« Chapter 1 Contents Chapter 3 »

2. The Two Reasons Economics Come to Be: Scarce Resources & Unlimited Wantsto table of contents

Economics examines how people use their scarce resources in an attempt to satisfy their unlimited wants. Would you like a grand new Porsche, a sea shore villa or a luxury ocean journey aboard the Luxury Liner Hawaii? Would you like more free time, more sleeping time and more money to spend? Who wouldn't? The problem is simply that the resources available to satisfy these wants, or desires, are virtually limited. They are scarce. Economic choices arise from scarcity. If it were not scarcity, we would never bother to study economics, making choices in between, constructing economic structures and market mechanisms to produce and distribute; and trying to maintain them work smoothly and efficiently.

2.1. Resources & Goods and Servicesto table of contents

Resources are the inputs, or factors of production, used to produce the goods and services that human wants. Resources scarcity causes goods and services scarcity. Generally, we put resources into 3 categories: labor, capital, land. Labor is the broad category of human effort, both physical and mental included. Capital ranges from factories, machines, tools, airports and highways to human knowledge and skill, that are used to, or facilitates further production of goods and services, complementing labor. Distinguish between human effort and human capital. Human effort is the process of allocating time, transforming your skills, that is the human capital to tangible results, that is the goods or services directly consumed. Land refers not only to land in the conventional sense of tracts of ground, but all other natural resources, that is, gifts of nature, including bodies of water, oil reserves, minerals and even animals.

To use resources, wages are paid to labor, interest to capital, and rent to land.

Goods and services are produced when a variety of resources are combined in a specific way. A good is something we can see and touch, like a hamburger, whereas a service is something intangible albeit we might as well consume it and pay for it, like a concert. Since goods and services are combinations of scarce resources, they themselves are scarce. "There is no such thing as a free lunch." Because we have to continually choose among the goods and services, given that we cannot have all those we want. We are giving up one thing upon choosing another. Sometimes certain goods are mistakenly thought of as free in that they involve no apparent cost to access. Imagine that you receive free subscription cards falling out of magazines, and you get an additional season of copies. Producing the cards and offering the free copies, however, absorbs scarce resources that are drawn away from competing uses, such as promoting the quality of the magazine.

2.2. The Three Basic Questionsto table of contents

Due to scarcity, all societies or economies must answer three basic questions:

  1. What will be produced?
  2. How will it be produced?
  3. Who will get what is produced?

That is, a economic system must decide the allocation of inputs(resources) among producers, the mix of output, and the distribution of output, no matter the scale of the economy and level of development.

The Economic Problem
The Economic Problem

All societies are endowed by nature and by previous generations with scarce resources. Every society must decide how to use these inputs to satisfy human wants. Specifically, resources must be divided up among producers who transform them into goods and services that in turn must be allocated among households or members of society.

2.3. Specialization & Comparative Advantageto table of contents

Suppose a weekend afternoon, the neighbor pays a total of 20 dollars for you and your friend Sam to mow the lawn and trim the bushes in his garden. You are skillful at trimming and take 1 hour to finish the given task compared to Sam's 1.5 hours, while Sam is more competent for the mowing job in that he can finish it in 2 hours compared to your 3 hours. Undoubtedly, you both want to finish the job as quickly as possible to get the money and hopefully will still have some leisure time. But how will the tasks be divided between you two? In this case, it is quite obvious from common sense. Yes, you trim and Sam mows.

Working separately
  Mowing(hour) Trimming(hour)
You 3 1
Sam 2 1.5

Nevertheless, common sense does not always stand its position. Since you have done the work together, each of you would receive less than the payment you would have received when you do it separately. Is it really that you both benefit from it? If so, how much more do you earn by the means of specialization? Let's now solve the problem that once made Adam Smith scratches his head(just kidding :)). Before we continue, a small notion of leisure hour is assumed that a leisure hour is an hour of leisure time for a single person. So, every hour you or Sam spend on working in the garden has a opportunity cost of a leisure hour, because you both value your time for leisure, but if you want to get paid, you have to give up some of them. In addition, your reward will be divided up based on the time each of you devotes into the work.

