Decisions made by consumers, workers, producers/firms and governments when allocating their resources

Opportunity Cost and the Allocation of Resources

1. The basic economic problem

• Scarcity: the world’s resources (land, labour, capital, entrepreneurship) are limited.
• Unlimited wants: human desires for goods and services are endless.
• Because resources are scarce while wants are unlimited, every economic agent must decide:

  • What to produce
  • How to produce it
  • For whom to produce it

• These three questions lie at the heart of the Cambridge IGCSE/A‑Level syllabus (Topic 1 – The basic economic problem).

2. Economic goods versus free goods

3. Factors of production and their rewards

4. The three basic economic questions – expanded

1. What to produce? – Determining which goods and services will satisfy the most pressing wants.
2. How to produce? – Choosing the combination of labour, capital and technology that gives the lowest cost.
3. For whom to produce? – Deciding how the output will be distributed among members of society (e.g., by price, by need, by government allocation).

5. Opportunity cost

Definition: the value of the next‑best alternative that is forgone when a decision is made.

Formula (Cambridge notation):

OC = Value of next‑best alternative

Numeric example (consumer): A student has £8. She can either buy a pizza for £8 (provides utility = 90) or a sandwich for £8 (utility = 70).

Opportunity cost of the pizza = utility of the sandwich = 70 units.

Numeric example (firm): A factory can use a machine for 10 hours to make bicycles (revenue = £5 000) or scooters (revenue = £4 200).

If the machine is used for bicycles, the opportunity cost is the foregone revenue from scooters: £4 200.

6. Decision‑making by the four economic agents

6.1 Consumers

• Allocate limited income among many competing wants.
• Decision rule (marginal analysis): Buy a good when its marginal benefit exceeds its marginal opportunity cost.
• Example: Choosing a pizza over a sandwich because the extra satisfaction (90) is greater than the opportunity cost (70).

6.2 Workers (Labour)

• Allocate limited time between work, leisure, study and other activities.
• Decision rule: Choose the activity that gives the highest net benefit – work the hour if the wage earned > the value placed on the alternative use of that hour.
• Example: An hour of work pays £12, but the student values an hour of study at £15; she will study instead of working.

6.3 Producers / Firms

• Allocate scarce factors of production to different products.
• Decision rule: Produce the output where marginal revenue exceeds marginal opportunity cost (the forgone revenue from the next‑best use of the factor).
• Example: Using a machine for bicycles yields £5 000, while using it for scooters yields £4 200; the firm chooses bicycles because £5 000 > £4 200.

6.4 Government

• Allocate public resources (tax revenue, public land, public labour) among health, education, defence, infrastructure, etc.
• Decision rule: Choose the project that generates the greatest net social benefit after deducting the value of the next‑best alternative use of public funds.
• Example: Spending £1 billion on a highway gives a social benefit of £1.3 billion, whereas the same money could fund health services worth £1.5 billion; the government should favour health spending.

7. Comparative summary of the agents

8. The Production Possibility Curve (PPC)

• Purpose: Shows the maximum combinations of two goods that can be produced with existing resources and technology.
• Key features:

  • Movement along the curve: To produce more of Good X you must give up some of Good Y. The slope at any point equals the opportunity cost of X in terms of Y.
  • Points on the curve: Efficient – all resources are fully and efficiently employed.
  • Points inside the curve: Inefficient – resources are under‑utilised; the economy could increase output of both goods.
  • Points outside the curve: Unattainable with current resources; they become reachable only after economic growth or a technological advance.

9. Evaluation – why understanding opportunity cost matters

• It forces decision‑makers to consider trade‑offs rather than focusing on a single objective.
• In a market economy, prices act as signals of opportunity cost, helping consumers and firms make efficient choices.
• Governments must estimate opportunity costs without market prices, which can lead to misallocation if the estimates are inaccurate.
• Opportunity‑cost analysis underpins the marginal decision rule – a core skill tested in IGCSE/A‑Level examinations.
• Efficiency (producing on the PPC) and equity (who receives the output) are separate considerations; policies may aim to improve one at the expense of the other.

10. Key points to remember

1. Scarcity + unlimited wants = the basic economic problem.
2. Economic goods require scarce resources; free goods do not.
3. Factors of production: land (rent), labour (wages), capital (interest), entrepreneurship (profit).
4. Opportunity cost = value of the next‑best alternative; it can be expressed numerically.
5. All four agents face opportunity‑cost decisions and use the marginal decision rule.
6. The PPC visualises trade‑offs, efficiency, inefficiency and economic growth.
7. In markets, prices reveal opportunity costs; in the public sector, officials must estimate them.
8. Evaluation skills – weighing efficiency against equity, and recognising the limits of price signals – are essential for exam answers.