Unit 1 - Basic Concepts of Economics and Allocation of Resources

 1.1 Concepts of Scarcity and Choice 

Scarcity means shortage. Every society has limited economic resources like land, capital, labor and entrepreneurship, which are required for the production of goods and services. Thus, every society can produce only limited goods and services. But human wants are unlimited. As soon as one want is fulfilled, another want immediately appears. It never ends. It is not possible to satisfy all wants with limited means.  Human beings are confronted with the problem of making choices, which wants are to be fulfilled, and what means are to be allocated among the competing wants. To solve the problem of unlimited wants and limited means, people have to make choice and it is the central problem of every society.  If economic means are free and unlimited, there would not be problems. People need not worry about budgeting their income.

Scarcity is a relative term.  It is related to human wants. For instance, air does not have price; it is not relatively scarce. People can have it as much as they want. It is free. Food, cloth and houses have price because they are scarce.

Economic problems arise due to the following reasons:

(i) Unlimited Wants and Different Importance: Human wants are unlimited.  Once a want is fulfilled, another crops up in its place.  Even if a particular want is fulfilled at a particular time, after some time it appears again. It is cyclic process.  For instance, when we are thirsty we drink a glass of water and at that moment our desire to drink water is fulfilled.  But after some time, we feel thirsty again.  Human wants are not only recurring, it multiplies all the time.  For instance, when a rural area is urbanized the wants of its inhabitants increase. People require to wear nice clothes and need many other things, which they were not using before.

(ii) Different Importance of Wants: All the wants are not of the same importance. Some wants are urgent and more pressing than the others.  For instance, for a student study is more important than doing any other things during examinations. Similarly, for a patient, buying medicine is more important than buying a box of cigarette.  Thus, all persons are required to prioritize their wants in accordance with their importance.  If all human wants are equally important, then there is no need of making choices and also there would be no economic problems.

(iii) Limited Means with Alternative Uses: This has two aspects:

(a) Limited means: Means are limited or scarce.  For example, family needs food, shelter, clothes, medicine, entertainment etc.  But they have limited resources, may be it is time or money or other economic resources.  Scarcity is a relative term.  It is in relation to human wants.  For example, nobody wants to have garbage though it is limited. So it cannot be termed as scarce commodity. But as soon as people learn to turn garbage into compost fertilizer, and make money, people start collecting garbage and it becomes economic resources.  It applies to all countries whether it is rich or poor.  Even developed countries face the problem of scarcity, as their wants have been multiplied as their country became richer.  Thus scarcity is basic problem and universal in nature.

(b) Means can be put into alternative uses: Although means are limited they can be put into alternative uses.  It is because of this nature, people need to make choices, which wants to be satisfied first. For instance, a piece of land can be utilized for several purposes, such as farming, building a house, making a playground etc.  Here lies the problem of choice.

(iv) Adjustments between wants and means: All the people are constantly facing the problem of making adjustment between limited means, which have alternative uses, and unlimited wants having different importance.  This leads to the problem of choice, which is fundamental economic problem.  It is rightly said that scarcity is mother of all economic problems. Had there been unlimited means, there would be no economic problem.  But this is not the case, all face the problem of limited means.  People in all countries and in all situations face the problem of scarcity of resources.

Quiz 1.1 - Scarcity and Choice

1.2 Opportunity Cost 

Opportunity cost is defined as the loss of income due to opportunity foregone. In other words, opportunity cost refers to what an input could earn in its next best alternative job. It rises due to scarcity and alternative uses of resources. Since, productive resources have alternative uses; they can be put for several uses. Opportunity cost is important for firms to make decisions among several choices.

For example, suppose a farmer can produce wheat and potato from the same piece of land. If he expects higher price of wheat in coming year, he will produce more wheat by sacrificing the production of potato. In this example, the opportunity cost of wheat is the quantity of output of potato sacrificed while producing wheat.

According to Benham, "The opportunity cost of anything is the next best alternative that could be produced instead by the same factor".

According to Ferguson, "The alternative or opportunity cost of producing one unit of commodity X is the amount of commodity Y that must be sacrificed in order to use resources to produce X rather than Y".

