Chapter 3/The Fundamental Economic Problem: Scarcity and Choice
CHAPTER 3
THE FUNDAMENTAL ECONOMIC PROBLEM:
SCARCITY AND CHOICE
This chapter introduces some of the most central concepts in economics: scarcity, opportunity
cost, efficiency, division of labor, and exchange. It deals with the ways in which markets
coordinate the resolution of the three most basic economic problems: how to produce efficiently,
CHAPTER OUTLINE
SCARCITY, CHOICE, AND OPPORTUNITY COST
Because goods and services are scarce, choices must be made.
The true cost of anything that is scarce is its opportunity cost, or what is given up to
get it.
Opportunity Cost and Money Cost
The opportunity cost is sometimes equivalent to the money cost, but only when markets are
well functioning.
SCARCITY AND CHOICE FOR A SINGLE FIRM
The Production Possibilities Frontier
The slope of the production possibilities frontier shows the opportunity cost of producing
more of one good, in terms of the amount of another good given up.
The Principle of Increasing Costs
The production possibilities frontier is bowed out, to show that the true cost of a good
SCARCITY AND CHOICE FOR THE ENTIRE SOCIETY
Because resources are scarce for an entire society, choices must be made: More of one good
implies less of another.
SCARCITY AND CHOICE ELSEWHERE IN THE ECONOMY
All units in the economy—small or large, rich or poor—face the problem of choice.
Chapter 3/The Fundamental Economic Problem: Scarcity and Choice
THE CONCEPT OF EFFICIENCY
Efficiency occurs when there is no waste, when all available resources are utilized.
All points on the economy’s production possibilities frontier are efficient.
The concept of efficiency does not tell us which point on the production possibilities frontier
is best.
THE THREE COORDINATION TASKS OF ANY ECONOMY
Every society must figure out:
1. How to utilize its resources efficiently
TASK 1. HOW THE MARKET FOSTERS EFFICIENT RESOURCE
ALLOCATION
Productivity is enhanced by specialization; specialization in turn requires exchange to enjoy
the fruits of comparative advantage.
The principle of comparative advantage states that a country (or worker) should specialize in
the production of the good in which it is most efficient (least inefficient) compared to the
other country.
TASK 2. MARKET EXCHANGE AND DECIDING HOW MUCH OF EACH
GOOD TO PRODUCE
Increased production resulting from specialization means that workers will have more than
they need of a single item, which leads to exchange based on a form of money to the entire
group.
TASK 3. HOW TO DISTRIBUTE THE ECONOMY’S OUTPUTS AMONG
CONSUMERS
The market system coordinates the distribution of goods and services as suggested by
Smith’s invisible hand theory.
The market system is very effective at meeting society’s goal of efficiently producing goods
and services.
Chapter 3/The Fundamental Economic Problem: Scarcity and Choice
Markets will not necessarily meet society’s goals of keeping unemployment low, protecting
the environment, or distributing income in an equitable manner.
LAST WORD: DON’T CONFUSE ENDS WITH MEANS
Liberals and conservatives may differ in their social goals, but both will find that the market
sometimes (not always) helps to achieve those goals.
MARGIN DEFINITIONS
Resources: the instruments provided by nature or by people that are used to create goods and
services (also called inputs or factors of production).
Opportunity Cost: the forgone value of the next best alternative that is not chosen.
Optimal Decision: one that best serves the objectives of the decision maker.
Outputs: the goods and services produced by a firm or an economy.
Inputs: the labor, raw materials, electricity, and other resources used by a firm or economy to
produce its outputs.
MAJOR IDEAS
1. When goods and services are scarce, choices must be made.
2. Two countries (or two people) can gain by specializing in the activity in which each has a
comparative advantage, and then trading with one another. These gains from trade remain
available even if one country is inferior at producing everything.
3. If an exchange is voluntary, both parties must benefit, even if no additional goods are
produced.
Chapter 3/The Fundamental Economic Problem: Scarcity and Choice
ON TEACHING THE CHAPTER
The material in this chapter is basic to an understanding of economics. Instructors will have to
decide how much time to devote to it. One possibility is to cover the material in depth at this
time, while another is to go over it lightly, then return to it throughout the course as the various
issues reappear. An intermediate strategy is to devote a full class or two to opportunity cost, and
leave most of the rest of the material to later treatment.
The authors have given us ten major ideas in Chapter 1. Some instructors of the introductory
course would argue, however, that one of these stands foremost, opportunity cost, and that if
students remember nothing else from this course they should understand the economist’s concept
of cost. There are many ways to approach the teaching of opportunity cost, and an emphasis on
the production possibilities frontier (Figures 1 through 3) is helpful. But examples taken from the
PROBLEMS
1. Draw the production possibilities frontier for a country that produces only two goods,
steel and rice. The curve should be bowed out from the origin.
a) What is the economic explanation of the bowing out of the curve?
b) Show two points on the diagram at which the economy is operating efficiently. What
is common about those points, and what is different?
c) Assuming that the economy is always operating efficiently, does the opportunity cost
of rice increase, decrease, or stay constant as more rice is produced?
d) How can you represent on the diagram the phenomenon of inefficient or wasteful
production?
