The Economizing Problem

Economizing  Scarcity, Choice, and

Problem: How Opportunity Cost
society uses its
limited resources to  Economics is concerned with
satisfy its unlimited scarcity. The basic fact of economic
economic wants life, and indeed the basis of the
economizing problem faced by
society, is that society’s economic
wants are unlimited, while the
means (resources) with which the
wants can be satisfied are limited (in
quantity and quality)
The Economizing Problem
 The fact that we live in a world of scarcity forces us to make
choices between alternative uses of resources.

 When resources are used to produce a certain good, they are

not available to produce other goods.

 A decision to produce more of one good means less of another

good can be produced: the forgone (sacrificed) alternative is
called the opportunity cost

 The opportunity cost of a choice is the value to the decision

maker, of the best alternative that could have been chosen but
was not chosen. It is the value of the best forgone alternative.
The Economizing Problem

 Every time a choice is made, an opportunity cost is incurred: a trade-off

is involved every time a choice is made

 Economists always measure costs in terms of opportunity costs. For the

economist, the cost of something is what you have to give up to get it.

 This manner of calculating costs is different from how an accountant

measures costs.

 Accountants concern themselves only with explicit costs (also called

accounting costs), while economists consider both explicit and implicit
costs (opportunity costs). This will become clear when we discuss the
theory of production.
The Economizing Problem
 Economic Wants and Needs
 Economic wants are human desires for goods and services:
they are unlimited.
 For example, most people want to drive the most expensive
car, live in the most expensive house, wear the most expensive
brands of clothing and jewellery.

 Economic wants are differentiated from Economic needs.

Economic needs are necessities, the things that are essential for
survival, such as food, water, shelter and clothing.

 Unlike economic wants, economic needs are not absolutely

unlimited. It is possible to calculate the basic needs which have
to be met if a person is to survive.
The Economizing Problem

 Goods and Services

 The purpose of economic activity is to satisfy economic
wants. Most wants are goods and services.

 Goods are tangible objects like food, clothing, shoes, furniture,

and household appliances.

 Services are intangible things like legal services, financial

services, the services of a lecturer, and the services provided by
public servants.
The Economizing Problem

 Types of Goods

 Consumer goods vs. Capital goods

 Consumer goods are goods that are used or consumed by individuals or
households (i.e. consumers) to satisfy economic wants. Examples include
food, wine, clothing and shoes.
 Consumer goods satisfy economic wants directly.

 Categories of consumer goods

 Consumer goods can be classified into three groups: non-durable,
semi-durable and durable

 Non-durable goods: goods that are used once or are easily perishable.
Examples are food, wine and tobacco.
The Economizing Problem

 Semi-durable goods: goods that can be used more than once

and usually last for a limited period. Examples include
clothing, shoes, blankets and sheets.

 Durable goods: goods that normally last for a number of years.

Examples include furniture, refrigerator, cars etc.
The Economizing Problem

 Capital goods are goods that are not consumed directly, but are used
in the production of other goods. Examples include all types of
machinery, plant and equipment used in manufacturing and
construction, buildings, roads etc.

 Capital goods do not themselves yield direct consumer satisfaction,

but they permit production of consumer goods.

 Note: capital goods are subject to wear and tear and may become
obsolete overtime. Their value therefore depreciates overtime.
Provision has to be made therefore for replacement of the existing
capital.

 Capital goods are an important factor of production.

The Economizing Problem

 A Note on Private goods vs. Public goods

 A private good is a good that is consumed by individuals,
households and firms. All typical consumer goods are private
goods.

 The distinguishing feature of private goods is that consumption by

others can be excluded.

 A public good is a good that is used by the community or society at

large.
 Consumption by individuals cannot be excluded.

 A traffic light, for example, is a public good. Other examples of public

goods are national defense and public roads
The Economizing Problem

 A Note on Economic goods vs. Free goods

 An economic good (sometimes called scarce goods) is a good
that is produced at a cost from scarce resources.
 Most goods are economic goods.

 A free good on the other hand is a good that is not scarce

and therefore has no price. Air, sunshine and sea water are
usually regarded as free goods.

 Nowadays however, air and sea water are often

polluted, with the result that clean air and sea water are
not always freely available.
The Economizing Problem

 Economic Resources
 There are four types of economic resources: land, labour,
capital, and entrepreneurship. These resources are called
factors of production. They are the means with which goods
and services are produced.