Quiz 1.2 - Opportunity Cost

1.3 Production–Possibility Frontier (PPF) or Production Possibility Curve (PPC) 

Production: Technological transformation of input (factor: Ld, Lb, K, O & non-factor: water, electricity, raw materials) into output (finished goods and services: cloth, food, electricity)

An economic model and visual representation of the ideal production balance between two commodities given finite resources.

A PPF or PPC is a curve which shows various possible/attainable combinations of  output (the amounts of two goods) which can be produced at the maximum level within the given (fixed) resources and technology. Where the given resources are fully and efficiently utilized at the given period of time.

A PPF illustrates several economic concepts

• Allocative Efficiency
• Economies of Scale
• Productive Efficiency or capability
• Scarcity of resources (the fundamental economic problem that all societies face)
• Different choices that an economy faces
• Opportunity Cost (or marginal rate of transformation or trade-off)

Trade off: PPC shows trade-off between producing one good versus another. Making more of one good will cost society the opportunity of making more of the other good. It means, one good can only be produced by diverting resources from other goods, and so by producing less of them.

Types of PPC:

1. Straight-line sloping down: Constant negative gradient or constant ratio, constant opportunity cost

• one item/good decreases by fixed amount, the other item/good will increase by one,
• not realistic because it cannot represent the market/economy.

Combination	Clothes (Thousand Meters)	Food (Metric Tons)	Opportunity Cost
A	20	0	-
B	15	1	(-5 : 1)
C	10	2	(-5 : 1)
D	5	3	(-5 : 1)
E	0	4	(-5 : 1)

2. Concave curve: increasing ratio, increasing opportunity cost

• one item/good decreases by more and more, the other item/good will increase by one,
• more realistic and it represent the whole market or economy.

Combination	Clothes (Thousand Meters)	Food (Metric Tons)	Opportunity Cost
A	20	0	-
B	18	1	(-2 : 1)
C	14	2	(-4 : 1)
D	8	3	(-6 : 1)
E	0	4	(-8 : 1)

3. Convex curve: decreasing ratio, Decreasing opportunity cost

• one item/good decreases by less and less, the other item/good will increase by one,
• does not really exist in the real-life economy, some says that in agriculture, this type of curve does exist but mostly it is not.

Combination	Clothes (Thousand Meters)	Food (Metric Tons)	Opportunity Cost
A	20	0	-
B	12	1	(-8 : 1)
C	6	2	(-6 : 1)
D	2	3	(-4 : 1)
E	0	4	(-2 : 1)

Assumptions

To simplify illustration or calculation

• Economy is producing only two goods X and Y
• Constant Technology or no change in technique of production (Labor intensive & Capital intensive)
• Fixed resources (inputs) supply to the economy but comparison with another time is possible
• Productive resources are fully utilized or employed and no waste of resources but in reality the resources are never been utilize fully. For eg. Labor without motivation or incentives, maintenance of machines
• Time period is given

Explanation Using Table & Diagram

The following table gives the various production possibilities of clothes and food.

Combination	Clothes (Thousand Meters)	Food (Metric Tons)	Opportunity Cost
A	20	0	-
B	18	1	(-2 : 1)
C	14	2	(-4 : 1)
D	8	3	(-6 : 1)
E	0	4	(-8 : 1)

If all available resources are employed for the production of clothes, 20,000 meters of it can be produced. If, on the other hand, all available resources are utilized for the production of food, 4 metric tons are produced. These are the two extremes represented by A and E and in between them are the situations represented by B, C and D.

At B the economy can produce 18,000 meters of clothes and 1 metric ton of food. At C the production possibilities are 14,000 meters of clothes and 2 metric ton of food, as we move from A to E, we give up some units of clothes for some units of food.

For instance, moving from A to B, we sacrifice 2000 meters of clothes to produce 1 metric ton of food, and so on. As we move from A to E, we sacrifice increasing amounts of clothes.

This means that, in a full-employment economy, more and more of one good can be obtained only by reducing the production of another good. This is due to the basic fact that the economy’s resources are limited.

The following diagram illustrates the production possibilities set out in the above table. PPCs are normally drawn as bulging upwards or outwards from the origin ("concave" when viewed from the origin). The curve is represented to show the number of products that can be created with limited resources and pausing the use of technology in between. 