Separately, you would have to sacrifice 4 leisure hours to get the 20 dollars, thus 5 dollars compensation for each leisure hour forgone; Sam would have to give up 3.5 leisure hours to get the 20 dollars, thus 5.71 dollars compensation for each leisure hour let go. However, when you two work jointly, employing the scheme that you trim while Sam mows, it would only take you a total of 3.2 leisure hours(that is 1.6 physical hours, because you both keep working until everything is done)to complete the whole job. Why? Because you both set to work at the same time, after an hour, that is when you are finished, Sam's mowing job still have half way to go, so you join him. At your joint effort, the remainder half is done in 0.6 hours, because

where W stands for the total amount of mowing work, and 1/3 is your efficiency while 1/2 is Sam's.

Finally we have, the compensation or payment for each leisure hour sacrificed when you and Sam worked together is 20/3.2=6.25 dollars, higher than both the hourly payment you receive when working solely. Plus, instead of giving up 4 or 3.5 hours of leisure time, you each had only 1.6 hours of leisure subtracted from that weekend afternoon. Although you earn only 10 dollars each, but you could easily earn the other 10 by working an extra 1.6 hours together and still have surplus leisure time.

Very clear now, that specialization does make you better off. A somewhat astonishing fact is that, you and Sam would be far better off if you have not helped him with the remainder half mowing work. Why? See if you can find the answer by yourself.

The idea that members of society benefit by specializing in what they do best has a long history  and is one of the most important and powerful ideas in all of economics. According to the theory of comparative advantage, specialization and free trade will benefit all trading parties, even when some are "absolutely" more efficient producers than others. If you were the absolutely more efficient producer, your efficiencies in both mowing and trimming are higher than those of Sam. In this case, suppose you are able to mow the lawn within 1.5 hours, according to the theory of comparative advantage, you and Sam can still benefit from specialization. The reason is beyond our discussion, though, if you are eager to know, search comparative advantage with Google.

2.4. The Production Possibility Frontierto table of contents

Production possibility frontier, or PPF, is a simple graphical device used to illustrates the constrained choice and scarcity, showing all the possible combinations of goods and services that can be produced if all resources of the society are used efficiently. Below is a PPF for a hypothetical economy.

Production Possibility Frontier
Production Possibility Frontier

Due to resources scarcity, the more capital goods are produced, the fewer consumer goods can be produced, and vice versa. Moving from possibility E to F, ΔK is the increase in the number of capital goods. To produce more capital goods, resources must be transferred from the production of consumer goods. So ΔC indicates the decrease in the number of consumer goods.

All points below and to the left of the dark green curve(the light green area) represent combinations of capital and consumption goods that are possible for the society given the resources available and existing technology. Points above and to the right of the curve such as G represent combinations that cannot be realized. Points on the production possibility frontier can be thought of as full employment and production efficiency, where resources are not going idle or wasted. If an economy ends up at the point that lies within the light green area such as D, it is suffering from unemployment and production inefficiency.

In reality, while all economies produce some of each kind of good, different economies emphasize different things, and it is usually very difficult for an economy to produce at a point on the possibility frontier. Resources misallocation and idleness such as unemployment always exist.

Production possibility frontier reveals economic growth very intuitively. As you can imagine, when an economy grows, that is, when the society acquires new resources or when society learns to produce more with existing resources, its total output increases, the PPF will expand outward, as shown below:

Economic Growth on PPF
Economic Growth on PPF

In addition to economic growth, PPF also illustrates several other key concepts that govern economics: scarcity, unemployment, inefficiency, opportunity cost, the law of increasing opportunity cost.

2.5. The Economic Problemto table of contents

Every society has to solve the economic problem for itself. In simple statement, economic problem is the problem that how exactly do large, complex societies answer the three basic questions presented in section 2.2., that what will be produced, how will it be produced, and in turn who will get the product. Basically, all economists are working for them, in history or contemporary, they try to give the answers. In fact there are already tons of different answers to each of them, some contradict, some complement. But economists are working still, trying to shape them better and better. They have been working for the last 300 years, and very probably they will keep working the next 300 years and more.

« Chapter 1 Contents Chapter 3 »

Of EconGuru
Back to Previous Page