H2 Lecture Notes - Scarcity, Choice and Opportunity Cost - 2012

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SCARCITY, CHOICE AND OPPORTUNITY COST

CONTENTS: 1. Introduction

2. Scarcity, Choice and Resource Allocation

3. The Marginalist Principle

4. Efficient Resource Allocation

5. Production Possibility Curve

This series of lectures provides an introduction to the nature of economics and examines the operation of markets for goods and services. It also focuses on how consumers and producers make decisions about the choices they face, recognising

that in the market economy, both are motivated by self-interest.

RAFFLES INSTITUTION YEAR 5 H2 ECONOMICS 2012

Year 5 H2 Economics Lecture Notes 2012 Scarcity, Choice and Opportunity Cost

RAFFLES INSTITUTION YEAR 5 H2 ECONOMICS 2012

SCARCITY, CHOICE & OPPORTUNITY COST Outline of Contents 1 Introduction to Economics 2 Scarcity, Choice & Opportunity Costs 2.1 Inevitability of Choices at all Levels (Individuals, Firms & Government) 2.2 Maximising Behaviour: Rational Choices 2.3 Opportunity Costs 2.4 Benefits 3 The Marginalist Principle 3.1 Decision Making at the Margin 4 Efficient Resource Allocation 4.1 Productive Efficiency 4.2 Allocative Efficiency 4.3 Distributive Efficiency 5 Production Possibility Curve (PPC) 5.1 What the PPC Illustrates 5.2 The Concept of Increasing Opportunity Cost 5.3 Shifts in the PPC Appendix A1 Science of Economic Analysis A2 Economics Systems: A Brief References *Sloman, J., Economics, 6th Edition, Hertfordshire: Prentice Hall *Beardshaw, J., Economics: A Student’s Guide, 5th Edition, Pearson Education Lipsey & Courant, Economics, 11th Edition, Harper Collins Miller, R., Economics Today, 13th Edition, Addison-Wesley Maunder, P. & Miller, R., Economics Explained, 3rd Edition, Collins Educational Begg, Fischer & Dornbusch, Economics, 5th Edition, McGraw Hill * - Primary References


Raffles Institution Economics Unit (Arts Department)

Lecture Objectives: After the series of lectures, students should be able to: - Explain the problem of limited resources and unlimited wants - Explain the concept of opportunity cost and the nature of trade-offs in the allocation of

resources using production possibility curve analysis - Explain that economic agents make decisions to arrive at the best alternative based on

their objectives - Understand that economic agents weigh the incremental benefits against incremental

costs in decision-making



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1 INTRODUCTION TO ECONOMICS

WHAT IS ECONOMICS? Some Definitions from the Past John S Mill (1806 - 1873) English Economist

Economics is the practical science of the production and distribution of wealth.

Alfred Marshall (1842 - 1924) English Economist

Economics is a study of mankind in the ordinary business of life.

General Modern Definitions J Harvey Economics is the study of how man allocates resources to

provide for his wants.

P A Samuelson Economics is the study of how man and society choose to employ scarce productive resources which could have alternative uses, to produce various commodities over time and distribute them for consumption, now and in the future.

Economics is a social science that studies the allocation of scarce resources to the production of goods and services used to satisfy consumers’ unlimited wants.

Wants refer to all those things people would consume if they had unlimited incomes. Resources are inputs used to produce goods and services.

Wants of people are unlimited. The resources used to satisfy these wants are, on the other hand, limited. Economists study how people make use of the scarce resources to satisfy their wants. They study the problem of scarcity.

What is the distinction between needs and wants? Needs are finite and must be satisfied for people to survive. Wants, on the other hand, are unlimited and cannot be satisfied fully because of limited resources.

Microeconomics and Macroeconomics The economist studies the real world at both the micro and macro level.

Microeconomics is a branch of economics that studies how individuals, households, and firms make decisions to allocate limited resources, typically in markets where goods or services are being bought and sold. It further examines how these decisions and behaviours affect the supply and demand for goods and services, which in turn determines prices.