• A shows the production level of clothes alone
• E indicates the production level of food only
• B, C & D shows various possible combination of production of both food and clothes

In this diagram AE is the PPC or PPF, which shows the various combinations of the two goods which the economy can produce with a given amount of resources. If the country wants to produce more food, they must produce fewer clothes, based on limited resource availability. Likewise, if they want to produce more clothes, they must produce less food.

The PPC is also called transformation curve, because when we move from one position to another, we are really transforming one good into another by shifting resources from one use to another.

Productive Efficiency

At point A, B, C, D, E & F : Points that lie on the frontier/curve are efficient. PPC for an economy shows Pareto efficiency or allocative efficiency or productive efficiency. 

At Point F: below the PPC are possible/attainable (but not desirable), the quantities can be produced with currently available resources and technology.

1. Allocative Inefficiency : Inefficient production due to allocative inefficiency, because the economy can produce more of at least one good without sacrificing the production of any other good, with existing resources and technology. For eg. More fertile land for housing & less fertile land for agriculture
2. Under employment, idle factor of production & wastage of resources : Some workers without jobs, some buildings without occupants, some fields without crops.
3. Lack of Specialization of labor (division of labor) : low level of production

At point G: Points that lie above the PPC are not possible/unattainable (but desirable) because the quantities cannot be produced using currently available resources and technology.

The combined output of the two goods can neither be at F nor G. This is so because at F the economy will be under-employing its resources and G is beyond the resources available.

Shift in PPC

Shift of the PPC indicates either economy is growing or shrinking.

Outward Shift in PPC (Economic Growth)

Output increases without sacrificing any good.

Results From

• Country discovers new resources
• Quantitative & qualitative growth of availability of inputs (labor & capital)
• Improvement in technological development or progress in knowledge of how to transform inputs into outputs.
• More Education or Training 
• Managerial efficiency (management expertise)

Inward Shift in PPC

Results From

• Natural or human-made disaster, like earthquake destroying a factory and machinery.
• Labor force shrinks,
• Depletion of supply of raw materials

Quiz 1.3 - Production Possibility Curve

1.4 Allocation of Resources 

The basic or fundamental economic problem for the society is how to reconcile the conflict between people's unlimited desire for goods and services and scarcity of resources to produce goods and services.  Thus, society is required to make decisions to use or allocate limited resources to satisfy unlimited wants.  In this respect problem arises regarding (a) what is to be produced (b) How it is to be produced (c) for whom to be produced.  These are three basic problems of economics.

(a) What is to be produced?

The major question is what commodities are to be produced and in what quantities? A society has to make choice between consumption goods like food, clothes, furniture etc. and capital goods like machine, equipment etc.  Thus, choice has to be made between consumer goods like clothes, shoes, books etc. and weaponry like machine guns, fighter planes etc. Likewise, choice has to be made between mass goods and luxury goods.  In this way, a country has to make choices in deciding allocation of scarce resources for the production of goods and services.

(b) How are goods produced?

Society must decide who will produce what and how? Which kind of production technique to be applied for production.  For example, food can be produced either with extensive cultivation or intensive method of cultivation.  Similarly, in industry as well there is choice of technique of labour intensive and capital-intensive method of production.  It depends on the decision of firm, household and society for how goods and services are to be produced? In case of labor-intensive technique less capital and equipment are used and more laborers do the work. Whereas, under capital intensive production method sophisticated machines and technology are used and machines replace the work of laborers.

(c) For whom to be produced?

Another question is for whom to be produced? This means how is national product  distributed among the members of the society.  How is national dividend distributed? In other words, who gets the fruits of development and how much?

Goods and services are made available utilizing various factors of production.  Thus, major question is how the national income is distributed among the various factors of production, i.e., land, labour, capital, and organization. Do the poor enjoy equally with the rich is the important question?  The main difficulty in distribution of national income is how to ensure equity, justice and incentive. If national income is distributed equally to all the members of the society equity is achieved. However, this discourages the people to produce more and work hard It diminishes National Income and may fall down living standard of the people. 

Thus, these three problems what, how, and for whom are the main problems of economy. All these problems come under the problem of allocation of resources.