1. Land: all natural resources (gifts of nature) e.g. agricultural

land, mineral deposits (e.g. diamonds), marine resources etc.

 Natural resources are fixed in supply – their availability

cannot be increased if we want more of them.
 It is possible however to exploit more of the natural resources
that are available.
The Economizing Problem

 But once they are depleted, they cannot be replaced (cause for
concern for natural resource based economies, such as
Botswana – economy based on diamond resources). We refer to
such resources as non-renewable, or exhaustible assets.

 Note: As a consequence of scarcity, resource suppliers have to

be paid to attract their resources from alternative uses.

 The payment received by land owners for supplying the

resource is rent.
The Economizing Problem

2. Capital: all capital or investment goods e.g. machinery used in the

production of consumer goods.

 The corresponding payment or reward received by suppliers of

capital is the interest paid on the capital.

3. Labour: goods and services cannot be produced without

human effort. Labour can be defined as the exercise of
human mental and physical effort in the production of
goods and services.

 Suppliers of labour are households e.g. services supplied by lawyers,

accountants, mechanics etc.
The Economizing Problem

 Note: the quantity of labour depends on the size of the

population and the proportion of the population that is willing
and able to work.

 The quality of labour is even more important than the quantity

of labour. The term human capital is usually used to refer to
the quality of labour, and thus to the skill, knowledge and
health of the workers. Education, training and experience are
all important determinants of human capital.

 The corresponding payment or reward received by suppliers of

labour are the wages earned for supplying the resource.
The Economizing Problem
4. Entrepreneurship
 The availability of land, capital and labour does not ensure production
takes place.

 These factors of production have to be combined and organized by

people who see opportunities and are willing to take risks by
producing goods in the expectation that they will be sold for a profit.
These people are called, ‘entrepreneurs’.

 The ‘entrepreneur’ organizes the resources needed for production, and

ensures that production takes place.

 He/she assumes the risk of putting together the resources (i.e. the
business risk) with the hope of making a profit
The Economizing Problem
 While he/she hopes to make a profit on the undertaking, the
entrepreneur may also suffer a loss. The profit/loss constitute the
reward he/she gets for employing his ability to organize
resources needed for production.

 Money is Not a Factor of Production

 Money is often regarded as the key to everything. While money
is obviously important in facilitating exchange of goods and
services, it is not a factor of production: goods and services
cannot be produced with money.

 To produce goods and services, we need factors of

production such as land, capital, labour and entrepreneurship.
The Economizing Problem

 Summary of corresponding rewards to resources

Resource Category Reward

Land Rent

Labour Wages

Capital Interest

Entrepreneurial ability Profit/Loss

The Economizing Problem

 Efficient Use of Resources

 Scarcity of resources and the unlimited economic wants of society
dictate that society use its limited resources efficiently to achieve
the maximum possible satisfaction of wants.

 When we say resources are being used efficiently, what

exactly do we mean?

 Efficient use of resources implies full-employment and full-

production in the use of scarce resources.

 Full employment: use of all available productive resources in

production – no idle resources
The Economizing Problem
 Full production: all resources employed must produce the maximum
possible satisfaction of economic wants i.e. society must achieve both
productive efficiency and allocative efficiency (anything but, implies
inefficiency in the use of resources, and underemployment of resources)

 Productive efficiency: goods and services must be produced in the least cost manner
(using the least cost production methods)

 Allocative efficiency: resources must be used to produce the mix of goods and services
most wanted by society

 Full production therefore means producing the ‘right mix of goods and
services (allocative efficiency) in the ‘right way’ (productive efficiency)
The Economizing Problem

 The Production Possibilities Curve (PPC)

 Scarcity, choice and opportunity cost can be illustrated using
a conceptual model called the Production Possibilities Curve
(PPC) or Production Possibilities Frontier (PPF)

 The PPC shows the maximum amount of any two products

that can be produced from a fixed set of resources, and the
possible trade-offs in production between them.