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Macroeconomics is the branch of economics that studies the entire economy. As such, it deals with economy-wide phenomenon such as changes in unemployment, the general price level and national income.

2 SCARCITY, CHOICE AND OPPORTUNITY COST

2.1 INEVITABILITY OF CHOICES AT ALL LEVELS (Individual, Firm, Government)

All societies face the basic problem of scarcity due to limited resources and unlimited wants. Scarcity makes it necessary for us to make the most of what we have. In trying to obtain the highest level of satisfaction from the available resources, good choices have to be made. Concept of choice applies to all the decision-making units.

2.1.1 RESOURCES Resources or factors of production, are inputs used in the production of goods and services. They are divided into four broad categories: land, labour, capital and entrepreneurship.

1. Land

This includes all those productive resources supplied by nature. This means that it includes not only land in the conventional sense of plots of land but all those resources freely supplied by nature such as rivers, trees, minerals.

How would you classify raw materials?

Raw materials delivered to factories have already been extracted, processed and transported. They therefore cannot be classified as pure land. Even land itself contains elements of capital if it has in some way been improved from its natural state – say by levelling or drainage. Hence, we might classify raw materials as capital.

2. Labour

Labour is human effort – physical and mental – which is directed to the production of goods and services.

Normally, the labor force of a country (or other geographic entity) consists of everyone of working age (typically above a certain age (around 14 to 16) and below retirement (around 65) who are participating workers, that is people actively employed or seeking employment. People not counted include students, retired people, stay-at-home parents, people in prisons or similar institutions, people employed in jobs or professions with unreported income, as well as discouraged workers who have stopped seeking employment.

3. Capital

Capital is a man-made resource used in the production of goods and services. It includes machines, tools and buildings.



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The production of capital involves postponing present consumption. Resources used for production of capital goods cannot be used to produce consumer goods, which are for present consumption.

Some distinctions to make:

Financial versus Real Capital Real capital refers to factories and machinery used to produce goods and services. On the other hand, financial capital consists of financial assets such as bonds, stocks or bank deposits.

Human versus Physical Capital

Human capital consists of the knowledge and skills people develop that enhance their production capacity. Physical capital consists of machines, buildings, etc.

Unless otherwise specified, economists use the term “capital” to refer to physical/real capital.

Would you consider money, stocks and shares as factors of production?

Money, stocks and shares should not be classified as capital, which refers only to physical assets, nor as any category of factor of production. They are paper assets, which are merely claims on physical assets.

4. Entrepreneurship

Entrepreneurship is a human resource that is separate from labour. An entrepreneur is one that performs the functions of organising and managing the factors of production, of innovating new products and ways of production and he takes the risks of being in business. Without entrepreneurship, virtually no business organisation can operate.

2.1.2 DECISION-MAKING UNITS

1. Households

A household is any group of people living together as a decision-making unit. Every individual in the economy belongs to a household.

2. Firms

A firm is an organisation that uses resources to produce goods and services. All producers are called firms, no matter how big they are or what they produce.

3. Government

A government is an organisation that provides goods and services, and redistributes income and wealth. The most important of services provided by the government is a framework of laws and a mechanism for their enforcement. Governments also



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provide services such as national defence, public health, transportation and education.

2.2 MAXIMISING BEHAVIOUR: RATIONAL CHOICES The basic assumption of Economics is that all decision-making units make rational choices. Rational choices are made by different decision-making units to maximize different objectives. To obtain the highest level of satisfaction, a rational decision must be made. This decision has to be an optimal one.

Assuming rational behaviour on the part of decision-making units, this optimal choice must be one that chooses the most desirable alternative among the possibilities that the available resources permit.

That is, decision-making units will always choose that alternative which yields them maximum “satisfaction”.

o Households with a limited income, will select the particular combination (holidays, food etc.) which yields the highest satisfaction;

o Business firms have to decide what goods and services to produce and which method of production to adopt to yield the highest level of profits.

o Governments will allocate tax revenue to fund projects and initiatives which help in securing votes from the public in elections.

