Economics Notes

Chapter # 1 – Scarcity, Choice and Opportunity Cost

Scarcity - The situation in which there are unlimited wants with only limited resources
- Makes it necessary to make choices – making a rational decision that is the most
desirable alternative amongst the possibilities
- The choice will be the one which yields them maximum satisfaction, according to the
scale of preference
o Scale of Preference is a list of all the unsatisfied wants of an individual in order of
priority
- Choices are made and need to be made at three main levels
o Individuals
 Will select combinations which yield highest satisfaction with a limited
income
o Firms
 Decide what goods and services to produce and the method of production
to adopt to yield the highest profit
o Government
 Choose where to allocate tax revenue to fund projects and initiative which
help in securing votes from the public in elections
- Choices are made regarding three main aspects
o What and How much to Produce
 Society must decide what goods it wants more of and what it wants less off
o How much to produce
 High labour, Low capital vs. Low Labour, High Capital
o For whom to produce

Opportunity Cost – Real cost in terms of the next best alternative that has to be forgone
- Arises from the fact that resources are too limited to fulfil unlimited wants
- Is a measure of choices in real terms
- While monetary cost approximation is the most convenient way of calculating
opportunity cost, it does include important elements such as time and effort.
- Are different in different societies due to following reasons:
o Different factor proportions
 Countries with productive labour workforce will produce high
technology goods, while those with less productive labour will
produce low technology goods, thereby affecting comparative
advantage
 Countries with fertile land but small population will produce land-
intensive goods cheaply and manufactured goods at high cost
o Different Climates
 Affects land ,labour and capital
o Different technology
  Some countries have earlier access to technology, and have cost
advantage over countries that rely on old technology.
Applications of Opportunity Cost
Division and Specialisation of Labour
- Assumes that production process is split into very large number of individual operations
- Each operation is the special task of one worker
o Leads to greater productivity
 Each worker can receive tasks for which he is best suited for
 Increases proficiency of a worker over time in that specific task e.g. greater
dexterity
 No time wasted moving from one job to another
 Less time in training of workers as only one task needs to be trained
 Allows for greater use of machinery for simpler tasks, and allows more
sophisticated production techniques
o Lowers opportunity cost of production as work is more efficient
- However there are problems present with this
o Monotony
o Loss of craftsmanship
o Risk of unemployment with changing needs of society
- Can be applied in the THEORY OF COMPARATIVE ADVANTAGE
Theory of Comparative Advantage
- Due to heterogeneous factors of production, certain countries have a comparative
advantage in producing certain goods compared to others
o A country has a comparative advantage in a commodity if the country can produce it
at a lower opportunity cost than its trading partner
o A lower opportunity cost refers to how much of the other good the country has to
give up in order to produce one unit of the first good.
- If countries specialise in the products they have a comparative advantage in, the trade
will be mutually beneficial to both countries
o Mutually beneficial terms of trade must lie between the opportunity cost ratios of
the 2 countries
o Will increase consumption of each commodity as compared if countries use one
unit of resource for each of its good
o E.G. If a good uses one unit of resource for each good, the following occurs
Country/Good Wheat Cloth
A 100 400
B 80 160
o But if a country specialises it can produce at the following amount
Country/Good Wheat Cloth
A 50 600
B 160 0
o Then, if the country trades between the opportunity cost ratios of ½ and ¼ , at 1
unit of cloth to 1/3 unit of wheat, Country A and B increase consumption of both
goods
Country/Good Wheat Cloth
A 110 420
B 100 180

Limitations of Theory of Comparative Advantage

1. Does take into account transport costs of goods which may eliminate any advantages
2. It assumes costs are constant, however it does not take into account that economies of
scale as well as the development of new comparative advantages through education and tax
incentives
3. It assumes all goods are homogenous i.e. all cars are the same ,which is not true
4. Does not take into account that factors of production are not perfectly mobile and that
when an industry loses its comparative advantage, it cannot specialise in a new industry as
its factors of production cannot be redeployed
5. Countries might not be able to conduct free trade with countries due to political and
protectionist measures.
Production Possibility Curve
- Graph that shows the maximum attainable combinations of TWO goods that can be
produced in an economy, when all the available resources are fully and efficiently used,
at a given state of technology

- Any point ON the curve represents a situation in which combinations of both goods are
produced.
o B is a situation in which resources are not fully and efficiently used i.e.
unemployment
o A is a situation which is unattainable, given the amount of resources and technology,
representing scarcity. Also the fact that a choice needs to be made amongst the
combinations should be noticed
- Opportunity cost is seen by the slope of the curve
o To choose to have more of one good, means to have to give up some of the other
good
o Additionally, the graph is bowed outwards as the more of a good is produced,
increasingly larger quantities of the alternative goods must be sacrificed, as the
resources in the economy are not perfectly suitable for production of both goods.
- Shifts in the PPC occur due to Economic Growth
o Increase in productive capacity of the economy
o Illustrated by outward shift of the curve
o Due to the following reasons
 Increase in Quality/Quantity of goods
 Increase in amt. of resources enable economy to produce more i.e.
increase in factors of production
 If the resource increased is perfectly adaptable for both goods, the
curve will shift parallel, but if it is more suitable for a certain good,
the curve’s shift will be skewed.
 Technological Improvements
 Represents new and better ways of producing goods
- Efficiency
o Productive Efficiency is achieved when all resources are fully employed i.e.
anywhere on the line
o Allocative efficiency is where society produces a combination that maximises its
welfare i.e. a single point on the line
o Distributive efficiency is achieved if the goods and services are distributed to those
who have the greatest need for them
Marginalist Principle

- Most economic choices are made at the margin

o The margin is the edge where one must decide whether to purchase one more unit
of good or whether to use one more unit of a resource
- Rational choices made at the margin involve weighing MARGINAL COSTS (MC) and
MARGINAL BENEFITS (MB)
- Everyone increases production until one more unit of output is worth less than the
resources need to produce it
o Ensures that our scarce resources are used to produce the items with least
opportunity cost
o Production/Consumption will continue until MB=MC, as if MB>MC, it is rational to
choose more of that product
- Marginal consumers are the ones who decide the price of goods as they switch to the
alternative which has the lowest cost
o No need for perfect knowledge by every individual
o As long as a portion of people know , and act by the marginal principle, the prices
will change
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