Scarcity, choice and opportunity cost

The fundamental problem of economics is scarcity. There are infinite wants, but limited resources and so all societies have to make a choice about which wants to satisfy. The cost of that choice is called the opportunity cost and is defined as the next best alternative forgone.

An example of these concepts is seen in the article linked below, which describes how the health service for England has rejected the use of a cancer treatment because they do not consider the benefits to be worth the costs.

A few words on health provision in the UK. The National Health Service (NHS) provides healthcare free at the point of use. No member of the British public, or indeed visitors, are charged for NHS care although there may be a small charge for prescriptions. The service is paid for from general taxation which means that those not working, the old or the young are not required to have contributed to tax in order to benefit. There is little need, or requirement, to have private health insurance and only 9% to 11% of the population have it.

The NHS therefore provides healthcare from a budget allocated by the government. This is, by definition, limited and the NHS must decide on the most effective way to allocate the resources it has between alternative uses.

This is a classic case of scarcity, choice and opportunity cost. The drug the article is concerned with treats a form of breast cancer that affects about 1200 women a year. It costs 90,000 GBP (AU$153,000) a year and is estimated to extend life for the average patient by around nine month.

The decision to deny access to the drug seems callous. It is really quite distressing to those who will be denied access. But what is the opportunity cost of providing the treatment? What could the NHS do with 108 million pounds a year otherwise? Of course the answer is quite a lot and hence the decision not to fund the drug.

The diagram below shows a PPF for the NHS.

As the NHS has a limited budget they cannot simply buy more of all cancer treatments. If they provide extra breast cancer treatments by reallocating resources from point A to point B there will be CD more breast cancer patients treated, but EF fewer patients treated with other forms of cancer. This is the inevitable consequence of scarcity. The opportunity cost of providing CD more breast cancer treatments is, in this case, EF fewer other treatments.

The Guardian article is here

This is a fundamental principle for all economics students when starting their course. This is a particularly unpleasant exampleto illustrate these central concepts.

'Remove dole payments after sixth months' call presumes a cause

A Queensland LNP MP is calling for unemployment benefits to be ceased to people under 45 after six months. The aim is to reduce government spending so it can be given to those with large superannuation funds instead - a reason sadly beyond our remit here.

The MP suggests that if somebody knows they will cease to get unemployment benefit then they will indeed get a job. This is of course assuming that those who are unemployed are voluntarily unemployed.

Since the 1980's governments have worked to improve incentives to work through supply-side policies. This has included lowering marginal income tax rates, so that people keep more of what they earn, making working more attractive. Governments have also reduced the real value of unemployment benefits to again make work more attractive relative to unemployment.

The theory is often expressed in terms of 'search costs'. Lowering income tax rates and reducing unemployment benefit makes the cost of 'searching' for new work more costly (in an opportunity cost sense) and so workers will therefore accept a new job more readily, probably one which does not match their ideal job, but it gets them back to work. This would be seen as an increase in economic efficiency.

There are a couple of issues with the MP's proposal. Firstly there is the tricky issue of involuntary unemployment (caused by structural or cyclical factors). The proposal will strand those who genuinely cannot find work. They will most likely have to move on to other benefits because their income is so low, meaning the savings to government will be minimal anyway.

Secondly there is the impact on the distribution of income. The unemployed are, by definition, the lowest income earners and this proposal makes them even worse off. The people who would benefit from the MPs proposed use of money saved would be from the higher income deciles, those with large superannuation savings. The effect on the distribution of income would be to make it more unequal (a higher gini co-efficient).

The New Daily covers the story here

This story has application to the goals of macroeconomic policy and their conflicting nature (equity vs efficiency). Both IB and VCE students can use this as an example of policy.

Applying Opportunitiy Cost

The central problem of economics is scarcity. There are finite resources in the world, but infinite wants. This means that all societies must make a choice about how to allocate resources.

Opportunity cost is the real cost of making a choice on how to allocate resources. It is defined as 'the next best alternative forgone' and is a vital concept to understand in the first week of any economics course.