The most desirable alternative is seen from the scale of preference of the decision maker.

The scale of preference is a list of all the unsatisfied wants of an individual which are arranged in order of preference in terms of priority

Near the top of the list will be the most pressing wants, and these will be satisfied first before the other want lower down the scale.

The marginalist principle is used to make optimal decisions. Rational choices involve weighing up the marginal benefits of each activity against all its marginal opportunity costs. These are the costs and benefits of doing a little bit more or a little bit less of a given activity. 2.3 OPPORTUNITY COST Every time a choice is made, an opportunity cost is incurred. When a choice is made, all other alternatives must be forgone. Opportunity cost is involved.

Opportunity cost refers to the real cost in terms of the next best alternative that has to be forgone.

It arises due to the fact that the resources available to meet the wants are limited so that all wants cannot be satisfied.

If the resources were unlimited, no action would be at the expense of any others; hence the opportunity cost of satisfying a want would be zero.

However in the real world of scarcity, opportunity cost is always positive.



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Illustration of Opportunity Cost: Case 1 Suppose you choose to spend an extra hour on studying economics. What is your opportunity cost? When you study for one more hour, there are many other things you could have done in that one hour. You could have watched your favourite television show, or you could have gone for a bowling session or you could have taken a nap. However, you need to understand that your opportunity cost is the next-highest ranked alternative, not all alternatives. If you consider taking a nap to be the next best alternative, a nap would have been your opportunity cost of studying for one hour. Illustration of Opportunity Cost: Case 2 The Singapore government has limited financial resources. By upgrading flats in one ward, Singapore lost the opportunity to build one more expressway. The opportunity cost of upgrading flats is the development of its transportation infrastructure. Illustration of Opportunity Cost: Case 3 (Theory of Comparative Advantage) All countries have limited resources. The table below illustrates what the countries can produce with each unit of resource available.

Good

Country

1 unit of resource can produce

Wheat (units) Cloth (units)

A 15 or 30

B 10 or 5

A country has a comparative advantage in a commodity if the country can produce it at a lower opportunity cost than its trading partner.

Opportunity Cost Ratios

In Country A In Country B

1 unit of wheat : 2 units of cloth 1 unit of wheat : ½ unit of cloth

1 unit of cloth : ½ unit of wheat 1 unit of cloth : 2 units of wheat

. To produce 1 unit of wheat, Country B sacrifices less cloth (incurs lower opportunity cost) than Country A does. Thus, Country B is said to have comparative advantage in wheat production. To produce 1 unit of cloth, Country A sacrifices less wheat (incurs lower opportunity cost) than Country B does. Therefore, Country A is said to have comparative advantage in cloth production. Because of differences in opportunity cost, international trade between countries would be mutually beneficial. Countries should specialise in producing goods that they have comparative advantage in and imports goods which they have a comparative disadvantage in. [Note: The theory of comparative advantage will be covered in greater detail under International Economics (Macroeconomics)]



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Problems in calculating opportunity costs

Calculating opportunity cost requires time and information. Acquiring information about alternatives is often costly and time consuming, people usually make choices based on limited or even wrong information about their opportunity costs and so some choices turn out to be poor ones. At the time you made the choice, however, you thought you were making the best use of all your scarce resources, including the time required to gather information about your alternatives.

Opportunity cost may vary with circumstance. Since opportunity cost depends on the alternatives, the opportunity cost of consuming a particular good or undertaking a certain activity will vary with circumstance. This is why you are less likely to study on a Saturday night than on a Wednesday night. On a Saturday night the opportunity cost of studying is greater because you have more alternative activities, and usually the expected benefit of at least one of these alternatives exceeds the expected benefit from studying.

To the economist, the very important concept of opportunity cost is the real cost of making a decision.

