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AS Markets & Market Systems

Scarcity and Choice in Resource Allocation

In this chapter we consider the nature of economics and the choices that all economic agents, be they consumers, businesses and different levels of government must make every day.

What is Economics?

The Economist's Dictionary of Economics defines economics as

"The study of the production, distribution and consumption of wealth in human society"

Another definition of the subject comes from the economist Lionel Robbins, who said in 1935 that

"Economics is a social science that studies human behaviour as a relationship between ends and scarce means which have alternative uses. That is, economics is the study of the trade-offs involved when choosing between alternate sets of decisions."

The purpose of economic activity

It is often said that the central purpose of economic activity is the production of goods and services to satisfy consumer’s needs and wants i.e. to meet people’s need for consumption both as a means of survival but also to meet their ever-growing demand for an improved lifestyle or standard of living.

The basic economic problem is about scarcity and choice since there are only a limited amount of resources available to produce the unlimited amount of goods and services we desire.

All societies face the problem of having to decide:

• What goods and services to produce: Does the economy uses its resources to operate more hospitals or hotels? Do we make iPod Nanos or produce more coffee? Does the National Health Service provide free IVF treatment for thousands of childless couples? Or, do we choose instead to allocate millions of pounds each year to providing beta-interferon to sufferers of multiple sclerosis?
• How best to produce goods and services: What is the best use of our scarce resources of land labour and capital? Should school playing fields be sold off to provide more land for affordable housing? Or are we contributing to the problem of obesity by selling off these playing fields?
• Who is to receive goods and services: What is the best method of distributing products to ensure the highest level of wants and needs are met? 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

If something is scarce - it will have a market value.

If the supply of a good or service is low, the market price will rise, providing there is sufficient demand from consumers. Goods and services that are in plentiful supply will have a lower market value because supply can easily meet the demand from consumers. Whenever there is excess supply in a market, we expect to see prices falling. For example, the prices of new cars in the UK have been falling for several years and there have been huge falls in the prices of clothing as supply from countries such as China and Vietnam has surged.

Insatiable human wants and needs

The Swedish furniture giant IKEA sells to millions of consumers throughout the world

Human beings want better food; housing; transport, education and health services. They demand the latest digital technology, more meals out at restaurants, more frequent overseas travel, more leisure time, better cars, cheaper food and a wider range of cosmetic health care treatments.

Opinion polls consistently show that the majority of the electorate expect government policies to deliver improvements in the standard of education, the National Health Service and our transport system. (Whether voters are really prepared to pay for these services through higher taxes is of course another question!)

Economic resources are limited, but human needs and wants are infinite. Indeed the development of society can be described as the uncovering of new wants and needs - which producers attempt to supply by using the available factors of production. For a perspective on the achievements of countries in meeting people’s basic needs, the Human Development Index produced annually by the United Nations is worth reading. Data for each country can be accessed and cross-country comparisons can be made.

Making choices

Because of scarcity, choices have to be made on a daily basis by all consumers, firms and governments. For a moment, just have a think about the hundreds of millions of decisions that are made by people in your own country every single day.

Take for example the choices that people make in the city of London about how to get to work. Over six million people travel into London each day, they have to make choices about when to travel, whether to use the bus, the tube, to walk or cycle – or indeed whether to work from home. Millions of decisions are being taken, many of them are habitual (we choose the same path each time) – but somehow on most days, people get to work on time and they get home too! This is a remarkable achievement, and for it to happen, our economy must provide the resources and the options for it to happen.

Trade-offs when making choices

Making a choice made normally involves a trade-off - in simple terms, choosing more of one thing means giving up something else in exchange. Because wants are unlimited but resources are finite, choice is an unavoidable issue in economics. For example:

1. Housing: Choices about whether to rent or buy a home – a huge decision to make and one full of uncertainty given the recent volatility in the British housing market! There are costs and benefits to renting a property or choosing to buy a home with a mortgage. Both decisions involve a degree of risk.