 Note: The real economy obviously produces more than just

two products, but this simplified PPC can help us understand
how scarcity, choice and opportunity cost are all related
The Economizing Problem

 The PPC is based on the following assumptions:

1. The economy produces only two products

2. The economy employs all available resources (full-production)
and produces in the least cost manner (productive efficiency)
3. The resources available to the economy are fixed in quantity
and quality
4. The state of technology is fixed: production methods do not
change in the period of analysis

 Note: Assumptions 3 and 4 imply that the period of analysis is

very short: it takes time for the quantity and quality of resources,
and production technology to change
The Economizing Problem

 Suppose an economy produces sewing machines (a capital

good) and food (a consumer goods).

 The production possibilities table (PPT) below shows the

combinations (production possibilities) of each of the two
goods that the economy can produce (with full-production
and productive efficiency) given the current state of
technology and available resources.

 Combination A: the economy devotes all resources to the

production of food (zero sewing machines)
 Combination F: the economy devotes all resources to the
production of sewing machines (zero food)
The Economizing Problem

 Combination B to E: The economy devotes some resources to

the production of food, and some to sewing machines

 Moving from combination A to F: The economy increases

production of sewing machines at the expense of food (a trade-
off is involved - food)
 In other words, the economy must give up some of the
production of food in order to produce more machines.

 The amount of food that the economy must sacrifice in order to

produce more sewing machines is the opportunity cost of
producing more sewing machines
The Economizing Problem

 Moving from combination F to A: The economy increases

production of food at the expense of machines (a trade-off is also
involved – sewing machines)
 In other words, the economy must give up some of the production of
machines in order to produce more food.
 The amount of sewing machines that the economy must sacrifice in
order to produce more food is the opportunity cost of producing
more food

 Note: the trade-offs are necessitated by the fact that the resources
available for production and the technology are fixed, and the
economy is at full production and achieving productive efficiency:
the only way the economy can increase production of the other good
is to sacrifice some of the other
The Economizing Problem

 Scarcity necessitates that society make choices in the use

of limited resources, and every choice society makes
involves an opportunity cost
The Economizing Problem

Production possibility Machines Food (Tons)

A 0 100

B 1 95

C 2 85

D 3 70

E 4 40

F 5 0
The Economizing Problem
 A plot of the data in the table on a two dimensional graph yields the
PPC for the economy (insert graph)

 The PPC shows the maximum amount of any two products that
can be produced from a fixed set of resources, and the possible
trade-offs in production between them.

 Note: each point on the PPC represents some maximum

combination of the two goods that the economy can produce with
the current state of technology and fixed resources (assuming full
production and productive efficiency)

 Generalization: all combinations on the PPC represent efficient use

of resources
The Economizing Problem

 All combinations inside the PPC represent inefficient use of

resources: the economy can achieve more with existing
technology and available resources (some resources are idle)

 Points outside the PPC are unattainable for the economy with
the current state of technology and available resources.
The Economizing Problem

Production Possibilities Curve: A Summary

Description Illustrated by

Attainable combinations All points on and inside the PPC

Unattainable combinations All points beyond the PPC

Efficient combinations All points on the PPC

Inefficient combinations All points inside the PPC

The Economizing Problem
 Calculating the Opportunity Cost: Example
Machines Food Opp. Cost of Opp. Cost of
producing producing
machines food
A 0 100

B 1 95 A&B B&A

C 2 85 B&C C&B

D 3 70 C&D D&C

E 4 40 D&E E&D

F 5 0 E&F F&E
The Economizing Problem

 Note: as the economy produces more of one good, the opportunity

cost of producing that good increases: the economy has to give up
larger and larger amounts of one good to obtain more of the other
(increasing opportunity cost)

 This is a reflection of the fact that the only way this economy can
increase production of the other good is to sacrifice some of the other
and indeed sacrifice more and more to produce more of the other
given fixed resources and current technology.

 Note: The PPC is said to reflect the law of increasing opportunity

cost: if the economy wishes to produce more of one good, it must give
up successively larger units of the other, given fixed resources and
current technology
The Economizing Problem

 Note: The law of increasing opportunity cost is indeed

reflected in the bowed out nature of the PPC :

 The bowed out nature of the PPC shows that to produce more
of one good, successively larger units of the other must be
forgone (sacrificed)
The Economizing Problem

 Exercise: Derive the PPC and calculate the opportunity

cost at each point
Food Tractors

A 0 100

B 1 90

C 2 70

D 3 40

E 4 0
The Economizing Problem

 Shifting the PPC outward

 So what restricts an economy – once its resources are fully utilized
– from producing more of everything?
 Answer: A lack of resources.

