There is no economics on a desert island with unlimited coconuts. Every question the subject asks exists because wants exceed the means of satisfying them, so choosing one thing means giving up another. That single fact generates the whole discipline: prices are how societies ration scarce things, markets are how they decide who gets them, and government intervention is what happens when the answer is judged unacceptable.
The basic economic problem
Unlimited human wants set against finite resources, which makes scarcity unavoidable and forces choices about what to produce, how to produce it and for whom.
Note the precision in that definition. The problem is not that resources are small; it is that they are finite while wants are not. A wealthy country faces the basic economic problem exactly as a poor one does, because however much it produces there remain things it would like and cannot have. Scarcity is therefore a permanent condition rather than a stage to be grown out of, and this is why the subject remains relevant to rich economies.
Scarcity is not shortage and examiners test the difference. A shortage is temporary and specific: demand exceeds supply at the current price, and a price rise resolves it. Scarcity is permanent and general: there will never be enough of everything to satisfy all wants at zero price. Defining scarcity as 'not enough of something' loses the mark.
Every society must answer three questions, and the way it answers them defines its economic system. What to produce, since resources used for one thing cannot be used for another. How to produce it, meaning which combination of labour and capital to use. And for whom, which is the distribution question and determines who actually receives the output. A market economy answers all three through prices; a planned economy answers them through government decision; a mixed economy uses both.
Resources are grouped into four factors of production, each with its own reward. Land covers all natural resources, including the soil, minerals, forests and fisheries, and earns rent. Labour is human effort, both physical and mental, and earns wages. Capital is goods used to produce other goods, meaning machinery, buildings, tools and infrastructure rather than money, and earns interest. Enterprise is the willingness to organise the other three and bear the risk of doing so, and earns profit. Capital is the one students most often get wrong: money is not capital, because money produces nothing by itself.
Opportunity cost
The value of the next best alternative forgone when a choice is made.
The words 'next best' carry the mark. Opportunity cost is not everything you gave up, it is the single most valuable thing you gave up. A student choosing to study economics gives up history, art and sleep, but the opportunity cost is whichever one of those they would otherwise have chosen. An answer saying 'what you have to give up' is incomplete.
Identifying opportunity cost in three different decisions
State the opportunity cost in each case. (a) A government spends $50m building a hospital; its alternatives were a school worth $50m of benefit or road repairs worth $30m. (b) A worker turns down a job paying $28,000 to stay in one paying $25,000 with better conditions. (c) A firm uses a warehouse it already owns rather than renting it out for $40,000 a year.
The production possibility curve
The production possibility curve shows the maximum combinations of two goods an economy can produce with its current resources and technology, all resources fully and efficiently employed. Points on the curve are attainable and efficient. Points inside are attainable but inefficient, meaning resources are unemployed or badly used. Points outside are unattainable with current resources. Movement along the curve shows the opportunity cost of producing more of one good, measured in units of the other given up, and the whole curve shifting outwards is economic growth.
The curve is usually drawn concave to the origin, bowing outwards, and the reason is worth knowing rather than memorising. Resources are not equally suited to every use. Transferring the first workers and land from agriculture to manufacturing moves those best suited to manufacturing, so little agricultural output is lost for a large industrial gain. Continuing means transferring resources increasingly ill-suited to their new use, so each extra unit of manufacturing costs progressively more agriculture. Opportunity cost therefore rises as you move along the curve, which is exactly what a concave shape shows. If all resources were perfectly substitutable the curve would be a straight line.
Draw a PPC for consumer goods and capital goods. Mark a point on the curve, one inside and one outside, and label what each represents. Then show three separate changes on fresh copies: an outward shift from new technology, a movement from inside the curve towards it after a recovery in demand, and a pivot where only capital goods output can rise.
The pivot is worth practising because it appears less often and catches candidates out. A technological improvement affecting only one industry rotates the curve outwards along that axis while the intercept on the other axis is unchanged, since the maximum possible output of the unaffected good has not altered.
An economy is producing at a point inside its production possibility curve. This shows that:
Why is the PPC normally drawn concave to the origin rather than as a straight line?