Opportunity cost measures choices in real terms (physical goods given up). In many circumstances money paid for goods and services becomes a reasonably

good approximation of the opportunity cost of their consumption. The measuring of opportunity cost in monetary terms is for convenience as money is the common yardstick to measure value of goods.

However, the monetary cost approximation may leave out some important elements, particularly the time involved. Between the choices of watching a movie on television or the cinema, one must consider that in addition to the ticket price, a trip to the movies will incur travel time and transport cost.

2.4 BENEFITS Decision-making units will consider the benefits reaped when making choices.

Households yield satisfaction (utility) from consuming goods and services. Firms gain revenue from the production of goods and services. Governments maximise the number of votes (to get re-elected) from improving

society’s welfare. Rational choices are made after considering all the benefits against the opportunity costs of using the limited resources.

3 THE MARGINALIST PRINCIPLE

3.1 DECISION MAKING AT THE MARGIN We have said that economics is about making optimal choices. Understanding economics helps us develop habits of thought that enable us to choose better – to compare the benefits of every choice against its opportunity cost and to make the most efficient choices.



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Making choices is necessary to everyone in our roles as consumers, producers or government. Most of our economic choices are made at the margin. The margin is the edge or border where we must decide whether to take one more step, whether to purchase one more unit of a particular good or whether to use one more unit of a particular resource. Rational choices made at the margin involve weighing up marginal costs (MC) and marginal benefits (MB). These are the costs and benefits of doing a little bit more of a given activity. We use marginal analysis unconsciously every day.

Marginal analysis helps students allocate study time and workers allocate work time among a number of tasks

We use marginal analysis when we allocate our time, continuing one activity (e.g. sleeping) until the benefits gained from spending one more minute are less than the benefits from spending that minute doing something else (e.g. studying). The decision is therefore based on the costs and benefits of extra sleep, not on the total costs and benefits of a whole night’s sleep.

Even a fun-seeker allocates pleasure time by comparing the benefits gained from spending one more minute playing with the benefits of spending that minute resting.

Consumers use marginal analysis when buying.

We spend on one item until the benefits gained from spending one more dollar are less than the benefits from spending that dollar on something else.

Consumers will consume until MPB (marginal private benefit or satisfaction) = MPC (marginal private cost). If MPB > MPC, it is rational to choose to consume more of that good.

Business firms use marginal analysis to decide the level of production.

An auto manufacturer produces autos until production of one more auto brings in less revenue than it costs to produce. That is, it compares the costs and revenue of an additional car produced. If an additional car add more to the firm’s revenue than to its cost, it will be profitable to produce it. It should keep on producing additional cars until additional revenue from selling that last car is equal to additional cost of producing that last car.

A barber keeps his shop open until one more hour brings in less revenue than the cost of staying open.

Business firms also use marginal analysis when they decide how many units of a particular resource to use in production.

They hire salespeople until hiring one more salesperson adds less to sales revenue than his or her wage.

They buy land for shopping centers until one more acre of space adds less to revenue than it costs.

Firms will produce until Marginal Revenue (MR) = Marginal Cost (MC). In effect, our entire economic system makes decisions at the margin. We increase production until one more unit of output is worth less than the resources required to produce it. In this way, we help ensure that our scarce resources are used to produce the things we want most.



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4 EFFICIENT RESOURCE ALLOCATION All societies face the problem of scarcity and hence have to make decisions like a household does. A society has to decide what and how much to produce, how to produce and for whom to produce. Economics is a study of how to allocate resources efficiently.

What and How much to Produce The society must decided what goods it is going to produce, and hence

what not to produce. Such choices usually take the form of more of one thin and less of another, rather than all of one and none of another. It needs to choose the composition of total output.

How to Produce Most goods can be produced by a variety of methods. Wheat can be

grown by making use of much labour and little capital, or by using vast amounts of capital and very little labour. A society must decide on the methods of production to be adopted.

For Whom to Produce The total output needs to be distributed among members of the society.

How is this distribution to be carried out?

