C. Basic Concepts

1. Scarcity and Shortage

i) What is scarcity?

• Scarcity refers to a situation where the quantity demanded for a good is greater than quantity supplied at zero price.
• Scarcity is a relative concept.
• Scarcity occurs when resources are not sufficient to satisfy all our wants.
• Scarcity arises because wants are unlimited.

ii)     What is shortage?

• Shortage exists whenever the quantity demanded for a good is greater than the quantity supplied at the prevailing price.
• When there is scarcity, shortage may not exist if the price is high enough.
• Since a rise in price decreases quantity demanded but increases quantity supplied, raising the price of the good can eliminate shortage.
• If the price is P₁, there is no shortage but scarcity still exists.
• If the price is 0, quantity demanded is greater than quantity supplied. scarcity exists.

             

2. Scarce Good and Free Good

i) What is a good?

• Goods are anything that at least one person prefers some to none.
• Goods can be physical or psychological

ii) What is a scarce good?

• It is a good which quantity demanded is greater than quantity supplied at price zero.

 

• It is anything that people prefer more to less.
• It is anything a person is willing to pay a cost (price) for it.
• The amount of scarce goods available is not sufficient to satisfy all people’s wants.
• The scarcity problem only applies to economic goods.
• Economic postulates that we want more than one kind of economic good, and that we are willing to substitute one for the others at the margin.

 

           

 

iii) What is a free good?

• It is a good that is not scarce. (That is, the quantity demanded for a good is not greater than quantity supplied at zero price.)
• It is anything that people do not prefer to have more of them even if its price is zero.
• A free good can alternative uses. A free good can satisfy all our wants of it for all different uses, so no alternatives are given up even though some of it is used in one way and some in others.
• No one will pay for a free good because the amount available is so abundant that everyone’s wants for it is satisfied.
• There is no scarcity problem for free goods.
• There is no such thing as free lunch
• A free-of-charge good need not be a free good even though both of them have no money price.
• Example: Public library is provided free of charge in Hong Kong, but this does not mean that it is a free good. Though the money price is zero, we have in fact to pay a cost for it as scarce resources are diverted from other uses to provide free public library.

 

         

3. Scarcity, Choice and Opportunity Cost

        i) Scarcity and Choice

• As people want more than one kind of scarce good, people are willing to substitute a scarce good for the others at the margin.
• A person makes choice among alternative options under scarcity.

ii) Choice

• Due to scarcity, people are forced to choose.
• An individual makes choice among alternative option under scarcity.
• People have to decide which wants to be satisfied and which wants to be given up.
• Economics studies how people make choice by using scientific method and so economics is a science of choice.
• In making a choice, a person’s decision is affected by the value (advantage and disadvantage of having that option) and cost (opportunity cost) of the option.
• Economists look at the choice problem as a problem of constraint maximization.
• A choice problem is usually made up of the following elements:

a) People’s preference or taste

b) The constraints (i.e. available options) – time, legal, income, information and property right etc.

c)The objection of the decision-maker (i.e. what to maximize)

iii) Opportunity Cost/Cost

• Cost of an action is measured by its highest-valued option forgone
• An individual has to bear a cost in making a choice.
• Cost is measured by the things one forgoes or gives up.
• Example:
• If Peter has 4 choices of how to spend his evening:
• 1^st choice: Attending Andy Lau’s concert
• 2^nd choice : Watching Italian soccer match
• 3^rd choice: Studying Economics
• 4^th choice: Chatting in ICQ
• If Peter is rational, he will choose the 1^st choice, as it gives him the highest value.
• The cost of Peter’s choice is giving up watching Italian soccer match because it is the best alternative forgone.
• Cost changes when the highest-valued option changes
• Example:
• If Peter’s 4 choices of how to spend his evening changes like these:
• 1^st choice: Watching Italian soccer match
• 2^nd choice:        Chatting in ICQ
• 3^rd choice: Attending Andy Lau’s concert
• 4^th choice: Studying Economics
• If Peter is rational, he will choose the 1^st choice, as it gives him the highest value.
• The cost of Peter’s choice is giving up chatting in ICQ because it is the best alternative forgone.
• The price paid for a good may not be the full cost of purchasing it since there are other costs in addition to the money cost.
• Example:
• If Mary watches the movie “Ocean’s 11”. The cost of watching the movie is the price of the ticket and the activity that she gives up to do within the hours of watching the movie. When a choice is made, the highest-valued option forgone is opportunity cost (cost).
• Scarcity implies cost.
• Under constrained maximization, a person cannot take all other choices when he/she gives up his/her favorite choice. So only the highest-valued option forgone in a decision-making is irrelevant.

iv)    Production Possibility Curve/Frontier (PPC/PPF)

a) Definition of PPC

• It is a graphical way to illustrate the basic concept of scarcity, choice and cost.

