Factors of production, Scarcity, Choice and Opportunity Cost

Needs and wants

Needs are basic essentials for survival. They are limited by nature. E.g. food, clothing, shelter
and air for survival.

Wants are desires of man, not essential for survival. They are unlimited. Always growing and
changing as technical progress and advertising has an important influence on mans unending
desire for goods and services.

Resources are inputs used to produce goods like television, cars and to provide services like
banking, insurance and health care. Another name for resources is ‘factors of production’.

Land – all natural resources. Includes everything that grows naturally on land (forest, lakes),
beneath land (minerals), around land in the sea and ocean and above land (climate). Natural
resources are of two types;
Renewable, resources that can be reused. Can be reused as it is replaced naturally but if usage
rate is faster than the rate of creation it depletes e.g. fish stock, forest. Non- renewable, cannot
be reused. Takes centuries to be recreated e.g. minerals.
The reward for owning land is the income it generates, rent or lease payments. If land is a
resource like oil or gold owner may receive royalty.

Labour (human resources) – is the workforce of an economy. The mental and physical
capabilities of man. The basic determinant of labour is the nation’s population but not all of the
population is available for work, only those in the working age. Labour can be skilled and
unskilled. The reward is wages/salary.

Capital – man made aid to production. E.g. factories, office buildings, computers etc. Capital
goods help land and labour produce more units of output. The reward is the rate of return that is
earned. Owners of capital can earn rent or lease or a share of profit made from their use.

Enterprise – brings together land, labour and capital in order to produce a good or service. Take
risk with their own money and financial capital of others. Entrepreneur carries out two functions;
 Organise land, labour and capital to produce a good or service
 Taking risk of production.
In large organisations salaried managers organise other factors of production and shareholders
take the risk. The reward to enterprise is profit.

The role of the factor Enterprise in a modern economy

Enterprise plays a very significant role in a modern economy. Entrepreneurs are vital in
organising the other factors of production and, in doing so, take a risk. This risk arises from the
situation of uncertainty that will be associated with any initiative that they take.

Physical capital, refers to non- human assets of a company, such as plant and machinery, tools
and equipment, office supplies etc., that help in the production process.

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Human capital refers to stock of knowledge, talent, skills and abilities brought by an employee
to the organisation. Education and training helps to increase human capital.

Wants Resources
Unlimited Limited

Scarcity

Choice

Opportunity cost

In relation to the unlimited wants the resources available to produce goods and services are
limited. This results in the basic economic problem which is scarcity (shortage). Because of
scarcity choices have to be made on a daily basis by all consumers, firms and governments.
Choice is an unavoidable issue in economics.
Making a choice involves a trade- off. In simple terms, choosing more of one thing means
giving up something else in exchange. This trade -off is identified as opportunity cost.
Opportunity cost refers to the next best alternative foregone.

Examples:
1. Work leisure choices – the opportunity cost of deciding not to work an extra ten hours a week
is the lost wages foregone. If you are being paid £6/hour to work at a super market, if you choose
to take a day off from work you might lose £48 from having sacrificed 8 hrs. of paid work.

2. Govt. spending priorities – opportunity cost of govt. spending nearly £10 billion on investment
in NHS might be that £10 billion less is available for spending on education or the transport
network.

3. Investing today for consumption tomorrow – the opportunity cost of an economy investing
resources in new capital goods is the current production of consumer goods given up. We have to
accept lower standard of living now so that long run living standards can improve.

4. A firm has an option between saving money in the bank or investing in a new machine. If it
decides to purchase the machine, opportunity cost would be the bank interest it could have
earned.

Importance of opportunity cost – this concept is of great importance in the study of economics.
1. It is important in product pricing – opportunity cost explains why goods and services are
priced. Resources used to produce goods are limited in supply in relation to the unlimited wants
and they have alternative uses. If they are used in one direction, it involves a sacrifice of another.
Therefore they command a price.

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2. Factor pricing – opportunity cost is important in the determination of factor prices. E.g. wages,
rent, interest and profits.

3. Opportunity cost is applied in international trade. Comparative advantage theory suggest that
trade between countries take place only when opportunity cost of production is low.

4. It has relevance in the field of social economics too. E.g. the govt. is considering the closure of
a coal mine which faces a loss of £50,000 but this creates employment and if closed govt. has to
pay unemployment benefit costing £75000. The govt. after considering the opp. cost of closing
the mine may decide that it is cheaper to keep the mine open.

The basic economic problem of scarcity gives rise to ‘choice’. The basic questions of what and
how much to produce, how to produce and for whom to produce are the best examples for
choice. These are the basic economic problems.

1. What to produce and how much? – A problem facing people when there is scarcity is
deciding exactly what goods and services to make. This involves choosing which wants to
satisfy. Every society no matter what its size, is faced with the same choice. Once it decides on
the type of goods, they have to decide on the quantity.