The trick is to apply the concept to the real world. Below are links to two articles from recent days. They look at two examples of applying opportunity cost.

The first is about decisions made by Britain's National Health Service (NHS) on which cancer drugs to pay for. Britain's health service is funded through taxation and is 'free at the point of use'. The problem is it has a fixed budget from the government and so the NHS must decide which treatments to fund. The NHS is left with the unpleasant fact that when they choose one treatment they can't fund another and some people go untreated. (Actually they get other less effective drugs or palliative care.)

The second article looks at the dilemma of an American Football Club which also has a fixed budget. They must decide which players to hire/retain. If they pay one player a great deal of money then they can't hire or retain a number of other players.

Read the articles and answer the questions below.

The Daily Telegraph looks at the NHS cancer budget here

A US site looks at hiring players here

Questions:

1. Identify all the examples of scarcity and opportunity cost in the articles

2. Using examples from the articles explain how there is always an opportunity cost for any choice.

This post is relevant to all students of economics.

Opportunity Cost - a choice always has to be made

The concept of opportunity cost is critical to understanding the basic economic problem. Because there is scarcity a choice has to be made on how to allocate scarce resources. The cost of that choice is 'the next best opportunity forgone' - the opportunity cost.

Britain's National Health Service (NHS) is a universal health service scheme, free at the point of use. It is comprehensive and includes dental, optical, physio etc. Very few Britons have or need private health insurance. (Around 11.7% of the population had private health insurance in 2010, with about half being provided this by their employer as part of a package. The figure for Australia is 54.7% in 2013.)

The NHS is therefore funded by the government from tax revenue. Of course it is very expensive and the NHS budget competes with all the other things government spends money on, such as pensions, defence and education. 

The government must decide how much to spend on health. If the spend more on health they can spend less on education for example. Then the NHS must decide how to allocate their budget between uses. More on cancer treatments might mean less on hip-replacements for example. 

The NHS is 'the envy of the world' according to many. However in the UK it is a constant struggle to fund it and illustrates the concept of opportunity cost every day. The attached article shows one example of opportunity cost.

The BBC article is here

Scarcity, choice and opportunity cost

So its the start of the course and you will all be encountering the concept of scarcity. It's a vital concept in Economics, but really not given anywhere near enough attention in VCE. This means when the exam asks about these early portions of the study design students have not revised it that well.

Therefore its really a good idea to get this right first time. I won't waste space repeating the textbooks, but I'd like to point you at some resources and draw a lesson from this concept.

A brief overview:

Scarcity is the issue that describes the problem that there are not enough resources to satisfy the wants of society. Therefore society has to make a choice about What to produce, how to produce it and who gets the goods and services produced.

The cost of the choices made is the opportunity cost, the next best alternative given up.

To reduce, but not eliminate, the problem of scarcity it is best for society to use its resources fully and efficiently and that means the economy operating on the boundary of the Production Possibility Curve (or PPF - Frontier). Please note that one text book states that you can distinguish between points on the PPF in terms of productive efficiency - this is wrong and in 2010 misled many candidates! All points on the PPF are efficient.

So what is the lesson?

In a word it is all about price.

Any system can be adopted to deal with scarcity. The method chosen in Australia is the market system. 

This means that each good and service has a price. If you can afford the price then you can have it.

So how does price allocate resources between alternative uses? The answer is that your income is like votes. One dollar equals one vote.

Households compete with each other for the goods and services produced because they are scarce. The more votes a good gets the higher the price it can command and as the price rises some people decide not to buy. The scarce resources of Australia are allocated to the uses which people will pay most for.

It may not be fair but it works.

So the prices we pay in the shops are due to scarcity. If there was no scarcity all goods and services would be free and Grand Final tickets would be available to all who want them. We can dream.

Here are a couple of Youtube links. One is a 15 minute lesson, very useful for revision too.

Scarcity, Opportunity Cost and the PPC - 15 mins

Scarcity and choice - 4.5 mins