The economy is a mechanism that allocates scarce resources among alternative uses. The way in which society answers these three questions on resource allocation differs from country to country, thus giving rise to different economic systems. (Refer to Appendix 2 for more details on economic systems)

THE CONCEPT OF EFFICIENCY

Efficiency is a key concept in the study of microeconomics. Given the problem of scarcity, it is of utmost importance that limited resources are efficiently utilized to meet the unlimited wants of people as best as possible. There are several meanings of the term but they usually refer to how well an economy allocates scarce resources to meets the needs and wants of consumers.

Static Efficiency: As the word “static” implies, it refers to efficiency at a given point in time. It focuses on how much output can be produced from a given stock of resources at a given point in time.

Dynamic Efficiency: This occurs in a market over a period of time. It focuses on changes in the amount and quality of goods and services available in the markets over a period of time. For example: Is new technology being developed and adopted at the best rate? Are firms reducing costs over time? Dynamic efficiency can be boosted by Research and Development (R&D) spending that leads to improvements in products and the production process; investment in the human capital of the workforce leading to gains in the product quality which is vital in high value high-knowledge sectors; greater competitive pressures in markets and the transfer of knowledge and ideas across countries.

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4.1 PRODUCTIVE EFFICIENCY Productive efficiency is defined as the situation where firms use the best combination of factor inputs to produce a given amount of output. It is achieved when firms are producing the maximum output for a given amount of inputs. Alternatively, it could be interpreted as producing a given output at the least average cost. The economy achieves productive efficiency when all the available resources are fully and efficiently employed to achieve the maximum output possible. Productive efficiency is achieved when:

Society produces at any point on the productive possibility curve (PPC) Firms produce at the lowest point on the long run average cost curve (Society’s point

of view) Firms produce at any point on the long run average cost curve (Firm’s point of view)

4.2 ALLOCATIVE EFFICIENCY Allocative efficiency is the situation in which the society produces and consumes a combination of goods and services that maximises its welfare. It is achieved when the goods and services that are wanted by the economy are produced in the right quantities. Allocative efficiency is achieved when:

Society produces at a point on the production possibility curve (PPC) Price = Marginal Cost, where society’s valuation of the last unit of good

produced/consumed is equal to the opportunity cost in producing the last unit of output produced/consumed.

Marginal Social Cost = Marginal Social Benefit, where the additional cost to society of the last unit of output produced/consumed is equal to the additional benefits to society of the last unit of output produced/consumed.

4.3 DISTRIBUTIVE EFFICIENCY Distributive efficiency is achieved if the goods and services are distributed to those who benefit the most from them. In other words, the attainment of productive and allocative efficiency does not necessarily mean that distributive efficiency is achieved. The concept of distributive efficiency is normative in nature (Refer to Appendix 1). NOTE: Economic Efficiency is attained by achieving both productive efficiency and allocative efficiency. [Efficiency concepts will be covered in greater detail under Resource Allocation in Competitive Markets, Firms and How they Operate, and Market Failure]



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5. PRODUCTION POSSIBILITY CURVE (PPC)

5.1 WHAT THE PPC ILLUSTRATES A Production Possibility Curve (PPC) is a graph that shows the maximum attainable combinations of output that can be produced in an economy within a specified period of time, when all the available resources are fully and efficiently employed, at a given state of technology. The PPC is an economic framework that can be used to illustrate concepts of scarcity, choices and opportunity costs. We make several assumptions when drawing such a PPC for any economy. 1) 2 types of goods produced 2) Fixed amount of resources 3) All resources are fully and efficiently utilised 4) Fixed state of technology within the specified time period Table 1: Possible Combinations of Goods produced Figure 1: The Production Possibility Curve

Alternative Combination

s

Consumption Goods (units)

Capital Goods (units)

A 450 0

B 400 10

C 300 20

D 180 30

E 0 40

In this economy, if all resources are fully and efficiently utilised in the consumption goods industry, the economy would produce a maximum of 450 units of consumption goods and no capital goods. If all resources were fully and efficiently used in the capital goods industry, the economy would produce a maximum of 40 units of capital goods and no consumption goods. The two end points of the curve, combinations A and E, represent these extreme possibilities.