 As long as all current resources are being used efficiently, the

only way to get more of one good is to sacrifice some of the
other good

 Overtime however, it is possible for a country’s PPC to shift

outward, making it possible for more of all goods to be produced
(insert graph). There is a number of factors that could potentially
shift the PPC outward:
The Economizing Problem
1. An increase in the economy’s resource base would expand the
ability to produce goods and services
 If this economy had more or better resources, it could
produce a greater amount of all goods and services

 Resources such as machinery, buildings, tools and education are

man-made: an economy can expand its resource base by devoting
efforts to producing them – investment

 However, like the production of other goods, devoting

effort and resources toward these long lasting physical
assets means fewer resources are available to produce other
things, in this case goods for current consumption (trade-off
current consumption for future consumption)
The Economizing Problem

2. Advancements in technology can expand the economy’s

production possibilities
 Technology determines the maximum amount of output an
economy can produce given the resources it has

 New and better technology makes it possible to get more

output from existing resources

 An important form of technological change is invention –

creation of new products or processes
 An economy can also benefit from technological change
through innovation – practical adoption of new techniques
(such innovation is commonly carried out by entrepreneurs)
The Economizing Problem
3. Improvement in the rules under which the economy functions can
also increase output
 The legal system of a country influences the ability of people to
cooperate with one another and produce goods

 Changes in legal institutions that promote cooperation and motivate

people to produce will also push the PPC outward

 However, poor institutions can reduce both the level of resources used
(shifting the curve inward) and how efficiently they are used (causing
the economy to operate inside the PPC)

 Take public sector corruption, and the ability of public institutions

and the judicial system to deal with it (corruption can have adverse
effects on the economy)
The Economizing Problem

 The PPC and Economic Growth

 Economic growth is one of the most, if not the most important
issues in economics: economic growth is associated with an
improvement in the living standards

 Within the production possibilities framework, economic growth

is simply an outward shift in the curve through time

 The more rapidly the curve shifts outward, the more rapid is
economic growth.

 Note: there are other economic models that are used to economic
growth. However, they all share the PPC as a foundation.
Economic Organization: Economic Systems

 Economic Systems: Classification

 As a consequence of scarcity of resources and unlimited economic
wants, every economy has to answer three central economic questions:
1. What will be produced?
2. How will it be produced?
3. For whom it will be produced?

 How an economy addresses these questions depends on how economic

activity is organized i.e. the economic system

 Note: No two economies have identical solutions to the questions,

what, how and for whom. However, certain common features can be
used to classify economic systems
Economic Organization: Economic Systems

1. Property rights: economic systems can be distinguished according

to the predominant form of ownership of resources (property
rights)

 Property rights refer to the rights to possess, use or dispose of

assets (tangible e.g. buildings and intangible e.g. patents)

 Property can be owned publicly by different levels of government

or public boards (public ownership); or privately by individuals,
partnerships and companies (private ownership).

2. Coordinating mechanisms: means of providing and transmitting

information to coordinate the economic activities of participants in
an economy
Economic Organization: Economic Systems
 On the basis of these criteria, different economic systems may be
distinguished as follows:

i. Capitalist market economy (Free Enterprise)

ii. Socialism (Command)
iii. Mixed economy

 Capitalist Market Economy (Capitalism)

 Sometimes referred to as the market economy or free enterprise
 Most of the factors of production (resources) are owned by
individuals (i.e. private ownership of resources) who take decisions
based on self-interest (decisions are decentralized)
 While the government does own property such as government
offices, most property is privately owned
Economic Organization: Economic Systems

 Individuals property rights are protected by law and they are

usually free to sell their property as they choose, subject only
to certain laws and regulations that govern such transactions

 Coordination of economic activity is achieved through the

market mechanism

 The concept of a Market

 A market is any institution or mechanism that brings together
buyers and sellers of particular goods and services

 A market may be local, regional, national or international.

