Study Note - The Basic Economic Problem: Scarcity and Choice

It is often said that the central purpose of economic activity is the production of goods and services to satisfy our changing needs and wants.The basic economic problem is about scarcity and choice. Every society has to decide:What goods and services to produce: Does the economy uses its resources to operate more hospitals or hotels? Do we make more iPhones and iPads or double-espressos? Does the National Health Service provide free IVF treatment for childless couples? How best to produce goods and services: What is the best use of our scarce resources? Should school playing fields be sold off to provide more land for affordable housing? Should coal be produced in the UK or is it best imported from other countries? Who is to receive goods and services: Who will get expensive hospital treatment - and who not? Should there be a minimum wage? If so, at what level should it be set?

Scarcity

We are continually uncovering of new wants and needs which producers attempt to supply by employing factors of production. For a perspective on the achievements of countries in meeting people’s basic needs, the Human Development Index produced by the United Nations is worth reading. The economist Amartya Sen (Winner of the 1998 Nobel Prize for Economics) has written extensively on this issue.

Scarcity means we all have to make choices

Because of scarcity, choices have to be made by consumers, businesses and governments. For example, over six million people travel into London each day and they make choices about when to travel, whether to use the bus, the tube, to walk or cycle – or whether to work from home. Millions of decisions are being taken, many of them are habitual – but somehow on most days, people get to work on time and they get home too!

Trade-offs when making choices

Making a choice made normally involves a trade-off – this means that choosing more of one thing can only be achieved by giving up something else in exchange.

Housing: Choices about whether to rent or buy a home – there are costs and benefits to renting a property or in choosing to buy a home with a mortgage. Both decisions involve risk. People have to weigh up the costs and benefits of the decision.Working: Do you work full-time or part-time? Is it worth your while studying for a degree? How have these choices been affected by the introduction of university tuition fees? Transport and travel: The choice between using Euro-Tunnel, a low-cost ferry or an airline when travelling to Western Europe.

The cost benefit principle

Every purchase is a trade-off, of course. If you decide to spend $20,000 on a new car, you’re saying that’s worth more to you than 20 bicycles or four vacations to Europe or the down payment on a house. Every choice involves opportunity costs; when you choose one thing, you’re giving up others. Plus, what you’re giving up isn’t always financial.Or obvious.”

In many of these decisions, people consider the costs and benefits of their actions – economists make use of the ‘marginal’ idea, for example what are the benefits of consuming

a little extra of a product and what are the costs.

Economic theory states that rational decision-makers weigh the marginal benefit one receives from an option with its marginal cost, including the opportunity cost.

This cost benefit principle well applied will get you a long way in economics!

Consumer welfare and rationality

What makes people happy? Why despite several decades of rising living standards, surveys of happiness suggest that people are not noticeably happier than previous generations?
Typically we tend to assume that, when making decisions people aim to maximise their welfare. They have a limited income and they seek to allocate their money in a way that improves their standard of living.

Of course in reality consumers rarely behave in a well informed and rational way. Often decisions by people are based on imperfect or incomplete information which can lead to a loss of welfare not only for people themselves but which affect others and our society as a whole.

As consumers we have all made poor choices about which products to buy. Behavioural economics is an exciting strand of the subject that looks at whether we are rational in our everyday decisions. One of the best people to read on behavioural economics is Dan Ariely (pictured).

Behavioural economics

Behavioural Economics is the name given to the discipline that tries to mix insights from Psychology with Economics, and looks at economic problems through the eye of a “Human”, rather than an “Econ”. Behavioural economics uses insights from psychology to explain why people make apparently irrational decisions such as why people eat too much and do not save enough for retirement.

An Econ is said to be infinitely rational and immensely intelligent, emotionless being who can do cost-benefit analyses at will, and is never (ever) wrong. The reality is often very different. Most of us are not infinitely rational, but rather face “bounded rationality”, with people adopting rules of thumb instead of calculating optimal solutions to every decision

Nudge, a book written by US economists Cass Sunstein and Richard Thaler, in 2008, offered an accessible and influential guide to applying behavioural economics to policy problems from fighting obesity to getting people to save for retirement. In the UK, the coalition government is trying to use ideas drawn from behavioural economics to raise organ donation rates, discourage smoking, improve food hygiene and stimulate charitable giving.

Opportunity Cost

There is a well-known saying in economics that “there is no such thing as a free lunch!” This means that, even if we are not asked to pay money for something, scarce resources are used up in the production of it and there is an opportunity cost involved.

Opportunity cost measures the cost of any choice in terms of the next best alternative foregone.

• 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 per hour to work at the local supermarket, if you take a day off from work you might lose £48 of income.
• Government spending priorities: The opportunity cost of the government spending nearly £10 billion on investment in National Health Service might be that £10 billion less is available for spending on education or the transport network.
• Investing today for consumption tomorrow: The opportunity cost of an economy investing resources in capital goods is the production of consumer goods given up.
• Making use of scarce farming land: The opportunity cost of using farmland to grow wheat for bio-fuel means that there is less wheat available for food production