Chapter 3/The Fundamental Economic Problem: Scarcity and Choice
Answers:
a) The principle of increasing cost states that as the production of a good expands, the
opportunity cost of producing another unit generally increases. It suggests that the
production possibilities frontier is bowed outward.
b) A and B (any other point on the curve as well) are points on the production possibility
curve where the economy is operating efficiently. Both points are equally efficient
from the point of view of the economy. The combination of two outputs is different.
c) Opportunity cost will increase.
2. The world is composed of two countries, Farmeria and Securitania. Each has 1,000
workers, and each produces just two goods, guns and butter. All workers in Farmeria
have the same skills, as do all workers in Securitania; the skills differ between the two
countries, however. In Farmeria, each worker can produce either 10 pounds of butter a
day, or one gun. In Securitania, each worker can produce either six pounds of butter a
day, or two guns.
a) Draw the production possibilities frontier for each country, clearly labeling the axes.
b) Explain why the curves you have drawn in a) are straight lines or bowed.
c) Compare the opportunity costs of producing guns in Farmeria and Securitania. Where
is gun production cheaper?
d) Compare the opportunity costs of producing butter in Farmeria and Securitania.
Where is butter production cheaper?
e) Suppose that each country devotes half of its labor to each good. Show the production
Chapter 3/The Fundamental Economic Problem: Scarcity and Choice
Answers:
a) Figures (A) and (B) shows the production possibility curves of Farmeria and
Securitania, respectively.
b) Production possibility curves for both countries are straight lines. The opportunity
cost of one over the other remains constant between the two extremes of production
possibility because all workers within each country had the same skills.
c) Gun production is cheaper in Securitania.
d) Butter production is cheaper in Farmeria.
DISCUSSION QUESTIONS
1. In each of these cases, discuss whether the value of the opportunity cost is likely to be the
same, greater, or less than the direct money cost.
a) Chemicals are produced in a factory in Los Angeles. The company pays for all its
inputs, labor, etc., and it discharges its wastes into the atmosphere.
b) The government pays wages to workers who are skilled but unemployed, putting
them to work producing goods in a factory that has previously been idle.
c) The government hires workers to build a road, attracting them away from an office
construction project.
d) Tickets for a local concert go on sale at 8 am, for $80 each. To be assured of getting
one, you camp out all night in front of the ticket booth.
Chapter 3/The Fundamental Economic Problem: Scarcity and Choice
Suggested Answer:
a) True cost of a decision is not the dollar cost but the opportunity cost. In the first case,
money cost does not represent the real cost to the society that includes the opportunity
2. Pick the one government program that above all others you believe should be expanded.
What would the opportunity cost be of that expansion? How would you persuade others
that this cost is worth incurring?
Suggested Answer: Student answers will vary depending on their individual choices. Free
education, unemployment, social welfare, health care, poverty alleviation programs, aid
3. Robinson Crusoe lives alone on a desert island. His food is the fish he kills by throwing
rocks at them. It is an awkward method, and he has to spend every daylight hour at it if
he is to meet his minimum nutritional requirements. He knows he could catch fish more
quickly if he had a pole, a line, and a hook. What is the opportunity cost to him of making
that equipment, and should he do it?
Suggested Answer: Opportunity cost is the time Robinson Crusoe spends on making the
new equipment that he could have utilized for catching fish using the awkward method.
4. Do you think your college is operating at the frontier of its production possibilities
frontier? Do you see any waste, and if so, do you see ways of eliminating that waste?
5. The text argues that our standard of living depends upon the division of labor, upon the
fact that people specialize, develop skills in their specialization, and then exchange for
the goods and services they do not produce. Do you think it is possible to carry the
division of labor too far? Is it likely that people get so “overspecialized” that they become
alienated, and lose their creativity and their ability to understand a broad range of
problems?
Suggested Answer: Students should discuss the advantages and disadvantages of division
of labor. Someone specializing in the execution of a single operation might master it, but
6. In the last section of Chapter 3, the authors say that the market does not have any
ideological content. The market is only a means to an end, not the end itself. In some
Chapter 3/The Fundamental Economic Problem: Scarcity and Choice
instances both liberals and conservatives can use it to achieve their goals, and in other
instances it fails to allow either group to achieve their goals. Many people disagree with
this argument: Some believe that reliance upon the market is inherently conservative,
supporting the status quo, while some believe that the market is inherently progressive,
allowing people to emerge from the oppressive hand of dictatorship. What is your
opinion?
Suggested Answer: Students are expected to discuss the virtues and drawbacks of the
market mechanism. Society has many important goals. Some of them, such as producing
goods and services with maximum efficiency, can be achieved extraordinarily well by