Economic Organization: Economic Systems
 For a market to exist, the following must be satisfied:
 The seller must have something to sell
 The buyer must have the means with which to purchase it
 An exchange ratio (price) must be determined
 The agreement must be guaranteed by law or tradition

 Prices are the most important elements of the market mechanism:

they are signals or indices of scarcity, which indicate to consumers
what they have to sacrifice to obtain the goods or services (also
indicate to the owners of the various factors of production how these
factors can be employed)

 In capitalism, economic activity is driven by self-interest: consumers

want to maximise their satisfaction; businesses want to maximise
profit; workers want to maximise income.
Economic Organization: Economic Systems

 Competition is another important feature of market capitalism:

It occurs on each side of the market i.e. among suppliers
(sellers) and among buyers (consumers)

 Competition among sellers protects consumers against

exploitation and promotes efficiency and growth

 Such competition also creates order among suppliers. The

successful ones are rewarded in the form of profit while the
unsuccessful ones make losses and are eliminated
Economic Organization: Economic Systems

 A Note on Competition

 The market system assumes there is perfect competition in the

market. In the real world, competition is rarely fair: most
markets are characterized by imperfect competition

 The existence of imperfect competition means that results are

not always as favourable as the proponents of the free market
system would have us believe: markets can fail – in such
instances, government has to take responsibility
Economic Organization: Economic Systems
 So how does the capitalist system address the three central
questions: what, how and for whom?

 According to Adam Smith, regarded as the father of the

capitalist system, the market mechanism works like an
invisible hand which coordinates the selfish actions of
individuals to ensure that everyone is better off

 What will be produced in a capitalist market system?

 Goods and services that consumers are willing to spend their
income on and which can be supplied profitably – if some
uninformed business person happens to produce unwanted
goods, he will incur losses and will cease to produce.
Economic Organization: Economic Systems
 How will it be produced?
 Producers are forced to combine resources in the cheapest
possible way. Their decisions on the combination of factors of
production are governed by the prices of the various factors.

 For whom will the goods and services be produced?

 The goods and services will go to those who purchase them.

 A typical example of an economy whose economic system is

based on the market system is the Unites States of America.
Economic Organization: Economic Systems

 Socialism (Command)
 Public ownership of factors of production is the predominant type
of ownership of resources. Decision making is centralized and
coordinated by a central plan, which contains binding directives
(commands) to the system’s participants.

 Participants are instructed what to produce and how to produce it

by a central authority, which also determines how the output is to
be distributed

 Because the economy is governed and coordinated by a central

authority, command systems are sometimes called centrally
planned systems.
Economic Organization: Economic Systems

 Central economic planning as you can imagine is a difficult

task: decisions have to be taken on how, where and for what
purpose every resource is to be applied.

 The planners have to determine what consumer goods should

be produced, how to produce them, and how to divide them
among consumers; what types of capital goods are to be
produced etc.

 These are, but a few of the problems that the planners have to
contend with. This is an extremely difficult task especially in a
changing environment. Mistakes are inevitable.
Economic Organization: Economic Systems
 In the 1970s and early 1980s, more than a third of the world’s
population lived in countries that relied heavily on central planning:
Russia, China, Poland, Romania, North Korea and East Germany
for example

 There are very few remaining countries today, whose economies

based on the command system

 Note however that even in the few remaining countries where

central planning is still proclaimed to be the basis of the economic
system, increasing reliance is being placed on private initiative and
on the market as a mechanism for coordinating economic activity: a
good example is the modern Chinese economy which has boomed
since the 1980s
Economic Organization: Economic Systems

 Important:
 Some elements of the command mechanism are used in all
economies: the government plays an important role in every
country. All government activity has to be planned and
coordinated by some central body.
Economic Organization: Economic Systems

 Summary: Capitalist and Socialist Economic Systems

Capitalism Socialism
Typical Example: the U.S Typical Example: N. Korea
Private ownership of factors of Public ownership of factors of
production dominant production dominant
Decision making is Decision making is centralized
decentralized: participants are and coordinated by a central
driven by self-interest plan
Market mechanism coordinates Central planning authority
economic activity: prices signal directs what to produce, how it
scarcity; competition between is to be produced, and how it is
consumers and between sellers to be distributed
Economic Organization: Economic Systems
 Mixed Economy
 In the real world, no economic system is based purely on
command or the market system.
 All economic systems are a mixture of command and market
systems. They are therefore described as mixed economy systems,
although one tends to dominate.

