Syllabus coverage
Students must be able to:
- explain the fundamental economic problem of scarcity;
- explain choices at the level of individuals, firms and governments;
- define and apply opportunity cost;
- explain what, how and for whom to produce.
The complete conceptual chain
Unlimited wants + limited resources → scarcity → choice → opportunity cost<br>→ resource allocation
Key definitions
| Term | Examination-ready definition |
|---|---|
| Want | Something an individual would like to consume or possess because it provides satisfaction. |
| Resource | An input that can be used to produce goods and services. |
| Scarcity | The condition in which limited resources are insufficient to satisfy unlimited wants. |
| Choice | The selection of one option from two or more alternatives. |
| Opportunity cost | The benefit or value of the next best alternative forgone when a choice is made. |
| Resource allocation | The process through which scarce resources are distributed between competing uses. |
The fundamental economic problem
Human wants are treated as effectively unlimited. People may want:
- additional goods and services;
- higher quality;
- more leisure;
- improved housing;
- better healthcare and education;
- new products generated by technological development.
Resources are limited at any point in time. These include:
- natural resources;
- labour and skills;
- capital and infrastructure;
- enterprise;
- time;
- income;
- government revenue.
Scarcity is universal. A wealthy individual has limited time. A high-income government still faces competing claims on tax revenue. Growth may expand productive capacity but does not eliminate scarcity because wants continue to change.
Scarcity versus shortage
Scarcity is the continuous economic condition caused by limited resources relative to wants.
A shortage is a market situation in which quantity demanded exceeds quantity supplied at a particular price. It may be temporary and can be corrected.
Why scarcity creates choice
Resources have alternative uses.
A piece of land might be used for:
- housing;
- farming;
- a hospital;
- a factory;
- a public park.
The same land cannot usually serve all uses simultaneously.
Analytical chain:
Resources are limited → wants compete for them → not all wants can be<br>satisfied → priorities are required → one option is selected → another<br>option is sacrificed → opportunity cost arises.
Choice by individuals
Individuals allocate limited income, time and energy.
Examples:
- consumption versus saving;
- work versus leisure;
- education versus full-time employment;
- laptop versus holiday;
- revision versus social activity.
Choice by firms
Firms allocate limited finance, labour, productive capacity and management time.
Examples:
- product A versus product B;
- workers versus machinery;
- advertising versus research;
- new factory versus digital expansion;
- dividends versus retained profit.
Choice by governments
Governments allocate limited revenue and productive resources across:
- healthcare;
- education;
- defence;
- infrastructure;
- housing;
- welfare;
- environmental protection.
Borrowing does not eliminate opportunity cost. It may create future interest, taxation and reduced borrowing capacity.
Opportunity cost in depth
Opportunity cost is the benefit or value of the next best alternative forgone.
Only the next best alternative counts. It is not:
- every rejected alternative combined;
- automatically the price paid;
- necessarily monetary.
Opportunity cost may involve:
- wages;
- profit;
- output;
- time;
- leisure;
- health;
- educational achievement;
- environmental quality.
Four-step identification method
- Identify the decision-maker.
- Identify the chosen option.
- Identify realistic alternatives.
- Select the next best alternative.
Worked examples
Individual
A worker attends a free event rather than working for $120.
Opportunity cost: $120 of wages forgone, assuming work was the next best option.
Firm
A firm uses its warehouse rather than renting it for $100,000.
Opportunity cost: the rental income forgone.
Government
A government builds hospitals rather than schools.
Opportunity cost: the benefits the schools would have provided, assuming they were the next best alternative.
Farmer
A field could produce:
- wheat worth $50,000;
- maize worth $42,000;
- vegetables worth $35,000.
If wheat is chosen, opportunity cost is the $42,000 of maize output.
Financial cost versus opportunity cost
A financial cost is the monetary payment made for the chosen activity.
Opportunity cost is the benefit from the next best alternative sacrificed.
A free activity can therefore have a positive opportunity cost.
When opportunity cost may be zero
Opportunity cost may be close to zero when a resource has no realistic alternative use. An otherwise empty seat may have a very low immediate opportunity cost. This is an extension point and should not distract from the usual next-best-alternative method.
Three questions of resource allocation
What to produce?
Which goods and services should be produced, and in what quantities?
Examples:
- hospitals or luxury hotels;
- food or biofuel;
- consumer goods or capital goods;
- housing or commercial offices.
How to produce?
Which production methods and factor combinations should be used?
Examples:
- labour or automation;
- renewable or non-renewable energy;
- domestic or imported components;
- small-scale or large-scale production.
For whom to produce?
How should output be distributed?
Possible mechanisms:
- willingness and ability to pay;
- income earned;
- government provision;
- assessed need;
- rationing;
- welfare payments.
Common misconceptions
- Scarcity means poverty.
- Scarcity means a temporary shortage.
- Opportunity cost is the chosen option.
- Opportunity cost is the price paid.
- Opportunity cost includes all rejected options.
- A free item has no opportunity cost.
- Borrowing removes government trade-offs.
- Growth eliminates scarcity.
- How to produce and for whom to produce are interchangeable.
Exam technique
AO1
Use precise definitions and relevant examples.
AO2
Develop the causal chain rather than stating an isolated fact.
Weak:
Government spending has an opportunity cost.
Strong:
Revenue and productive resources are limited. More healthcare spending may<br>reduce resources available for education. If education was the next best<br>use, the forgone educational benefit is the opportunity cost.
AO3
Where evaluation is relevant, consider:
- measurability;
- uncertainty;
- non-monetary effects;
- different stakeholder values;
- time period;
- whether the true next best alternative is clear.
Rapid revision
- Scarcity: limited resources relative to unlimited wants.
- Choice: required because not every want can be satisfied.
- Opportunity cost: benefit of the next best alternative forgone.
- What: composition and quantity of output.
- How: methods and resources.
- For whom: distribution of output.