2 Defining Economics
Learning Objectives
- Define economics.
- Explain the concepts of scarcity and opportunity cost and how they relate to the definition of economics.
- Understand the fundamental economic questions: What should be produced? How should goods and services be produced? For whom should goods and services be produced? How much progress can society afford? How can we adjust consumption to production in the short run?
Economics is a social science that examines how people choose among the alternatives available to them. It is social because it involves people and their behavior. It is a science because it uses, as much as possible, a scientific approach in its investigation of choices.
Scarcity, Choice, and Cost
All choices mean that one alternative is selected over another. Selecting among alternatives involves three ideas central to economics: scarcity, choice, and opportunity cost.
Scarcity
Our resources are limited. At any one time, we have only so much land, so many factories, so much oil, so many people. But our wants, our desires for the things that we can produce with those resources, are unlimited. We would always like more and better housing, more and better education—more and better of practically everything.
If our resources were also unlimited, we could say yes to each of our wants—and there would be no economics. Because our resources are limited, we cannot say yes to everything. To say yes to one thing requires that we say no to another. Whether we like it or not, we must make choices.
Our unlimited wants are continually colliding with the limits of our resources, forcing us to pick some activities and to reject others. Scarcity is the condition of having to choose among alternatives. A scarce good is one for which the choice of one alternative requires that another be given up.
Consider a parcel of land. The parcel presents us with several alternative uses. We could build a house on it. We could put a gas station on it. We could create a small park on it. We could leave the land undeveloped in order to be able to make a decision later as to how it should be used.
Suppose we have decided the land should be used for housing. Should it be a large and expensive house or several modest ones? Suppose it is to be a large and expensive house. Who should live in the house? If the Lees live in it, the Nguyens cannot. There are alternative uses of the land both in the sense of the type of use and also in the sense of who gets to use it. The fact that land is scarce means that society must make choices concerning its use.
Virtually everything is scarce. Consider the air we breathe, which is available in huge quantity at no charge to us. Could it possibly be scarce?
The test of whether air is scarce is whether it has alternative uses. What uses can we make of the air? We breathe it. We pollute it when we drive our cars, heat our houses, or operate our factories. In effect, one use of the air is as a garbage dump. We certainly need the air to breathe. But just as certainly, we choose to dump garbage in it. Those two uses are clearly alternatives to each other. The more garbage we dump in the air, the less desirable—and healthy—it will be to breathe. If we decide we want to breathe cleaner air, we must limit the activities that generate pollution. Air is a scarce good because it has alternative uses.
Not all goods, however, confront us with such choices. A free good is one for which the choice of one use does not require that we give up another. One example of a free good is gravity. The fact that gravity is holding you to the earth does not mean that your neighbor is forced to drift up into space! One person’s use of gravity is not an alternative to another person’s use.
There are not many free goods. Outer space, for example, was a free good when the only use we made of it was to gaze at it. But now, our use of space has reached the point where one use can be an alternative to another. Conflicts have already arisen over the allocation of orbital slots for communications satellites. Thus, even parts of outer space are scarce. Space will surely become more scarce as we find new ways to use it. Scarcity characterizes virtually everything. Consequently, the scope of economics is wide indeed.
Scarcity and the Fundamental Economic Questions
The choices we confront as a result of scarcity raise these fundamental questions, which every economy must answer:
- What should be produced? Using the economy’s scarce resources to produce one thing requires giving up another. Producing better education, for example, may require cutting back on other services, such as health care. A decision to preserve a wilderness area requires giving up other uses of the land. Every society must decide what it will produce with its scarce resources.
- How should goods and services be produced? There are all sorts of choices to be made in determining how goods and services should be produced. Should a firm employ a few skilled or a lot of unskilled workers? Should it produce in its own country or should it use foreign plants? Should manufacturing firms use new or recycled raw materials to make their products?
- For whom should goods and services be produced? If a good or service is produced, a decision must be made about who will get it. A decision to have one person or group receive a good or service usually means it will not be available to someone else. For example, representatives of the poorest nations on earth often complain that energy consumption per person in the United States is 17 times greater than energy consumption per person in the world’s 62 poorest countries. Critics argue that the world’s energy should be more evenly allocated. Should it? That is a “for whom” question.
- How much progress society can afford or cares to have at the cost of sacrificing present values and what forms it should it shall take? What choices should a society make to maintain and improve the social structure? These can include infrastructure investments such as roads, sewers, and Internet; public health interventions, healthcare, or education.