 During most of the 20th century, there was a great debate about
the relative merits of the command and market systems for
coordinating economic activity.

 There was also great competition between capitalist and socialist

countries – what came to be known as the cold war between the
largely capitalist west, and the socialist bloc
Economic Organization: Economic Systems
 This debate was somewhat settled by the collapse of central planning
in the 1980s and early 1990s.

 Nevertheless, the correct mixture between the market system and

government intervention, or between the private sector and the public
sector, will always be a topical issue: the appropriate mix of the mixed
economy will always be debated

 The mix depends on perceived problems of the society concerned:

likely to change overtime

 A typical example of a mixed economy is Botswana: both public and

private sector participate in the economy (although private sector
participation remains relatively low and the sector relies heavily on
government)
Economic Organization: Economic Systems

 Production, Spending and Income in a Mixed Economy

 Economics is concerned with what to produce, how to produce
it, and how to distribute the products between the various
participants in the economy: Production
 The ultimate aim of production is to use or consume the goods
and services produced to satisfy human wants

 Note: Production creates income (earned in the production

process by the various factors of production), and this income
is spent on goods and services products – continuous circular
flow of production, income and spending
Economic Organization: Economic Systems

 This circular flow of production, income and spending can be

illustrated using a conceptual model referred to as the circular
flow model of production, income and spending
Economic Organization: Economic Systems
Tutorial (Review) Questions

1. Economics is concerned with scarcity. State the

economizing problem faced by society and explain the
relation between scarcity, choice and opportunity cost.

2. Differentiate the following concepts: Give examples.

i. Goods and services
ii. Economic wants and economic needs
iii. Consumer goods and capital goods
iv. Non-durable, semi-durable and durable goods
v. Private goods and public goods
vi. Economic goods and Free goods
Tutorial (Review) Questions

3. List and describe the four major types of economic

resources. What is the corresponding reward associated
with the supply of each. Why is money not regarded as a
factor of production?

4. Scarcity of resources and unlimited economic wants dictate

that society use its limited resources efficiently to achieve
the maximum possible satisfaction of wants. Explain fully,
the meaning of efficiency in the use of resources.

5. Differentiate the following:

i. full-production and full-employment
ii. productive efficiency and allocative efficiency
Tutorial (Review) Questions

6. Scarcity, choice and opportunity can be illustrated using

a production possibilities curve (PPC). Describe the
PPC and its underlying assumptions

7. Explain the following:

i. All points on and inside the PPC are attainable
ii. All points on the PPC represent efficient combinations
iii. All points on inside the PPC represent inefficient combinations
iv. All points beyond the PPC are unattainable

8. The PPC is said to reflect the law of increasing

opportunity cost. Explain.
Tutorial (Review) Questions

9. What factors are likely to cause a shift of the PPC?

Explain how each of these are likely to affect the
position of the PPC if they were to change. What
economic term is used to describe a shift of the PPC
outwards to the right?

10. The alternative production possibilities faced by the

economy of Botswana in the production of cloth and
bread are indicated in the following production
possibilities table
Tutorial (Review) Questions

Production possibilities Bread (000’loaves) Cloth (000’metres)

A 0 10

B 1 9

C 2 7

D 3 4

E 4 0
Tutorial (Review) Questions

i. With cloth on the vertical axis (Y) and bread on the horizontal
axis (X), graph the data in the table using an appropriate scale
to derive the production possibilities curve
ii. Define the law of increasing opportunity cost
iii. If the economy wants to move from combination B to C, what
is the cost of producing one million more loaves of bread?
iv. Explain how the law of increasing opportunity cost is reflected
in the shape of the production possibilities curve
v. When the quantity and quality of resources and the level of
technology change, what will happen to the position of the
PPC?
Tutorial (Review) Questions
11. Explain why every economy faces the questions: what
to produce? How to produce? For whom to produce?

12. What is an economic system? What criteria is used to

classify economic systems?

13. Examine the characteristics of the market, command

and mixed economies. Give typical examples of
economies based on each of these economic systems.

14. Explain the concept of a market. What purpose do

prices serve in a market?
Tutorial (Review) Questions

15. Explain the concept of the market mechanism and the

invisible hand due to Adam Smith

16. With the aid of an appropriate diagram, explain the

circular flow of production, income and spending in a
typical mixed economy.