Quiz 1.4 - Allocation of Resources

1.5 Division of Labor (Work) 

The division of a complex production process into a number of simpler tasks, each one of which is undertaken by a different individual who typically (but not necessarily) specializes in one task (or a very few tasks) on a more or less permanent basis. The advantages of division of labor for enhancing human productivity were first extensively analyzed by Adam Smith in his 1776 classic The Wealth of Nations, where he coined the phrase. Whereas Smith's famous analysis of the pin factory emphasized improvements in technical efficiency (the time and physical movement saved by workers no longer having to switch from one operation and set of tools to another), it also took note of the improvements in allocational efficiency made possible by developing and then taking advantage of workers' differing skills and talents according to the (at that time not yet named) principle of comparative advantage.

In the broadest sense, the extension of the division of labor is the fundamental feature of a modern or developed economy, in which gigantic increases in the volume and variety of production have been attained -- but at the cost of massively increasing economic interdependence within larger and larger populations spread over larger and larger geographical areas. In such a complex society, instead of each individual or family attempting to produce all or most of what it consumes, the individual specializes in producing only a few kinds of good or service (or perhaps only small components of a single good or service) and then acquires all other desired goods or services from the production of other specialists by means of mutual exchange (or, in non-market economies, perhaps through coercive or customary transfer).

Merits of Division of Labor

1. Increase in Production: With the adoption of division of labor, the total production increases. Adam Smith has explained the advantage of division of labor with the help of an example that a worker can produce only 20 pins daily. If the making of pins in a modern factory is divided into 18 processes, then 18 workers can produce 48,000 pins in a single day.

2. Increase in Efficiency of Labor: With division of labor, a worker has to do the same work time and again, and he gets specialization in it. In this way, the division of labor leads to a great increase in efficiency.

3. Increase in Skill: Division of labor contributes to the development of skill, because with the repetition of the same work, he becomes specialized in it. This specialization enables him to do the work in the best possible way, which improves his skill.

4. Increase in Mobility of Labor: Division of labor facilitates greater mobility of labor. In it, the production is split up into different parts and a worker becomes trained in that very specific task in the production of the commodity which he performs time and again. He becomes professional, which leads to the occupational mobility. On the other hand, division of labor implies a large-scale production and laborers come to work from far and near. Thus, it increases geographical mobility of labor.

5. Increase in Use of Machines: The division of labor is the result of the large-scale production, which implies more use of machines. On the other hand, the division of labor increases the possibility of the use of machines in the small-scale production also. Therefore, in modern times the use of machines is increasing continuously due to the increase in the division of labor.

6. Increase in Employment Opportunities: Division of labor leads to the diversity of occupations which further leads to the employment opportunities. On the other hand, the scale of production being large, the number of employment opportunities also increases.

7. Work According to Taste: Workers have their own taste in production. For example, a person can take up that type of job for which he considers himself to be the most suitable and which is in accordance with his taste. Division of labor extends the work to such an extent that every person can find work according to his taste and interest.

8. Work for Disable: Division of labor splits up the production work in small processes and different persons can work at different places with the help of machines. Certain machines can be operated with the help of hands only and others with the help of foot as well. Therefore, the disabled persons can also find work according to their suitability.

9. Best Use of Tools: In this system, it is not necessary to provide each worker with a complete set of tools. He needs a few tools only for the job in which he can make their best use. Therefore, the continuous use of tools is possible which are used at different stages.

10. Best Selection of the Workers: Division of labor helps the employers in the best selection of workers. As the work is divided into different parts and each part is taken up by such a worker who is more suitable for it, the employer can select very easily the man who is best suited for the work.

11. Saving of Capital and Tools: Division of labor helps in the saving of capital and tools. It is not essential to provide a complete set of tools to every worker. He needs a few tools only for the job he has to do. Thus, there is the saving of tools as well as capital. For instance, if a tailor stitches the shirt, he requires a sewing machine, scissors, etc. But on the basis of division of labor, one can do the cutting and the other can stitch the clothes. In this way, two tailors can work with the help of one pair of scissors and one machine only.

12. Goods of Superior Quality: Division of labor is beneficial in making goods of superior quality. When the worker is entrusted with the work for which he is best suited, he will produce superior quality goods.