- How should we adjust consumption to production within very short periods? When there is a negative supply shock, such as the 1970’s oil embargo, or a negative demand shock, such as the 2008 financial crisis, the government has an opportunity to step in and adjust the economy to support consumers and businesses. How much they choose to do so is a question both of economic fundamentals and the values of the society in which the economy operates.
We shall return to these questions again and again.
Opportunity Cost
It is within the context of scarcity that economists define what is perhaps the most important concept in all of economics, the concept of opportunity cost. Opportunity cost is the value of the best alternative forgone in making any choice.
The idea of “value” in economics has been the subject of debate for hundreds of year. Classical economic theory, starting with Adam Smith, identifies value, and its necessary inverse, cost, in terms of productive cost. Here, opportunity costs takes on a simplistic explanation, an objective value, comparing the output of a day’s labor between two people, with wages justified in part or whole by the physical nature of the work[1]. Following the development of marginal utility theory, the details of which will be investigated in later chapters, so developed the concept of value, and therefore opportunity cost as a subjective entity. This led to the idea of opportunity cost as it is written here, and in most economics texts, as the alternative use of a resource.
The opportunity cost to you of reading the remainder of this chapter will be the value of the best other use to which you could have put your time. If you choose to spend $20 on a potted plant, you have simultaneously chosen to give up the benefits of spending the $20 on pizzas or a paperback book or a night at the movies. If the book is the most valuable of those alternatives, then the opportunity cost of the plant is the value of the enjoyment you otherwise expected to receive from the book.
The concept of opportunity cost must not be confused with the purchase price of an item. Consider the cost of a college or university education. That includes the value of the best alternative use of money spent for tuition, fees, and books. But the most important cost of a college education is the value of the forgone alternative uses of time spent studying and attending class instead of using the time in some other endeavor. Students sacrifice that time in hopes of even greater earnings in the future or because they place a value on the opportunity to learn. Or consider the cost of going to the doctor. Part of that cost is the value of the best alternative use of the money required to see the doctor. But, the cost also includes the value of the best alternative use of the time required to see the doctor. The essential thing to see in the concept of opportunity cost is found in the name of the concept. Opportunity cost is the value of the best opportunity forgone in a particular choice. It is not simply the amount spent on that choice.
The concepts of scarcity, choice, and opportunity cost are at the heart of economics. A good is scarce if the choice of one alternative requires that another be given up. The existence of alternative uses forces us to make choices. The opportunity cost of any choice is the value of the best alternative forgone in making it.
Key Takeaways
- Economics is a social science that examines how people choose among the alternatives available to them.
- Scarcity implies that we must give up one alternative in selecting another. A good that is not scarce is a free good.
- The fundamental economic questions are: What should be produced? How should goods and services be produced? For whom should goods and services be produced? How much progress society can afford? How should we adjust to short run changes?
- Every choice has an opportunity cost and opportunity costs affect the choices people make. The opportunity cost of any choice is the value of the best alternative that had to be forgone in making that choice.
Try It!
Identify the elements of scarcity, choice, and opportunity cost in each of the following:
- The Environmental Protection Agency is considering an order that a 500-acre area on the outskirts of a large city be preserved in its natural state, because the area is home to a rodent that is considered an endangered species. Developers had planned to build a housing development on the land.
- The manager of an automobile assembly plant is considering whether to produce cars or sport utility vehicles (SUVs) next month. Assume that the quantities of labor and other materials required would be the same for either type of production.
- A young man who went to work as a nurses’ aide after graduating from high school leaves his job to go to college, where he will obtain training as a registered nurse.
Case in Point: The Rising Cost of Energy
Oil is an exhaustible resource. The oil we burn today will not be available for use in the future. Part of the opportunity cost of our consumption of goods such as gasoline that are produced from oil includes the value people in the future might have placed on oil we use today.
It appears that the cost of our use of oil may be rising. We have been using “light crude,” the oil found in the ground in deposits that can be readily tapped. As light crude becomes more scarce, the world may need to turn to so-called “heavy crude,” the crude oil that is found in the sandy soil of places such as Canada and Venezuela. That oil exists in such abundance that it propels Venezuela to the top of the world list of available oil. Saudi Arabia moves to the second position; Canada is third. The US is 11th, and most of that oil is not easily extractable. Recently, technologies like fracking have been used to access this oil, and it has consequences.
