1.1.1   Scarcity, choice and opportunity cost

The Basic Economic Problem

Economics is the science of choice. We would like to have it all, but there are limits on our ability to produce. So, we must make a choice about what to produce and consume. All of Economics derives from the basic economic problem: that resources have to be allocated between competing uses because wants are infinite while resources are scarce.

This applies to individuals. As consumers we have unlimited wants and needs, but only so much money and time to pursue these. We make a choice to ensure that we purchase those goods that will maximise our utility, or the usefulness that we get from these products.

Governments must make these choices. There may be unlimited number of things that the government might wish to pursue, but only so much money in the public purse that they can afford to direct to these programmes. They must choose the ones that they think will have the greatest benefit for society.

Whole societies must make these choices. Collectively, there are unlimited number of things that we might wish to accomplish as a society. Yet there are only so many people and resources available to us that we may use to complete these aims. We must ensure that these resources are directed toward the right people, to ensure that our social benefit is maximised. This will involve countless choices made by individuals, firms, and governments.

Scarcity

Scarcity is at the heart of the economic problem (scarce resources). This simply means that there is a limited amount of a good or resource available to us. In other words, if we all wanted to use it, it would eventually be used up.

Most goods or resources will be scarce in some way. Some are more obvious than others. Goods like gold and diamonds are rare and easily considered to be scarce. Yet even those goods that are seemingly plentiful have some element of scarcity if you think with a wide perspective. The Amazon rainforest may appear to be limitless, but if enough people want the land for cattle ranching then eventually it will run out.

Given this, nearly all goods and resources are scarce in some way. The only obvious contenders for having no scarcity whatsoever are goods that are so plentiful that we will never run out, such as the air we breathe or water in the sea.

Opportunity Cost

Say you’ve made a choice between two products. To do so, you would need to weigh up the benefits of both options.

Presumably, you will pick the product that gives you the highest benefit.

But to do this, you will need to compare this against the benefit of the product you haven’t chosen.

When we consider the benefits of the option we haven’t chosen, we are referring to opportunity cost.

Opportunity cost is a very important concept. It is defined as the benefits foregone of the next best alternative. It’s worth breaking down in the following way:

• Benefits: these are the good things that you would have had, if you had chosen this product.
• foregone: but you didn’t choose this product, so you have not received (foregone) these benefits
• of the next best alternative: we’re only considering the benefits of one other product, the next best We can’t compare the benefits of every single possible alternative, so we’re just going to focus on the one you would have had.

Put it this way: where do you decide to study A Level Economics? You could either:

• Stay at your secondary school
• Go to a FE college.

Each choice would have had its benefits:

Say you’ve chosen to attend FE college. So what is the opportunity cost of this decision?

It’s the benefits of the secondary school that you’re missing out on.

Knowledge Check: Opportunity Cost Exercise

Opportunity Costs and The Government

Everybody in the economy faces the economic problem, including the government. The government will face opportunity cost just like anybody else.

An example of this is a big project like HS2, a high-speed rail network between London and the North of England.

https://www.bbc.co.uk/news/uk-16473296

The cost of this will be £106bn, by the latest estimates. So what is the opportunity cost of this decision?

It’s the benefit the government could have received by spending this money on other projects.

As a guide, £1bn equates to the following:

• 2 flagship hospitals
• Annual salary for 19,000 GPs.
• Annual salary for 27,000 secondary school teachers
• 2/3 of a nuclear powered submarine
• Electrification of 200 miles of trainline

Source: https://www.bbc.co.uk/news/av/uk-50576648

You can do the maths to work out how much the government is giving up by spending so much on HS2. They must really think the benefits of the project are substantial.

Factors of Production

When discussing scarcity we are discussing scarce resources. Resources are the basic building blocks of the economy. It’s what society uses to produce economic activity.

In economics we categorise resources into these four categories: land, labour, capital, and enterprise.

Land

Land refers to the space that is used for buildings, as well as any primary materials that may be extracted from nature. This will include:

• The physical space for houses and new buildings
• Agricultural production
• Mining
• Oil extraction
• Fishing

These are all industries which make up the primary sector of the economy: the first stage of any production process.

Land is scarce because there is only so much of it. Should we build a new housing estate in town? We’ll need to find some space, and this presents an opportunity cost as the space could have been used for another purpose. Should we produce more wheat? We’ll need to find some fields that will produce it, and this presents an opportunity cost because these fields could have been used for some other purpose.. The seas have plenty of fish, but if you take too many you’ll deplete the fish stocks. The opportunity cost of taking fish out of the sea today is the amount of fish that will be available in the future. So all resources based on land are scarce in some way.

It’s hard to improve the amount of land that exists, but it can be done. Logan Airport in Boston, USA, is built on land that was reclaimed from Boston Harbour, filled in with earth from the surrounding area.

Labour

Labour refers to the work done by human beings as part of the production process. Any human input counts as labour. This will include:

• Building labourers
• Workers in restaurants
• Professionals (e.g. solicitors, accountants)
• Teachers
• Computer programmers

Any work done by humans for a business counts as labour.

It’s possible to increase this factor of production- just add more people to the economy. This can be done either through making new people (having babies) or by letting in people from other parts of the world (immigration). If you don’t have enough people around to do the work then you won’t be able to get as much done; Japan and Italy are examples of countries with ageing populations, which has a significant effect on their economic performance.