If the economy were to divide its resources efficiently between the two industries, it

could produce various combinations of consumption goods and capital goods, for example, combinations B, C and D.

Combination F is an example of an unattainable combination, given the current

amount of resources and the state of technology the economy has. In other words, the economy can produce at any point on or inside the production possibility curve but it cannot produce at points outside the curve.

Combination G is an example of an attainable but inefficient combination.

Resources have not been fully and efficiently employed. The economy is experiencing unemployment (idle resources) or inefficiency (under use of resources). More goods can be produced by increasing the employment of the idle resources or use them more efficiently.

40

Consumption Goods

Capital Goods

A B

C

D

E

F

G

0

450



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All points on the PPC represent productive efficient levels of production (for example, points A and C in Figure 1). Points inside the PPC (for example, point G in Figure 1) are productive inefficient because resources are either unemployed or underemployed – the economy is not producing the maximum output possible.

Unemployment is the situation in which not all the available resources are used in the production of goods and services.

Underemployment refers to the case in which resources are engaged in production but are operating below their production capacity.

At point G, it is possible to use the unemployed and underemployed resources to increase the production of one good without decreasing the production of the other good, that is, opportunity cost incurred is zero (for example, movement from point G to C). Scarcity is illustrated by the unattainable combinations outside the PPC as well as the fact that society has to choose among combinations of the two goods as resources cannot be used to produce all at the same time. (The combination of goods an economy eventually chooses depends on its priorities). The downward (negative) slope of the PPC illustrates the concept of opportunity cost. To choose to have more of one good means having to give up some of the other good, given that the limited amount of resources have been fully and efficiently employed.

5.2 THE CONCEPT OF INCREASING OPPORTUNITY COST

Figure 2: The Concept of Increasing Cost The PPC above is concave to the origin. This means that as more of a good is produced; larger and larger quantities of the alternative good must be sacrificed. There is increasing opportunity cost in the production of consumption goods in terms of capital goods foregone. This is because the resources in the economy are not perfectly suitable / transferable to the production of both the goods. As the economy concentrates on the production of one good, it has to start using resources that are less and less suitable – resources that would have been better at producing other goods. To produce an additional unit of a good means having to move increasingly greater amounts of resources from the alternative good, and hence, the greater the amount of alternative good that has to be sacrificed.

PPC

Consumption Goods

Capital Goods 0



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Under what circumstances would a PPC be a straight line?

A straight line PPC means that there is constant opportunity cost. This happens if the factors of production are perfectly suitable in the production of both goods. This might possibly occur in our highly simplified world of just two goods. In the real world, it is unlikely.

5.3 SHIFTS IN THE PPC Economic growth refers to an increase in the real output of a country (actual economic growth) accompanied by an increase in an economy’s capacity to produce goods and services (potential economic growth). Actual economic growth is the percentage annual increase in national output: Newspaper statistics tend to indicate actual economic growth. A movement from a point inside the PPC to a point closer/on the PPC will indicate actual growth. Potential economic growth is the speed at which the economy could grow. It is the percentage annual increase in the economy’s capacity to produce. This is illustrated by an outward shift of the PPC. The two main sources of potential growth are: 1) Increase in quantity and/or quality of resources 2) Technological improvement

Note: As economists, it is important to consider both aspects of growth when discussing economic growth. Increase in the Quantity and/or Quality of Resources An increase in the amount or quality of resources enables the economy to produce more than before; hence there is a shift in the PPC outwards. It may be an increase in the size of the labour force, an increase in the skills and educational levels of the labour force, an increase in the amount of land or an increase in the size of the capital stock. Figure 3: Parallel Shift of the PPC Figure 4: A Rightward Skew of the PPC

Consumption goods

0 F0 F1

C1

C0

C1

C0

Capital goods 0 F0 F1

Consumption goods

Capital goods



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The shift of the PPC in Figure 3 appears to be parallel indicating that the resource whose availability is altered is perfectly adaptable to the production of both types of goods. If that resource is better suited to the production of one type of good, capital goods, then the shift of the PPC on the capital goods axis will be greater than the shift of the PPC on the consumption goods axis. The shift of the PPC will be skewed. Notice that the opportunity cost of producing capital goods in terms of consumption goods has fallen with this shift (refer to Figure 4).

