Lesson Objective

Dear learner,

At the end of this lesson, you will be able to:

• Define concepts like scarcity, choice, opportunity cost, and production possibility frontier.
• Explain the difference between scarcity and shortage of resources.
• Calculate the opportunity cost of a good.

Brainstorming Question

What basic concepts in economics can you mention? What do you mean by these concepts?

Key Terms and Concepts

Dear Learner,

In the first unit, we discuss the fundamental concepts of economics and its definition. In this unit, we will delve deeper into the main economic concepts such as scarcity, choice, and opportunity cost with the help of the Production Possibility Frontier (PPF). In this lesson, we will cover the key concepts of economics including scarcity, choice, and opportunity cost. Please pay attention and be sure to complete the quiz questions at the end.

key concepts of economics

The scarcity of resources relative to unlimited human wants is a plain fact of life. Households, producers, and the entire economy face the problem of scarcity of natural and human-made resources. Consequently, it is necessary to use resources as efficiently as possible. In effect, resources should be allocated efficiently among the prevailing choices. Let’s explore some basic economic concepts in more detail.

Scarcity

The fundamental economic problem that any human society faces is the problem of scarcity.

Scarcity refers to the fact that all economic resources a society wants to use to produce goods and services are finite or limited in supply. However, their limitation should be expressed about human wants. Thus, the term “scarcity” reflects the imbalance between our wants and the means to satisfy those wants. The scarcity of resources generates economic problems. There would be no economic problems if resources were fully abundant.

Note: Scarcity does not mean shortage. A good is said to be scarce if the amount available is less than the amount people wish to have at a zero price. On the other hand, we say that there is a shortage of goods and services when people are unable to get the amount they want at the prevailing price. A shortage is a specific and short-term problem, while scarcity is a universal and endless problem.

Choice

If resources are scarce, output will be limited. If output is limited, we cannot satisfy all of our wants. So, a choice must be made. Due to the problem of scarcity, individuals, firms, and governments are forced to choose what output to produce, in what quantity, and what output not to produce. In short, scarcity implies choice, which, in turn, implies an opportunity cost.

Scarcity → limited resources → limited output → unlimited human wants → choice involves costs → opportunity cost.

Opportunity Cost

In a world of scarcity, a decision to have more of one thing at the same time means a decision to have less of another thing. Thus, the value of the next best alternative that must be sacrificed is the opportunity cost of the decision.

Definition: Opportunity cost is the amount or value of the next best alternative that must be sacrificed (forgone) to obtain one more unit of a product.

For example, suppose a country spends all of its limited resources on the production of cloth or computers. If a given amount of resources can produce either one meter of cloth or 20 computers, then the opportunity cost of one meter of cloth is the value of 20 computers.

Key Points about Opportunity Cost:

• It is measured in terms of goods and services but not in terms of money.
• It should align with the principle of substituting one activity for another.

To sum up, when the opportunity cost of any activity increases, people substitute other activities in its place. In effect, the cost of producing a quantity of a commodity is measured in terms of the quantity of some other commodity that could have been produced in its place. In short, opportunity cost arises due to the problem of scarcity of resources and the fact that resources have alternative uses.

The Production Possibilities Frontier

The production possibilities frontier (PPF) or curve (PPC) is a curve that shows the various possible combinations of goods and services that society can produce given its resources and technology. To draw the PPF/PPC, we need the following assumptions:

1. The quantity and quality of economic resources available for use during the year is fixed.
2. There are two broad classes of output to be produced over the year.
3. The economy is operating at full employment and is achieving full production (efficiency).
4. Technology does not change during the year.
5. Some inputs are better adapted to the production of one good than to the production of another (specialization).

Suppose a hypothetical economy produces food and computers given its limited resources and available technology.

Types of products	Unit	Production alternatives
		A	B	C	D	E
Food	Metric tones	500	420	320	180	0
Computer	Number	0	500	1000	1500	2000

Figure 2.1 Production possibilities frontier/curve for Food and Computer

Note the following points:

• All points on the curve are both attainable and efficient.
• Any point inside the curve (for example, point Q) is attainable but inefficient.
• Any point outside the curve (for example, point R) is unattainable.

The PPF describes three important concepts:

i) The concept of scarcity: even if a society employs all of its resources and uses them optimally, it cannot produce an infinite amount of output.

ii) The concept of choice: any movement along the curve denotes a shift in preference.

iii) The concept of opportunity cost: when the economy produces on the PPF, producing more of one good necessitates sacrificing some of another, as reflected by the PPF’s downward slope. Related to the opportunity cost, we have a law known as the law of increasing opportunity cost. This law states that as we produce more and more of a product, the opportunity cost per unit of the additional output increases (its called diminishing marginal returns). This makes the shape of the PPF concave to the origin.

Opportunity costs increase when we produce more of one good because economic resources are not completely adaptable to alternative uses (specialization effect).

$\text{Opportunity cost} = \frac{\text{the amount of next alternative sacrificed}}{\text{the amount of the good gained}}$

Referring to Table above, if the economy is initially operating at point A, what is the opportunity cost of producing one more unit of computer?

$\text{Opportunity cost} = \frac{(420 – 500)}{(500 – 0)} = \frac{-80}{500} = |-0.16| = 0.16$

Referring to Table above, if the economy is initially operating at point B, what is the opportunity cost of producing one more unit of computer?

$\text{Opportunity cost} = \frac{(320 – 420)}{(1000 – 500)} = \frac{-100}{500} = |-0.2| = 0.2$

Referring to Table above, if the economy is initially operating at point C, what is the opportunity cost of producing one more unit of computer?

$\text{Opportunity cost} = \frac{(180 – 320)}{(1500 – 1000)} = \frac{-140}{500} = |-0.28| = 0.28$

Referring to Table above, if the economy is initially operating at point D, what is the opportunity cost of producing one more unit of computer?

$\text{Opportunity cost} = \frac{(0 – 180)}{(2000 – 1500)} = \frac{-180}{500} = |-0.36| = 0.36$

Note: we take absolute value of opportunity cost as we are interested to interprete its magnitude.

Student from the above calculation we understand that the slope of PPF is increasing which is opportunity cost, indicating that the PPF curve is bowed outward or concave to the origion.

Economic Growth and the PPF
Economic growth, which is an increase in the total output level, occurs when one or both of the following conditions occur.

1. Increase in the quantity and quality of economic resources.
2. Advances in technology
   Economic growth is represented by the outward shift of the PPF as depicted in Figure 2.2 below

Figure 2.2 Economic growth with a new PPF

An economy can grow because of an increase in productivity in one sector of the economy. For example, improved technology applied to either food or computers would be illustrated by a shift of the PPF along the Y- axis or X-axis. This is called asymmetric growth.

Figure 2.3 Effects of technological advancements in: a) food production and b) computer production