13. Saving of Time: There is no need for the worker to shift from one process to another. He is employed in a definite process with certain tools. He, therefore, goes on working without loss of time, sitting at one place. Continuity in work also saves time and helps in more production at less cost.

14. Right Man at the Right Job: Division of labor implies splitting up of production into a number of processes. Each person is given the job for which he is best suited. There will be no round pegs in square holes. In this way, a right man is placed at the right job.

15. Reduction in the Cost of Production: If a shoe-maker makes himself two pairs of shoes daily, then four shoe-makers can make more than eighth pairs of shoes if they work in cooperation with each other. In this way, division of labor increases production which reduces the average cost of production. Saving of capital, tools and machinery, etc. also help in the reduction of cost of production.

16. Cheap Goods: Division of labor helps in mass production. Thus, production becomes less expensive and more economical. Therefore, cheaper goods are turned out, which improve the standard of living of the people.

17. Saving of Time and Expenses in Training: Under division of labor, a worker has to train himself in a small part of production. There is no need to learn the whole process of production. It ensures saving of time as well as expenses in training.

18. Spirit of Co-operation among Workers: Division of labor gives chances of working under the same roof and with the cooperation of each other. It further gives rise to the feeling of cooperation and trade unionism in their daily lives. The work cannot be completed unless they cooperate with each other. They help each other at the time of adversities as well.

19. Development of International Trade: Division of labor increases the tendency of specialization not only in the workers or industries, but in different countries also. On the basis of specialization, every country produces only those goods in which it has a comparative advantage and imports such goods from those countries which have also greater comparative advantage. Therefore, division of labor is beneficial for the development of international trade also.

Demerits of Division of Labor

1. Monotony: Under division of labor, a worker has to do the same job time and again for years together. Therefore, after some time, the worker feels bored or the work becomes irksome and monotonous. There remains no happiness or pleasure in the job for him. It has an adverse effect on the production.

2. Loss of Joy: In the absence of division of labor, he feels a lot of pleasure on the successful completion of his goods. But under division of labor, nobody can claim the credit of making it. The work gives him neither pride nor pleasure. Therefore, there is total loss of joy, happiness and interest in the work.

3. Loss of Responsibility: Many workers join hands to produce a commodity. If the production is not good and adequate, none can be held responsible for it. It is generally said that ‘every man’s responsibility is no man’s responsibility.’ Therefore, the division of labor has the disadvantage of loss of responsibility.

4. Loss of Mental Development: When the laborer is made to work only on a part of the work, he does not possess complete knowledge of the work. Thus, division of labor proves to be a hurdle in the way of mental development.

5. Loss of Efficiency: Division of labor is sometimes accounted for the loss of efficiency. For instance, if a cobbler goes on cutting the leather for a long time, he may lose the efficiency of making shoes.

6. Reduction in Mobility of Labor: The mobility of labor is reduced on account of division of labor. The worker performs only a part of the whole task. He is trained to do that much part only. So, it may not be easy for him to trace out exactly the same job somewhere else, if he wants to change the place. In this way, the mobility of labor gets retarded.

7. Increased Dependence: When the production is split up into a number of processes and each part is performed by different workers, it may lead to over-dependence. For instance, in the case of a readymade garments factory, if the man cutting cloth is lazy, the work of stitching, buttoning, etc. will suffer. Therefore, increased dependence is the result of division of labor.

8. Danger of Unemployment: The danger of unemployment is another disadvantage of division of labor. When the worker produces a small part of goods, he gets specialized in it and he does not have complete knowledge of the production of goods. For instance, a man is expert in buttoning the clothes. If he is dismissed from the factory, it is difficult for him to find the job of buttoning. Thus, division of labor has a fear of unemployment.

9. Increased Dependence on Machines: As division of labor increases, there will be an increased use of machines. Almost all the workers work on different types of machines. It is difficult for them to work without machines. Thus, division of labor increases the dependence on machines.

10. Danger of Over-Production: Over-production means that the supply of production is comparatively more than its demand in the market. Because of the division of labor, when production is done on a large scale, the demand for production lags much behind its increased supply. Such conditions create overproduction which is very harmful for the producers as well as for the workers when they become unemployed.