 

• PPC shows the maximum combinations of two goods that can be produced with the existing resources and technological level in an economy over a period of time.
• The curve does not show the actual output. The economy can only pick up a point on or inside the PPC to produce.
• Wants beyond PPC implies scarcity.
• The economy can produce at combination A or B only.

 

b)     Assumptions of PPC

1)     Fixed factor endowment (resources)

2)     Given level of technology

3)     The economy produces 2 goods only (Good X and Good Y)

 

c)     Construction of PPC

Good Y	0	1	2	3	4	5	6	7	8	9	10
Good X	120	118	114	108	100	90	78	64	48	30	0

 

       

d) Implication of concave PPC

1) Scarcity

• If there is no scarcity, there will be no “boundary” or “frontier”. The economy can produce whatever amount it wants.
• That is, the economy can produce at combination A, B, C or D.
• With scarcity, the PPC divides the diagram into two portions: the attainable and unattainable combinations.

2) Choice

• To maximize the availability of goods, people always try to choose a point on PPC.

3) Full employment of resources

• On the PPC (i.e. combination A), all resources are used and it implies full employment of resources.
• Production is efficient.
• What is productive efficient?
• It refers to a situation in which it is impossible to produce more of a good without leading a reduction of the other goods

4) Unemployment of resources

• Points inside the PPC (i.e. combination B or D) is said to be insufficient which represent unemployment of resources.
• Production is inefficient.
• It can raise the production of one good without cutting down the production of another. (i.e. move from combination D to A).
• The economy is producing below its production capacity.

 

• It is possible to increase the output of both goods. (i.e. move from combination B to A).

                  5) Cost

• On the PPC, production is said to be efficient.
• When the economy is moving along the PPC, a cost is incurred.

6) Concavity and the Law of Increasing Costs – why PPC is concave

• With fixed resources and given technology, when more units of a good are produced, the cost of producing the extra units will increase.
• Example:

Good Y	0	1	2	3	4	5	6	7	8	9	10
Good X	120	118	114	108	100	90	78	64	48	30	0
Cost of producing an extra unit of Good Y	-	2	4	6	8	10	12	14	16	18	30

 

• Imperfect factor substitution
• Costs are rising because of imperfect factor substitution.
• Though resources are versatile, their productivities vary in different jobs.
• A concave PPC shows increasing cost:
• i)      Extra units of Good Y are produced at an increasing cost.

           

ii)     Extra units of Good Y are produced at an increasing cost.

       

 

7) Economic growth

i) Increase resources

• If the amount of resources in the economy increases, even if the technology level remains unchanged, the amount of goods that can be produced increases.
• The PPC will shift outward.

 

 

ii) Improve level of technology     

• If technology level improves, even the amount of resources remains unchanged, the amount of goods that could be produced increase.

a)     Breakthrough in production technology of Good X only

b)     Breakthrough in production technology of Good Y only

       

e)     Measuring opportunity cost on PPC

• The marginal cost of producing Good X in terms of Good Y = ΔY/ΔX = the slope of PPC
• If the PPC is a downward sloping straight line, the marginal cost of producing Good X is a constant.
• If the PPC is concave to the origin, the marginal cost of producing Good X is increasing.

 

4.     Scarcity, Competition and Discrimination

                a)     Competition

                        1)     What is a competition?

• Competition refers to a situation where two or more individuals strive for more of the same economic good.
• Competition exists when two or more individuals want more of the same economic good.
• Competition criterion serves to allocate the available commodities among different individuals.

2)     Scarcity and competition

• In an economy with more than one person, scarcity implies competition and vice versa.
• Since different people will regard the same good as scarce, they will compete for it.
• In a Robinson Crusoe economy (i.e. one man economy), scarcity exists when the available resources are not sufficient to satisfy all wants of Robinson Crusoe. But there is no competition.

3)     Forms of competition

i)      Price Competition

• Price competition refers to situations that people compete for scarce goods by means of offering the owner other scarce goods.
• Goods and services are allocated to the highest bidder under price or market system.
• That is people who are willing and able to pay the market price will get the thing they want.
• This result in allocative efficient because the commodity will be in the hands of the highest-value users.

 

• What is allocative efficient?
• It is a state when it is impossible to reallocate resources so that a person can gain without loss to others.

                         ii)     Non-price Competition

• Non-price competition refers to situations that people compete for scarce goods through means other than offering the owner other scarce goods.
• Types of non-price competition

1)     Allocation by social customs and traditions

• Example: New Territories Exempted House

                                      2)     Allocation by seniority

• Example: Mortgage loan to teachers

                                       3)     Allocation by beauty

• Example: Miss Hong Kong Pageant

                                      4)     Allocation by religion affiliation

• Example: Christian and Catholic schools prefer to hire teachers of same religions belief

                                              5)     Allocation by academic performance

u        Example: A place at the university

6)     Allocation by sex

• Example: Teaching post in kindergarten

                                              7)     Allocation by violence or physical force

• Example: Get on a MTR train on rush hours

8)     Allocations by queuing or first come first serve.

