resources

Figure 2

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10 20 300

Brown shoes

40 50

10

20

Bla

ck s

hoes

30

40

50

A

B

C

D

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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 15

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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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Production possibilities frontier for the entire economy

Figure 3

17100 200 3000

Missiles per Year

400 500

100

200

Tho

usan

ds o

f A

utom

obile

s pe

r Y

ear

300

400

500

600

700

D

B

C

F

G

E

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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 18

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Three Coordination Tasks - Any Economy

• AllocationAllocation 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

1.1. HowHow to utilize resources efficiently– Reach production possibilities frontier

2.2. WhatWhat – Which combination of goods to produce

– Select one point on production possibilities frontier

3.3. To whomTo 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 inefficientlyless inefficiently• Than it produces other goods

– Compared with other country 21

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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 down, firms produce less 24

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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 pineapples in Vermont supermarkets 25

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Summary

• Opportunity cost• PPF: single firm vs. society• Three tasks

– How (Production)

– Which (Exchange)

– To Whom (Distribution)