Microeconomics: The Basic Economic Problem, Factors of Production, and Opportunity Cost
The Basic Economic Problem and Resource Scarcity
Definition of Microeconomics:
Microeconomics is the study of how to best solve the basic economic problem.
The Basic Economic Problem:
The basic economic problem centers on how to allocate scarce resources given unlimited human wants.
Human individuals possess real, unlimited desires and wants.
The planet does not provide enough resources to fully satisfy these unlimited wants, making resources scarce.
The Four Factors of Production (CELL)
Definition of Factors of Production:
In economics, resources are also referred to as factors of production.
Factors of production are resources that, when combined together, produce goods and services.
Mnemonic for Factors of Production:
The acronym CELL stands for the four factors of production:
C — Capital
E — Enterprise
L — Land
L — Labor
Detailed Breakdown of the Four Factors:
Capital:
Capital does not mean money in economics.
Defined as man-made aids to production (things made by humans that allow for greater production of goods and services to take place).
Examples include:
Machinery
Tractors and vehicles
Factories
Shop premises
Schools
Hospitals
Computers
Enterprise:
Refers to entrepreneurs and entrepreneurship.
Represents risk-taking individuals who innovate and produce goods and services.
Innovate and take risks specifically to earn profits.
Land:
Refers to natural land where goods can be produced or extracted.
Examples include farmland and rainforests.
Labor:
Refers to human resources and workers who produce goods and services.
Resource Scarcity:
The world does not supply an infinite quantity of these four factors of production, resulting in scarcity alongside unlimited wants.
The Three Fundamental Economic Choices in a Market Economy
Economics as the Study of Choice:
Because resources are scarce, choices must be made regarding how resources are allocated.
Economics is fundamentally the study of choice.
The Three Fundamental Choices:
Allocating scarce resources requires answering three core questions:
What to produce?
How to produce it?
For whom to produce?
Answering Fundamental Choices in a Market Economy:
What to produce:
Private businesses decide what to produce based on consumer demand.
How to produce it:
Businesses decide based on what is most cost-effective and productive in order to minimize the use of scarce resources.
Businesses that succeed at producing at the lowest cost while minimizing scarce resource usage survive in the market.
For whom to produce:
Allocated to individuals who possess sufficient income to afford goods and services in the market.
General market rule: if a consumer can afford a good or service, they receive it.
The government can step in to assist, but primary allocation relies on income affordability.
Opportunity Cost and Decision Evaluation
Definition of Opportunity Cost:
Opportunity cost is the cost of the next best alternative foregone when a choice is made.
It serves as the fundamental concept used in economics to measure whether choices are good or bad.
Measuring Choices Using Opportunity Cost:
To evaluate a decision, a value is assigned to the chosen option and compared to the value of the next best alternative foregone.
Evaluation Criteria:
Good Decision:
Bad Decision:
Reallocation of Resources:
When the value of the opportunity cost exceeds the value of the current choice, a bad decision has been made.
In this scenario, resources should be reallocated away from the current choice and toward the next best alternative (the opportunity cost).
Application:
Understanding opportunity cost provides the foundation for evaluating real-world economic decision-making prior to analyzing choices in greater detail using tools such as Production Possibility Frontiers (PPF).