• Example: Tickets for pop concert

9)     Allocation by lottery or ballot

• Example: Private developers sell flats to prospective buyers.

10)   Allocation by rationing

• Example: Distribution of food to citizens during wartime

11)   Allocation by mixture of competitive criteria

• Example: Primary One admission System
• Reallocation
• In order to “win” or “survive”, people behave differently as governed by the type of competition criteria.

 

• In many mixed economies some goods initially allocated through non-price competition tend to be resold through price competition (legally or illegally)
• Example: Selling of unused garment quotas
• Reallocation is not a bad thing as it ensures that the commodity will then be allocated to its highest-value user.
• Dissipation of Valuable Resources

1)     Non-price competition do not encourage production

• In price competitions, people produce valuable commodities to obtain income before they can bid for goods and services they want.
• That is people have to be productive.
• Non-price competitions may not encourage production of goods and services.
• Example: queuing leads to waste of time. People could use the time for productive activities.

                                                2)     Non-price competition may lead to wastage of resources

• Resources that are wasted in deciding who enjoy the commodities produced.                                    

                b)     Discrimination

• Scarcity implies competition and discrimination.
• As people compete for scarce goods, some sorts of criteria will emerge to separate the losers from the winners.
• Only those who can meet the criteria can get the goods.
• The criterion of a competition is discriminatory because it decides among the competitor who wins and who loses.
• Example: As for the AL examination, the examination results are the criterion of competition. Those who have better grades can get seats in university because they can meet the criterion.
• Under price competition, those who are able and willing to pay a higher price will discriminate against those who are not able and willing to pay.
• Each form of competition favors certain kinds of people while discriminating against others.
• Example: When Distributing free pop concert tickets to people on ‘first-come, first served’ basis, people who are able to withstand the rigours of standing in line and those whose time is less valuable would have the chance to get the tickets.

 

                c)     Inter-dependence of Scarcity, competition and discrimination

• Alchain and Allen stress the inter-dependence of these concepts as follows:

‘Scarcity, competition, and discrimination are inextricably tied together. Any one implies the other two. Furthermore, to think of a society without these is to be a romantic dreamer.’

 

5. Property Rights

• N.S. Cheung classifies the constraints of choice as:

      a) Resources

      b) The law of nature

      c) Property rights

      d) Transaction cost

• What is property rights?
• Property rights are set of rules regulating the behaviour in the competition for economic goods, i.e., the rules of competition.
• What is a property?
• A property refers to any goods that is under competition.
• Property right stem from the competition for scarce goods.
• What is the use of property rights?
• Property rights serve to determine resource distribution among competing users by:

 1) Defining the criterion of competition.

 2) Restricting human behaviour

• Under different property right structure, people’s behaviour may probably change to fit the new criterion.
• Example: After the use of Chinese is sanctioned in most AL subjects, we can predict that those who write poor in English will choose to be examined in Chinese. They may even become winners after the change.
• Private property rights

1) What is private property rights?

• The owner of a property has private property rights if he has:

i) the right to exclude others from the use of it

ii) the right to extract exclusive income from its use

iii) the right to transfer or sell the property to anyone

                        2)Property right arrangements serve to resolve the conflict caused by competition by regulating the behaviour in competition.

• Given that private property rights are well defined, resources allocation will be determined by means of price competition.

3) The relationship between private property rights and market transactions

• Private property rights encourages price competition and market transactions.
• A market is existed when property owners exchange the rights over their properties.
• Market exchange/transaction is the transfer of the rights over a private property.
• Private property rights are the prerequisite for market exchange and price competition.

4) Function of price in private property rights

                                i) Determines resource distribution or income distribution

• Price serves as the criterion for competition.

ii) Coordinates resource allocation by transmitting information

• Price serves as a signal to guide exchange and production
• Example: If the price of residential building increases, wealth maximizing farm owners will sell their lands for developers.

iii) Act as an indicator of comparative advantage and thus a guide of specialization.

iv) Rewards those who act in accordance with the price signals and penalizes those who act otherwise.

• If a person sells pork in a Muslim country, he will lose at least.

 

6. Transaction Cost

• What is transaction cost?
• Transaction costs are institutional costs involved in the capture, defining, policing, and exchange of scarce resources as they encompass all costs involved in the set-up and the operation of all institutional arrangements in the coordination or regulation of human activities.
• Transaction costs exist in any society where people interact and compete.
• Example: Before economic reform, China’s transaction costs are still large as the cost for government to coordinate productive activities and to decide the distribution of resources is significant.
• The choice of institutional arrangement is mainly constrained by transaction cost.