The difficulty with the oil mixed in the sand is that extracting it is far more costly than light crude, both in terms of the expenditures required and in terms of the environmental damage that mining it creates. Northern Alberta, in Canada, boasts a Florida-sized area whose sandy soils are rich in crude oil. Some of that oil is 1,200 feet underground. Extracting it requires pumping steam into the oily sand and then pumping up the resultant oily syrup. That syrup is then placed into huge, industrial-sized washing machines that separate crude oil. What is left over is toxic and will be placed in huge lakes that are being created by digging pits in the ground 200 feet deep. The oil produced from these sands has become important—Alberta is the largest foreign supplier of oil to the United States.
Sands that are closer to the surface are removed by bulldozers and giant cranes; the forest over it is cleared away. The oily sand is then hauled off in two-story dump trucks which, when filled, weigh more than a Boeing 747. Total SA, a French company, is leading the race to develop Canada’s oil. Jean Luc-Guiziou, the president of Total SA’s Canadian operations, says that the extraordinarily costly process of extracting heavy crude is something the world is going to have to get used to. “The light crude undiscovered today is getting scarcer and scarcer,” he told The Wall Street Journal. “We have to accept the reality of geoscience, which is that the next generation of oil resources will be heavier.”
Already, Total SA has clear-cut thousands of acres of forest land in order to gain access to the oily sand below. The process of extracting heavy crude oil costs the company $25 a barrel—compared to the $6 per barrel cost of extracting and refining light crude. Extracting heavy crude generates three times as much greenhouse gas per barrel as does light crude. By 2015, Fort McMurray, the small (population 61,000) town that has become the headquarters of Northern Alberta’s crude oil boom, will emit more greenhouse gas than the entire country of Denmark (population 5.4 million). Canada will exceed its greenhouse gas quota set by the Kyoto Accords—an international treaty aimed at limiting global warming—largely as a result of developing its heavy crude deposits.
No one even considered the extraction of heavy crude when light crude was cheap. In the late 1990s, oil cost just $12 per barrel, and deposits of heavy crude such as those in Canada attracted little attention. By mid-2006, oil sold for more than $70 per barrel, and Canada’s heavy crude was suddenly a hot commodity. “It moved from being just an interesting experiment in northern Canada to really this is the future source of oil supply,” Greg Stringham of the Canadian Association of Petroleum Producers told Al Jazeera.
Alberta’s energy minister, Greg Melchin, defends the province’s decision to proceed with the exploitation of its oily sand. “There is a cost to it, but the benefits are substantially greater,” he insists.
Not everyone agrees. George Poitras, a member of the Mikisew Cree tribe, lives downstream from the oil sands development. “You see a lot of the land dug up, a lot of the boreal forest struck down and it’s upsetting, it fills me with rage,” he says. Diana Gibson of the Parkland Institute, an environmental advocacy group, says that you can see the environmental damage generated by the extraction of oil sands around Fort McMurray from the moon. “What we are going to be having is destruction of very, very valuable ecosystems, and permanent pollution,” she says.
Sources: “Alberta’s Heavy Oil Burden,” Al Jazeera English, March 17, 2008 (see english.aljazeera.net); and Russell Gold, “As Prices Surge, Oil Giants Turn Sludge into Gold,” The Wall Street Journal Online, March 27, 2006, A1.
Answers to Try It! Problems
- The 500-acre area is scarce because it has alternative uses: preservation in its natural state or a site for homes. A choice must be made between these uses. The opportunity cost of preserving the land in its natural state is the forgone value of the land as a housing development. The opportunity cost of using the land as a housing development is the forgone value of preserving the land.
- The scarce resources are the plant and the labor at the plant. The manager must choose between producing cars and producing SUVs. The opportunity cost of producing cars is the profit that could be earned from producing SUVs; the opportunity cost of producing SUVs is the profit that could be earned from producing cars.
- The man can devote his time to his current career or to an education; his time is a scarce resource. He must choose between these alternatives. The opportunity cost of continuing as a nurses’ aide is the forgone benefit he expects from training as a registered nurse; the opportunity cost of going to college is the forgone income he could have earned working full-time as a nurses’ aide.
- The Collected Works of James M. Buchanan, Vol. 6 (Cost and Choice: An Inquiry in Economic Theory) [1969] ↵