2. How to produce? – Once it has been decided what goods and services to produce there is the
problem of deciding how to make them. Since resources are limited in relation to the unlimited
wants, we need to consider how to use resources so that the best outcome arises. There are many
different ways of making things, labour intensive where more labour is used than capital and
capital intensive where more capital is used than labour. E.g. when producing wheat a lot of
machinery could be used to plough land, plant seeds and to harvest crop.
Today when considering methods of production it is encouraged to consider the impact on the
environment.

3. For whom to produce? – This problem deals with the distribution of goods and services
produced. Because of scarcity not every individuals wants can be satisfied. Therefore it must be
decided who gets the goods and services that have been made.

The economic problem arise only with economic goods. These are goods that are limited in
supply, involves production cost and opportunity cost. The opposite of economic goods is
free goods.

Specialisation and exchange

Specialisation occurs when an individual, a firm, a region or a nation concentrates on producing
some goods and services rather than others. As specialisation allows individuals, firms or nations
to concentrate on what they are best at, more goods and services will be produced. Specialisation
has led to exchange or trade of goods and services. Regions and nations that specialise in goods

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produce in surplus and exchange with the surplus of others. This helps to raise world living
standards.

However there are dangers too. With the pace of technological change in modern society, there is
always the possibility the specialist skills and experience that any individual has acquired may
become redundant as the economy develops. Therefore one needs to be flexible and multi skilled
and be able to move between occupations. Changes in consumer wants mean the goods and
services produced by a region or country are no longer required in the same quantity. This will
result in unemployment.

Division of labour
It is when the production process is broken down into several tasks and each task is performed
by an individual or group of individuals. Generally used in mass scale production.

Advantages
1. Abilities and interest of people differ, by creating a large number of jobs division of
labour makes it possible for people to find jobs that suit their abilities and interest.

2. People become skilled in their job as practice makes a person perfect.

3. Work can be done with speed thus increase the level of production.
4. When a person becomes an expert trial and error reduces thus reducing wastage.
5. Time is saved – when a person is performing several tasks time would be wasted
switching from one job to another.
6. When an individual is responsible for many tasks, will require different tools and
they won’t be used all the time but when an individual performs a specific job he
will only require one set of tools and will be used all the time.
7. Makes it easy to mechanise the production process (devise a machine for each
process).
8. Once work is completed workers are free.

Disadvantages
1. Production process will come to a halt if a group of people in one section stop work. E.g.
strike
2. Creates boredom as the job becomes monotonous.
3. Workers may be exposed to job related sicknesses.
4. Workers may feel alienated, they feel unimportant as they perform only an insignificant part in
the whole process.
5. Might be difficult to find another job as their skills are limited.

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Economic systems
An economic system is a complex network of individuals, organisations and institutions and their
social and legal interrelationships. The function of an economic system is to resolve the basic
economic problem.
There are three types of economic systems, free, command and mixed economy. Free economy
and command economy in its purest form exist only in theory.

Free economy (market economy / capitalist)

 Resources are owned by individuals (pvt. sector).
 Decisions are made by individual sellers and buyers who can generally be expected to act in
their own self-interest.
 The producers’ main aim is to maximise their profit. Therefore firms will produce and sell
according to consumers demand.
 Allocation of resources is determined by the market forces of demand and supply (price
determined through demand and supply price mechanism).
 There is no, or certainly very little state or govt. intervention.
 There is freedom of choice, producers are free to decide on what they are going to produce
and consumers are free to buy what they want in order to maximise satisfaction (consumer
sovereignty).
 There is competition among consumers and firms.

In the USA government plays an important role in the economy, proving that market economy is
an ideal which does not exist in today’s globalised economy.

How free economy solves basic economic problems

1. What and how much to produce? – produce what is demanded. Price determines profit and
because of that price acts as a signal for what is to be produced. If firms are earning insufficient
profit or incurring losses it must be a signal that consumers wish to see a fall in production in
that industry. Consumers are the king, therefore firms produce more of high priced goods (goods
in high demand) and less of low priced goods (goods demanded less).

2. How to produce? – Consumers will buy from producers that offer the lowest price, so
producers must produce at a lower cost if they are to survive. Firms will adopt the lowest cost
technique of production. Therefore free market results in productive efficiency. If labour is
cheaper than capital labour intensive methods of production will be used, if capital is
comparatively cheaper capital intensive methods will be used.

3. For whom to produce? – The amount of money consumers can spend depends on their wealth
and income. In a free economy this is determined by ownership of factors of production. More
resources means more income those with high income can acquire a large no. of goods and
services and those with low income can acquire less. Therefore in a free economy there is
inequality in the distribution of goods and services.