2. Working: Choosing between full-time or part-time work, or to take a course in higher education lasting three years – how have these choices and commitments been affected by the introduction of university tuition fees?

3. Transport and travel: The choice between using Euro-Tunnel, a speedy low-cost ferry or an airline when travelling to Western Europe. Your choices about which modes of transport to use to get to and from work or school each day.

Consumer welfare and rationality

What makes people happy? Why despite several decades of rising living standards do surveys of happiness suggest that people are not noticeably happier than previous generations? When we study the decisions of consumers in different markets, we can start to consider and explore what their aims are. Our working assumption for the moment is that consumers make choices about what to consume based on the aim of maximising their own welfare. They have a limited income (i.e. a limited budget) and they seek to allocate their funds in a way that improves their standard of living.

Of course in reality consumers rarely behave in a perfectly informed and rational way. We will see later that often decisions by people are based on imperfect or incomplete information which can lead to a loss of satisfaction and welfare not only for people themselves but which affect other and our society as a whole. As consumers we have all made poor choices about which products to buy. Do we always learn from our mistakes? To what extent are our individual choices influenced and distorted by the effects of persuasive advertising? Multinational companies have advertising and marketing budgets that often run into hundreds of millions of pounds. We are all influenced by them to a lesser or greater degree and there is always the risk that advertising can be misleading.

Economic Systems

An economic system is best described as a network of organisations used by a society to resolve the basic problem of what, how and for whom to produce. 

There are four categories of economic system.

• Traditional economy: Where decisions about what, how and for whom to produce are based on custom and tradition. Land is typically held in common ie private property is not well defined.
• Free market economy: Where households own resources and free markets allocate resources through the workings of the price mechanism.  An increase in demand raises price and encourages firms to switch additional resources into the production of that good or service.  The amount of products consumed by households depends on their income and household income depends on the market value of an individual’s work. In a free market economy there is a limited role for the government. Indeed in a highly free market system, the government limits itself to protecting the property rights of people and businesses using the legal system, and it also seeks to protect the value of money or the value of a currency.
• Planned or command economy:  In a planned or command system typically associated with a socialist or communist economic system, scarce resources are owned by the state (i.e. the government). The state allocates resources, and sets production targets and growth rates according to its own view of people's wants.  The final income and wealth distribution is decided by the state. In such a system, market prices play little or no part in informing resource allocation decisions and queuing rations scarce goods.
• Mixed economy: In a mixed economy, some resources are owned by the public sector (government) and some resources are owned by the private sector. The public sector typically supplies public, quasi-public and merit goods and intervenes in markets to correct perceived market failure. We will come back to all of these concepts later on in our study of microeconomics.

Opportunity Cost

There is a well known saying in economics that “there is no such thing as a free lunch!” Even if we are not asked to pay a price for consuming a good or a service, scarce resources are used up in the production of it and there must be an opportunity cost involved.

Opportunity cost measures the cost of any choice in terms of the next best alternative foregone. Many examples exist for individuals, firms and the government.
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 choose to take a day off from work you might lose £48 from having sacrificed eight hours of paid work.
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 new capital goods is the current production of consumer goods given up. We may have to accept lower living standards now, to accumulate increased capital equipment so that long run living standards can improve.
Making use of scarce farming land: The opportunity cost of using arable farmland to produce wheat is that the land cannot be used in that production period to harvest potatoes.

Sectors of production in the economy

• Primary sector: This involves extraction of natural resources e.g. agriculture, forestry, fishing, quarrying, and mining

• Secondary sector: This involves the production of goods in the economy, i.e. transforming materials produced by the primary sector e.g. manufacturing and the construction industry

• Tertiary sector: the tertiary sector provided services such as banking, finance, insurance, retail, education and travel and tourism
• Quaternary sector: The quaternary sector is involved with information processing e.g. education, research and development

Manufacturing industry in the United Kingdom only accounts for 18 per cent of national output. The bulk of our income and employment comes from the service sector.