Figure 5: Effects of the Size of Capital Stock on Economic Growth Assuming a country produces goods that can be broadly categorised into consumption and capital goods. If an economy chooses to produce more capital goods (plant, machinery and equipment) in one period, it will find that it can produce more output in the next period (i.e. its productive capacity has increased). However to produce more capital goods in the current period, an economy must reduce present consumption (i.e. less production and hence consumption of consumption goods). An economy must decide between producing goods for current consumption and producing goods for future production and consumption. In Figure 5, if the economy chooses to produce at point A instead of point B in period 1, it will experience a smaller increase in its productive capacity in period 2, as represented by the shift of PPC1 to PPC2(A) as compared to a larger shift to PPC2(B). This is because producing at point B would give the economy a larger size of capital stock, which will mean that in the future, its ability to produce is much greater. However, this means experiencing a lower current standard of living at point B as compared to point A. Technological Improvement Technological improvement represents new and better methods of producing goods. If the technological improvement is in the capital goods industry, the PPC will shift in a skewed manner, as shown in Figure 6. If the technological change can enhance the production of both goods, the entire PPC will shift outwards, as in Figure 7.

0

Consumption Goods

Capital Goods

A

B

PPC1

PPC2 (A)

PPC2 (B)



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Effects of Technological Improvement on the PPC Figure 6: A Rightward Skew of the PPC Figure 7: Parallel Shift of the PPC Is it possible for the PPC to shift inwards? What can cause this to happen?

Yes, a PPC can shift inwards if there were a reduction in the quantity or quality of resources or if there was a loss of technology. For example, resources such as labour or natural resources could be reduced during a prolonged war.

******END******

Consumption goods

Capital goods 0

F0 F1

C0

Capital goods 0

F0 F1

C1

C0

Consumption goods



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APPENDIX 1 THE SCIENCE OF ECONOMIC ANALYSIS Positive and Normative Economics

Positive economics seeks to describe and explain economic facts and events observed objectively. It deals with what was, what is and what will be.

A positive statement is a statement of fact. It may be right or wrong. By appealing to the facts, a positive statement can be tested for its accuracy.

Examples : The economy grew by 7% last year. If GST is raised from 5% to 7%, the price of most goods will rise.

Normative economics looks at the outcomes of economic behaviour and questions whether they are good or bad. It deals with what ought to be.

A normative statement is a statement of value: it is about what ought or ought not to be, about whether something is desirable or undesirable. Such statements cannot be proved or disproved. Often, they have their origin in positive statement but they cannot be proven true or false by referring to objective data.

Examples : The GST should not be increased from 5% to 7%. The rich ought to be taxed more than the poor. Is Economics a Science? To the extent that the economists make use of scientific method (which involves the formulation of a hypothesis and the testing of these hypothesis under assumptions); economics may be described as a science. However, because economists study human behaviour, they, like other social scientists, cannot be as precise as the natural scientists (chemists, physicists, biologists, etc.) in their predictions. The most obvious limitation experienced by the social scientist is that he cannot test his hypotheses by laboratory experiment but against developments in the real world. This is not helped by the fact that the real world is highly complex – so many things are changing simultaneously. Natural scientists in their laboratories can “hold other things constant” while they study the effects of changes in X on Y. Experiments which test hypothesis can be constructed such that changes in other factors are minimised. Economists can also try to get as close to the real world as possible by extending their theory to include more factors – but no one can construct or understand a model that includes everything. Predicting Average Behaviour: Law of large numbers The random actions of individuals tend to offset one another so that the average behaviour of a large group can be predicted more accurately than the behaviour of a particular individual. For example, an economist cannot predict very well which particular individuals will buy more Coca-Cola when its price falls, but can predict fairly accurately how much more Coca-Cola will be demanded in the market when price falls. The economists focus on average behaviour of people in groups rather than on specific behaviour of a particular economic agent.



