Learning objectives
Explain the basic economic problem of finite resources and unlimited wants, with examples for consumers, workers, firms and governments, and distinguish economic goods from free goods
State the three resource allocation questions — what to produce, how to produce and for whom to produce — and explain why scarcity forces every economy to answer them
Define land, labour, capital and enterprise, give examples of each and identify the reward each earns
Explain the causes of changes in the quantity and quality of factors of production
Define opportunity cost as the next best alternative forgone and explain why scarcity creates it
Apply opportunity cost to decisions made by consumers, workers, producers and governments
Key definitions
Scarcity
The basic economic problem: wants are unlimited but the resources available to satisfy them are finite.
Economic good
A good that uses scarce resources to produce, so it has an opportunity cost and normally a price.
Free good
A good, such as sunlight or air, that is so abundant that using it has no opportunity cost.
Opportunity cost
The benefit of the next best alternative forgone when a choice is made.
Resource allocation
The way an economy decides which goods and services its scarce resources are used to produce, how they are produced and who receives them.
Factors of production
The resources used to produce goods and services: land, labour, capital and enterprise.
Explanation
Every person, firm and government faces the same problem: wants are unlimited, but the land, workers, machines and time available to satisfy them are finite. This is scarcity, and it forces choice. Because a resource used for one purpose cannot be used for another, every choice carries a cost. Goods made with scarce resources are economic goods: a loaf of bread uses flour, energy and labour that could have made something else, so it has an opportunity cost and a price. A free good is so abundant that consuming it forgoes nothing — sunlight, air, seawater at the beach. Be careful: a product given away at zero price is not a free good if resources were used to make it. State schooling has no fee at the point of use, but it costs taxpayers billions, so it is an economic good. The test is scarcity, not price.
The basic economic problem is the same for every decision-maker; only the resource that runs out is different. A consumer has a limited income and limited time but wants food, housing, clothes, travel and entertainment, so a family that pays for a holiday may have to keep its old car for another year. A worker has only so many hours in a week and one set of skills: an hour spent at work cannot also be spent resting or studying. A firm has a limited budget, a limited number of staff and machines and limited space, so a factory already working at full capacity cannot accept every order or launch every new product. A government collects a limited amount of tax revenue but is asked for more hospitals, schools, roads, pensions and defence than that revenue can pay for. To give an example of the basic economic problem in an exam, name the decision-maker, the resource that is limited and the wants that compete for it.
Because of scarcity an economy cannot produce everything its people want, so its resources have to be allocated — shared out between competing uses. Every economy, rich or poor, must therefore answer three resource allocation questions. What to produce? Which goods and services, and how much of each: more housing or more farmland, more buses or more cars. How to produce? Which resources and methods to use: many workers with simple tools or a few workers with machines, coal or solar power. For whom to produce? Who receives the output: those able to pay the most, those in greatest need or everyone equally. The questions never go away, because wants grow as fast as output does. What differs between countries is who answers them: buyers and sellers through prices in a market economic system, and the government for part of the output in a mixed economic system. The notes on markets and on government intervention explain both.
Resources are grouped into four factors of production. Land is every natural resource: fields, forests, minerals, fish, rivers and the site a shop stands on; its reward is rent. Labour is the physical and mental effort of workers; its reward is wages. Capital is human-made goods used to produce other goods — machines, factories, vans, computers and roads; its reward is interest. Enterprise is the entrepreneur who organises the other three factors, takes the decisions and bears the risk of loss; the reward is profit. A bakery combines a rented site (land), bakers (labour), ovens (capital) and an owner who risked her savings (enterprise). Money is not capital in economics: it is used to buy capital goods, but it does not itself produce anything.
Factors of production are not fixed: both their quantity and their quality change over time. The quantity of a factor changes when new mineral deposits are found or land is reclaimed from the sea, when a higher birth rate, net immigration or a later retirement age enlarges the workforce, when firms invest in new machinery, or when lower taxes encourage more people to start businesses. Quality rises with irrigation and fertilisers, with education, training and better health for workers, and with more advanced technology built into capital.
Because resources are scarce, choosing one use means giving up another. Opportunity cost is the benefit of the next best alternative forgone — not every alternative, and not the money spent. A consumer with $20 who buys a book forgoes the cinema ticket she would otherwise have chosen. A worker who takes a job with shorter hours gives up the higher pay of a longer-hours job, and a worker who takes an evening off forgoes the wage. A producer that spends its profit on a new delivery van forgoes the advertising campaign it could have run, and a farmer who plants maize forgoes the rice the same field could have grown. A government that builds a new hospital forgoes a school, a road or a tax cut. Good decisions compare the benefit of a choice with its opportunity cost.
Formulae
Opportunity cost of one unit of A = units of B given up ÷ units of A gained
Worked examples
q: A farmer can use his land to produce either 300 tonnes of wheat or 120 tonnes of coffee. Calculate the opportunity cost of one tonne of coffee and explain why the farmer faces this cost.
steps: Producing only coffee means giving up all 300 tonnes of wheat.
Opportunity cost per tonne of coffee = 300 ÷ 120 = 2.5 tonnes of wheat.
The cost arises because the land is scarce: it cannot grow both crops at once, so choosing coffee forgoes the next best use, which is wheat.
In context
When a government hosts a major sporting event, the true cost is not the money bill but the hospitals, schools or debt repayments the same money could have funded.
Rainwater in a wet region is close to a free good, but fresh water in a desert city is an economic good, because desalination plants use scarce capital and energy to produce it.
Common misconceptions
Thinking a free good is anything with no price tag. State schooling has no fee, but it uses teachers and buildings, so it is an economic good.
Treating money as capital. Capital means human-made goods used in production; money only buys them.
Adding up every alternative given up. Opportunity cost is the single next best alternative.
Thinking scarcity only affects poor people and poor countries. Rich ones face it too: their resources are also finite while their wants keep growing, so they still have to choose.
Study tips
When asked for a factor of production, give the factor, an example and its reward in one sentence: "land, such as a farm, earns rent."
For opportunity cost questions, name the specific alternative forgone rather than writing "other goods".
For an example of the basic economic problem, name the decision-maker, the resource that is limited and the wants competing for it, then say what has to be given up.
Evaluate the idea
The opportunity cost of the same decision differs between people and countries: a low-income country that builds an airport may forgo basic healthcare, while a rich one forgoes far less.
A choice may have almost no opportunity cost if the resources had no alternative use, such as unemployed workers or idle land.
Reasoning
Unlimited wants + finite resources → scarcity → choices must be made → every choice has an opportunity cost → resources should go to their most valued use
Summary
Scarcity: finite resources cannot satisfy unlimited wants, so choice is unavoidable.
Scarcity forces three allocation questions on every economy: what to produce, how to produce it and for whom.
Land earns rent, labour earns wages, capital earns interest and enterprise earns profit.
Factor quantity and quality change through discovery, migration, investment, education and technology.
Opportunity cost is the next best alternative forgone; consumers, workers, producers and governments all face it.
Check your understanding
Question 1: Which factor of production earns interest?
1. Enterprise
2. Land
3. Capital
Question 2: A student has one free evening and ranks revision first, a paid shift second and a film third. The opportunity cost of revising is…
1. the paid shift
2. the film and the shift together
3. the price of the revision guide
Question 3: A bakery replaces hand-kneading with a dough-mixing machine. Which resource allocation question has it answered?
1. What to produce
2. For whom to produce
3. How to produce