need to make choices at all levels (individuals, firms, governments)

Scarcity, Choice and Opportunity Cost

Learning Objective

Explain why individuals, firms and governments must make choices because resources are scarce, and calculate and interpret opportunity cost in a range of economic contexts.

Key Concepts

• Scarcity: Resources (land, labour, capital, entrepreneurship, time, money) are limited while human wants are unlimited.
• Choice: Selecting one alternative over another when resources are insufficient to satisfy all wants.
• Opportunity Cost: The value of the best (next‑best) foregone alternative when a decision is made.
• Marginal: The additional benefit or cost arising from a small (usually one‑unit) change in activity.
• Efficiency (Pareto): An allocation where it is impossible to make anyone better off without making someone else worse off.

1.1 The Fundamental Economic Problem

Because of scarcity, every economy must answer three basic allocation questions:

1. What goods and services should be produced?
2. How should they be produced (technique, factor combination)?
3. For whom are they produced (distribution of output)?

These questions apply to households, firms and governments and form the framework for all economic decisions.

1.2 Economic Methodology (Box)

1.3 Factors of Production

Human capital (skills, education) and physical capital (machinery) are distinguished, and the division of labour allows each factor to be used more productively.

1.4 Resource Allocation in Different Economic Systems

1.5 Production Possibility Frontier (PPF)

The PPF shows the maximum feasible combinations of two goods given current resources and technology.

• Marginal Opportunity Cost (MOC): The slope of the PPF at a particular point.
• Formula:  MOC of Good X = –ΔY/ΔX (the amount of Good Y that must be given up to produce one more unit of Good X).
• An outward‑bowed (concave) PPF indicates increasing marginal opportunity cost because resources are not perfectly adaptable.

1.6 Efficiency and Equity

• Allocative efficiency: Production at a point on the PPF where marginal benefit equals marginal cost; the mix of goods reflects consumer preferences.
• Productive efficiency: Operating on the PPF (no resources wasted).
• Equity (fair distribution): Concerned with how the total output is shared among members of society. Different systems achieve equity in different ways (e.g., progressive taxation, universal services).
• Evaluating policies often requires a trade‑off between efficiency and equity (AO3 evaluation).

2. Why Choices Are Required at All Levels

1. Individuals (households)
   • What: How much of limited income to spend on food versus clothing.
   • How: Cook at home (time‑intensive) or buy ready‑made meals (more expensive).
   • For whom: Allocate leisure time between paid work and unpaid activities such as caring for children.
2. Firms
   • What: Product mix – e.g., high‑end smartphones versus budget models.
   • How: Choose automated assembly line versus manual assembly.
   • For whom: Target market – domestic consumers only, or also export markets.
3. Governments
   • What: Allocation of the national budget between health care and defence.
   • How: Financing via taxes, borrowing or cutting other programmes.
   • For whom: Distribution of benefits – universal health coverage versus means‑tested programmes.

3. Opportunity Cost – Formal Definition

Opportunity Cost = Benefit of the Best Foregone Alternative

If a net‑benefit comparison is required, the formula can be expressed as:

Note: The simple definition does **not** subtract the benefit of the chosen option; it merely states the value of what is given up.

4. Illustrative Examples

4.1 Individual Decision

Maria has £250. She can either:

• Buy a concert ticket for £180 (provides 9 “happiness units”).
• Buy a textbook for £120 (raises her exam score by 6 marks; each mark valued at 1 “happiness unit”).

If she chooses the concert, the opportunity cost is the 6‑mark improvement (or 6 happiness units) she forgoes from the textbook.

4.2 Firm Decision

A bakery has one oven that can be used for either 100 loaves of bread or 60 pastries per day.

If the bakery produces bread, the opportunity cost is the £180 profit it could have earned from pastries.

4.3 Government Decision

A city council has a £5 million budget. It can:

• Build a new park (£3 million).
• Upgrade a secondary school (£4 million).

Choosing the park means the opportunity cost is the additional educational benefits (e.g., higher exam results, lower dropout rates) that the upgraded school would have delivered.

5. Applying Opportunity Cost to Decision‑Making

1. List all realistic alternatives.
2. Quantify the benefits (or net benefits) of each alternative.
3. Identify the next‑best (highest‑valued) alternative that will be forgone.
4. Calculate the opportunity cost using the definition above.
5. Compare the opportunity cost with the net benefit of the chosen option to assess whether the decision is efficient.

6. Common Pitfalls

• Treating explicit monetary cost as the whole opportunity cost – non‑monetary benefits (e.g., leisure, knowledge) must be considered.
• Using the worst alternative as the benchmark instead of the next‑best.
• Assuming opportunity cost is constant; in reality it often rises because resources are not perfectly adaptable.
• Neglecting the ceteris paribus condition – other factors may be changing simultaneously, obscuring the true cost.

7. Practice Questions

1. John can work overtime for £12 per hour or study for an exam. One hour of study raises his exam score by 3 marks; the exam contributes 25 % to his final grade. Calculate the opportunity cost of working one overtime hour in terms of exam marks.
2. A country can produce either 5 000 cars or 20 000 computers. If it decides to produce 3 000 cars, how many computers must be given up? What is the marginal opportunity cost of each car in terms of computers?
3. Explain why governments use cost‑benefit analysis to ensure that opportunity cost is taken into account when choosing between competing public‑policy projects.
4. Using a PPF diagram, illustrate why the marginal opportunity cost of producing more of Good X increases as production moves away from the axis of Good Y.

8. Summary

Scarcity forces every economic agent to make choices. The concept of opportunity cost provides a systematic way to evaluate those choices by measuring the value of the best foregone alternative. Understanding the three allocation questions, the role of the factors of production, the characteristics of different economic systems, the shape of the PPF, and the trade‑off between efficiency and equity equips students to analyse decisions at the individual, firm and government levels and to assess economic efficiency.