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APPENDIX 2

ECONOMIC SYSTEMS: A BRIEF All societies face the problem of scarcity and hence have to make decisions like a household does. A society has to decide what and how much to produce, how to produce and for whom to produce. Different Economic Systems The way in which society answers these three questions on resource allocation differs from country to country, thus giving rise to different economic systems. One important difference between them is in the degree of government control of the economy. At one extreme lies the completely planned or command economy, where the government owns resources and all the economic decision are taken by the government. It plans the allocation of resources between current consumption and investment for the future. It plans the output of each industry and firm, the techniques that will be used and the resources required by each industry and firm. It also plans the distribution of output between consumers. At the other extreme lies the completely free market economy where there is no government intervention at all. There is private ownership of all resources and individuals and firms take all economic decisions. Producers are free to make and sell whatever output they think will be profitable. Consumers are free to buy whatever goods they can afford. This entire voluntary buying and selling is coordinated by unrestricted markets, where buyers and sellers make their wishes known. Market prices guide resources to their highest valued use and direct goods and services to consumers who value them the most. The free market economy relies solely on market forces of demand and supply to allocate resources. In order for the free market to function, the following characteristics must be present:

Private ownership of property Individuals have the right to own, control and dispose of land, capital and natural resources. Owners of factors of production, thus, have the right to the income (in the form of rent, interest and profits) earned from the use of these factors of production.

Freedom of choice and enterprise All decisions are taken by households and firms. Consumers are free to decide what to buy with their incomes. (This is commonly known as consumer sovereignty.) Workers are free to choose where and how much to work. Firms are free to choose what to sell and what production methods to use.

Pursuit of self-interest Economic activity in the free market system is driven by self-interest. Each unit in the economy attempts to do what is best for itself. Hence, firms try to maximise profits, consumers try to maximise satisfaction and workers try to get jobs which pay the highest wages. (Adam Smith, father of modern Economics, believed that individual pursuit of self-interest leads to the maximum good for society.)

Competition Competition is an essential feature for the proper functioning of the free market economy. Competition here refers primarily to price competition where in the market for



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each commodity, there are large number of buyers and sellers, each having an insignificant share of the market and hence no influence on the market demand and the market supply. No single buyer or seller is strong enough to control a market and exploit other sellers or buyers. (That is, perfect competition is assumed.) However, it must not be assumed that all free markets are competitive ones. In fact, there can be free markets which have no or little competition. Such free markets do not function well, and experience what is known as market failure.

Price mechanism at work The price mechanism is used for allocating resources to their various uses. The decisions of producers determined the supply of a commodity while those of buyers determine demand. The interaction of demand and supply determines the price. Changes in the demand and the supply will, ceteris paribus, cause changes in the price, which in turn affects resource allocation. In the free market, price plays three important functions: - to act as a signalling and incentive device (i.e. to guide consumers’ decisions on what and how much to consume, and producers’ decisions on what and how much to produce) - to act as a rationing device (i.e. to ration scarce goods among buyers) In acting as signalling, incentive and rationing devices, the price mechanism allocates limited resources to satisfy unlimited wants and answers the three questions that every society is confronted with – “What & How Much to Produce”, “How to Produce” and “For Whom to Produce”.

In practice, all economies are a mixture of the two where economic decisions are made partly by the government and partly through the market. We call these economies mixed economies.

Documents

H2 Lecture Notes - Scarcity, Choice and Opportunity Cost - 2012