11. Exploitation of Labor: Division of labor is concerned with large scale production in big factories which are owned by the capitalists. No poor worker can afford to start his own production. Therefore, they have to seek employment in big factories of the capitalists. These employers pay less wages to them as compared to their marginal productivity, because there is no other alternative to the workers but to work at very low wages. Therefore, division of labor results in the exploitation of labor.

12. Evils of Factory System: The modern industrial or factory system has been developed as a result of the division of labor. This system further gives rise to the evils like dense population, pollution, bad habits of gambling and drinking, low standard of living, poor food, clothes and housing, etc.

13. Exploitation of Women and Children: Division of labor results in the large-scale production in which children and women are also employed. It is because a simple and small part of the whole task can easily be performed by them. Thus, the number of employed women and children increases. They are also exploited by the employers by paying them lower wages.

14. Industrial Disputes: The industrial disputes mean strikes by workers, closure of factory, etc. due to clashes between the employees and the employers. Division of labor results in the division of society into workers and employers. The employer always tries to increase his profits by exploiting the workers and workers form trade unions against the employers to put an end to their exploitation or to make them increase their wages. It gives rise to a severe conflict between the employers and the workers in the form of strikes, closures and lockouts of factories.

Quiz 1.5 - Division of Labor (Work)

1.6 Economic System (Market, Command and Mixed) 

Economy: large set of inter-related production and consumption activities that aid in determining how scarce resources are allocated.

Major Types of Economic System

Basis	Capitalist Economy	Socialist Economy	Mixed Economy
Ownership of Property	Private	Public	Both public and private
Price Determination	by the market forces (D & S)	by the central planning authority	by central planning authority and market forces
Motive of Production	Profit motive	Social welfare	Private: Profit Public: Welfare motive
Role of Government	No role	Complete role	Public sector: Full Private sector: Limited
Competition	Exists	No competition	Exist only in the private sector
Distribution of income	Very Unequal	Quite Equal	Considerable inequalities exist
Example	US, Japan, Australia	North Korea, Cuba	Nepal, Bangladesh

Market Economy

A market economy is an economy where most resources are owned and controlled by individuals and are allocated through voluntary market transactions governed by the interaction of supply and demand.

A market economy has a number of advantages like consumer sovereignty, efficient production, rewards innovation, investment promotion. On the other hand, lack of optimization, economic inequality, labor exploitation, profiteering is favored over social welfare are some disadvantages of market economy.

 Characteristics of Market Economy

1. Private Property. The owners can make legally-binding contracts to buy, sell, or lease their property like land, building, machinery and other some natural resources. Individuals are allowed to profit from private ownership of business and property.

2. Freedom of Choice. Owners are free to produce, sell, and purchase goods and services in a competitive market. They only have two constraints i.e. price (willing to buy or sell) and capital.

3. Motive of Self-Interest. Everyone sells their wares to the highest bidder while negotiating the lowest price for their purchases. It gives an accurate picture of supply and demand at any given moment.

4. Competition. There is competition in product market and also in factor market. It ensures efficient allocation of resources.

5. System of Markets and Prices. A market economy is an economic system in which the decisions regarding investment, production and distribution are guided by the price signals created by the forces of supply and demand. Where all buyers and sellers have equal access to the same information.

6. Limited Government. The government plays a limited role in a market economy but performs a regulatory function to ensure fair play and less monopoly.

Characteristics	Free Market Economy (Capitalism)	Command Economy (Communism)
Security/Choice	Individual must make choices because resources are limited	Central Authority makes choices because  resources are limited
Trade-Offs	Individuals make trade-offs because choices must be made between alternative uses of resources	Central Authority makes trade-offs, choices made at government level not by individual
Supply and Demand	Supply and demand determines price; price determines who can purchase	Government determines price; price determines who can purchase
Private ownership	Private individuals own resources	Government owns resources
Consumer Sovereignty	Consumer choice determines what is produced	Government decides what is produced
Competition	Competition and price determine how goods and services are produced	Government determines production methods and practices
Incentives	Profit determines economic behavior	Government controls incentives and determines their use
Markets	Buyers and sellers exchange goods and services in free markets	Buyers and sellers exchange goods and services as determined by government in controlled markets

Video Link: Concept of Market Economy

Quiz 1.6 - Economic System (Market, Command and Mixed)