It’s also possible to increase this factor of production through providing skills and training. People with higher skills can produce more, economically, than people with lower skills. Human capital refers to the skills of the workforce (not to be confused with the next type of factor of production).

Labour is scarce because there is only so much of it. If you devote people to a certain industry, there will be fewer workers available for other industries.

Even on an individual level, there is an opportunity cost associated with labour. What is the opportunity cost of working for a morning? You miss out on the benefit of relaxation that you would have had spending that morning pursuing leisure.

Capital

Capital as a factor of production refers to the machines and equipment that businesses use as part of their production process. This will include:

• The machines used in the production process.
• The factory or any buildings
• Vehicles used by businesses
• Any durable equipment that is used for a service (e.g. a rental surfboard).

It is important to recognise that capital in this sense is different from the way that we usually use this term. In everyday language, people often refer to financial capital, meaning the money that is put into a business as investment.

For our purposes, capital will be limited to meaning the machines and equipment used by business.

Capital is easy to increase: you just need to get your businesses to spend more on their equipment. But spending more on equipment presents an opportunity cost because the business will have less money to return to shareholders in the form of profit. An economy that has lots of factories and tools will be able to produce more than an economy with less capital stock, so in the long-term it makes sense to encourage businesses to build more equipment to make themselves productive. Governments often use tax breaks to encourage businesses in this way.

Capital is scarce: there is only so much out there that can be used. Using buildings, vehicles, and equipment in one industry will mean they cannot be used by another industry, so the use of capital presents an opportunity cost.

Enterprise

Enterprise is the most conceptual factor of production. It’s not a person like labour, and it’s not a physical object like land or capital, but it is still a vital element that is necessary to produce goods in an economy.

Enterprise means people are seeking out profitable opportunities for production and taking risks in attempting to exploit these. They are matching resources to each other in a profitable way. An entrepreneur is a person who engages in enterprise.

The most important part of this concept is that people are taking risks. People who engage in enterprise are actively deciding to take a risk with their time and money. They’re engaging in entrepreneurial activity because they know there is a profit to be made, but there is a good chance that the venture will fail and they will lose it all. Even knowing this, they try their hand in the hope they might be successful. This is the spirit of enterprise.

What does enterprise do? A useful conceptualisation of this factor of production is that enterprise connects the other factors of production together. An entrepreneur will see an opportunity and organise the land, labour, and capital in such a way as to exploit the opportunity to make money. Think of it like the first person who ever built a shopping centre: they saw that land was available, they put buildings on it (capital), and got people to work there (labour). In doing so they provided a service that added to the economy (and would have made themselves a lot of money along the way).

To see for a concrete example of enterprise we often look to those entrepreneurs who embody this spirit of risk taking and combining other factors of production. Oprah Winfrey, Elon Musk, Anita Roddick, and Richard Branson are just a few famous examples. Consider Richard Branson’s latest venture, Virgin Galactic. The capital and labour all exist to send people into space, but it takes the enterprising spirit of Richard Branson to take the risk in connecting these factors of production in trying to open up the market for space tourism.

Another good example is Ray Kroc, the ‘founder’ of the McDonald’s (the story of which is also featured well in the movie The Founder starring Michael Keaton). Ray Kroc didn’t invent McDonalds. He was selling milkshake machines when he came across two brothers, the McDonald brothers, who were running a restaurant selling super-speedy burgers. The McDonald brothers invented the system and the brand, but they didn’t have the ambition or desire to grow the business beyond their single store. Ray Kroc agreed to help them grow as a franchise, and it was up to him to take the risks and connect the factors of production to build McDonalds into the global brand that it is today.

It’s possible to increase this factor of production if you can persuade people and support them to take risks and try new businesses. The UK government provides lots of information through the gov.uk website to encourage new businesses (https://www.gov.uk/set-up-business), and charities such as the Prince’s Trust (https://www.princes-trust.org.uk) are designed to support new entrepreneurs taking a risk. Getting rid of red tape and regulations will make it easier for people to start their own businesses. Cultural attitudes toward risk and enterprise are important too, as well as the financial infrastructure that can help fund new enterprises. For example, the culture of Silicon Vallely, USA, supported through the vast networks of venture capital funding that channel money to new companies, has made it a hot spot for new ideas and technologies.

Allowing entrepreneurs to keep more of their profits, for example through lower income and corporation tax, increases the incentive to become an entrepreneur and increases the enterprise available in the economy. While the topic of optimal rate of tax is a matter of debate, it is certainly true that prohibitively high marginal rates of tax acts as a deterrent to enterprise. In order to support enterprise, governments around the world have consistently lowered marginal tax rates since the early 1980s.

Is enterprise scarce? It’s difficult to be sure, given that it is so much more conceptual than the other factors of production. But the fact that there is only so much appetite for risk in a society, and only so many people willing to bear that risk through entrepreneurship, we can say that enterprise is scarce like the other factors of production like land, labour, and capital.

Free Goods and Economic Goods

Are all resources scarce? Are there some goods which do not fit this description?

Economic goods are goods which are scarce because their use has an opportunity cost.

By producing these goods, we have made a decision to forego other goods that could have been produced with the scarce resources.

Yet some goods do not involve a decision: they are free goods.

Free goods are goods that are unlimited in supply and which therefore have no opportunity cost.