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Central Problem of Economics, Choices and Opportunity Cost

Theme 1: Introduction of Economics

Topic: The Central Problem of Economics, Choices and Opportunity Cost

Relevance: H1 and H2 Economics

Introduction:

The first concept in understanding economics or the existence of economics would be the central problem of economics, scarcity. Without the problem of scarcity, many concepts such as decision-making and price might not exist.


Scarcity:

The central problem of economics is scarcity. While scarcity can be view in terms of the limited resources and unlimited human wants, the problem arises from these limited resources are unable to satisfy the unlimited human wants

All societies are endowed with four types of resources, also known as factors of production that are used to produce goods and services. They are land, labour, capital and entrepreneurship.

  • Land are all-natural resource.

  • Labour are all human effort, both mental and physical.

  • Capital consists of all man-made resource.

  • Entrepreneurship are the specialised type of human resources that makes the decisions and assume the risk of combining the other three factors of productions to produce goods and services.

As these resources are finite or limited, only a limited amount of goods and services can be produced which cannot satisfy the unlimited human wants of goods and services.

Therefore, as the unlimited human wants cannot be satisfied using the limited resources, society are forced to make choices.

Choices:

Some important choices that society needs to decide include what to produce; how and how much to produce; and for whom to produce the goods and services for.

  • As only a limited amount of goods and services can be produced, society needs to decide what to produce, which of the unlimited human wants to produce and satisfy.

  • After which, society needs to decide how and how much of those chosen goods or services to produce using the factors of production and technology available.

  • Once the goods and services are produced, society needs to decide how to allocate the goods and services.

As long as choices are being made, opportunity cost is incurred.

Opportunity Cost:

Opportunity cost is the value or net benefits of the next best alternative forgone when a choice is made. The idea of opportunity cost is the value or amount of the another (next best) good or service that could have been produced instead using the same resources.


If the society chooses to produce more food, the opportunity cost would be in terms of the net benefits of producing the next best alternative. For example, the same amount of resources can be used to produce food that provides society with 10 units of utility, clothing that provides society with 8 units of utility or entertainment will provide society with 4 units of utility as shown in Figure 1.

Figure 1: Rational Choice and Opportunity Cost

A rational society will choose to produce food as it provides the highest amount of utility. In this case, the opportunity cost will be 8 units of utility that could have been provided by clothing.


In the event that society chose to produce either clothing or entertainment, the opportunity cost will be 10 units of utility that could have been provided by food as it is the next best alternative.

Figure 2: Irrational Choice and Opportunity Cost

There can only be one ‘next best alternative’ as the opportunity cost as at any point of time, the same amount of resources cannot be used for different purposes.

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