Wealth is a stock of assets held at a given time – e.g. land jewellery, house etc.

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Income is a flow of money received over a period of time. – E.g. salaries and wages, rent
income, dividends etc.

Role of government in a free economy

1. Some goods are not adequately provided by the private sector, therefore the shortfall is
provided by the state. E.g. merit goods.

2. Some goods are not provided by the market mechanism. These goods are identified as public
goods. E.g. defence, street lights. They are not provided by the private sector due to free rider
problem.

3. Government is responsible for the issue of money and for maintaining its value.

4. Introduce rules and regulations.

5. Firms or trade unions may seek to gain control over individual markets. Government therefore
have to intervene and breakup monopolies and prevent practices that restrict free trade and
control activities of trade union.

Advantages of free economy

1. There is freedom of choice for producers and consumers.

2. Consumers have a variety of goods and services to choose from.
3. The system encourages competition between firms. This compels firms to be efficient as less
efficient firms will be driven out.
4. Successful firms can earn higher profits, this gives them the incentive to search for new
products and for new and better techniques of production.
5. Consumer is the king.

Disadvantages

1. Inequality in the distribution of income and goods and services.

2. Competition drives out less successful firms. This will lead to a small no. of large firms
remaining in the market. These firms would have great market power and may charge prices well
above cost.
3. Free market may fail to provide certain goods and services that cannot be charged. E.g. public
goods.
4. Free market may encourage consumption of harmful goods. These goods may be provided if it
is profitable.
5. Externalities – social effects of production may be ignored. E.g. pollution.

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Command economy (planned economy/ socialist)
 The state or government will own all, or certainly most of the economic resources.
 Economic decisions are primarily made by the state or government through some form
of Central Planning Agency, rather than through the operation of market forces.
 Prices are generally determined by the state rather than the price mechanism.
 The key aim of production is the maximisation of social welfare rather than profit.
 No freedom of choice.

From a practical point of view it is difficult for all enterprises to be state owned. There should be
opportunity for private ownership in areas such as shops, restaurants, personal services like
hairdressing and cleaning. On more substantial businesses ownership is on a shared basis
between government and private sector. E.g. foreign investors with govt.

How command economy solves the basic economic problems

1. What and how much to produce? – Is decided by the central planning committee on behalf of
the government. Production is carried out according to a national plan, which sets production
targets to different industries.

2. How to produce? – In the production plan the method of production is decided. State will
direct labour into jobs. Since profit is not the objective finding production methods that is of a
lower cost is not important.

3. For whom to produce? – Is not solved according to purchasing power. In a command economy
planners limit prices, so they are within the range of all consumers but low prices results in
excess demand. This is solved through rationing or queuing. Education and health are provided
free. For housing payment has to be made but there is no free market, houses are allocated by the
state.

Advantages

1. Less inequality in the distribution of income and goods and services.

2. Unemployment is relatively low.
3. No exploitation of consumers.

Disadvantages

1. Limited choice. There are no varieties of the same product in the market. As consumers they
will have little say about what is provided by the state particularly in the case of education.
2. Shortage of goods lead to rationing and queuing.
3. Firms may be inefficient as there are no incentive schemes (no competition).
4. Workers might not put much effort in their job as they are unlikely to lose their job.
5. Goods may often be of low quality as firms and workers are not provided incentives.

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Mixed economy

In a mixed economy both the private sector and the state are involved in taking economic
decisions.
Mixed economy is where the balance between allocation of resources by price mechanism and
allocation of resources by planning process is much more equal. Mixed economy will maximise
the advantages of both market and planned economies and minimize the disadvantages.
The best example for a mixed economy in the mid 1970 was UK but over the years the strength
of the public sector in UK has been reduced due to privatisation.

 Ownership of the economy’s resources is divided between the public sector and the
private sector.
 The private sector will be influenced by self interest, with producers aiming to maximise
profits and consumers aiming to maximise their welfare, whereas the public sector will
have broader, community aims relating to the public interest.
 There will be competition within the private sector, whereas the public sector will
intervene through measures such as taxation and regulation. Market failure is corrected
through government intervention.
 The allocation of resources in the private sector will be determined through the price
mechanism, whereas in the public sector decisions will be taken by the government, with
prices either free at the point of use or in the form of certain charges.

How mixed economy solves basic economic problems

1. What and how much to produce? – Solved by both parties. Private sector will solve the
problem based on price. In this sector consumers are offered a choice of goods and services.
In the public sector the state decides what to produce through the planning process.

2. How to produce? – Private firms will select a method where cost of production is low. In the
public sector method of production will be decided through the planning process.

3. For whom to produce? – Goods produced by the private sector will be distributed according to
purchasing power. Goods which are not adequately provided by the private sector will be
provided by the government (merit goods) government also provides public goods.