Explain the economic problem of relative scarcity and how it forces individuals, firms and governments to make choices that carry an opportunity cost.

What this dot point is asking

Economics begins with one stubborn fact. Human wants are effectively unlimited, yet the resources available to meet them are finite. This mismatch is called relative scarcity, and it is the central economic problem that every individual, business and government faces.

The four resources

Economists group productive resources, also called factors of production, into four types. Land is all natural resources, such as Tasmania's farmland, forests and mineral deposits. Labour is human physical and mental effort. Capital is the produced goods used to make other goods, such as machinery, factories and software. Enterprise is the willingness of entrepreneurs to combine the other three resources and bear risk. Because each of these is limited at any point in time, output is limited too.

The three basic economic questions

Every economy, whatever its system, must answer three questions. What to produce, given that we cannot produce everything. How to produce it, choosing between labour-intensive and capital-intensive methods. And for whom to produce, deciding how the goods and services are distributed across the population. In a market economy these questions are answered largely by the price mechanism; in a planned economy by government direction; and in a mixed economy such as Australia by a combination of both.

Opportunity cost

Because resources are scarce, choosing one option means forgoing others. The opportunity cost of a decision is the value of the next best alternative given up. If the federal government spends a billion dollars on a new hospital, the opportunity cost is the school, road or tax cut that the same money could have funded. Opportunity cost applies to everyone. A student choosing to study Economics gives up the time that could have gone to paid work or another subject.

The production possibility frontier

The production possibility frontier (PPF) is the standard diagram for showing scarcity, choice and opportunity cost. It plots the maximum combinations of two goods an economy can produce when all resources are fully and efficiently employed.

• Points on the frontier are efficient: all resources are used and you cannot make more of one good without making less of the other.
• Points inside the frontier are inefficient, signalling unemployed or underused resources, such as an economy in recession.
• Points outside the frontier are unattainable with current resources and technology.

The frontier is usually drawn bowed outward because resources are not equally suited to producing both goods, so opportunity cost rises as you specialise. Economic growth, from more resources or better technology, shifts the whole frontier outward.

Choices at every level

The same logic applies across the economy. Consumers with limited income choose which goods to buy. Firms with limited budgets choose which projects to fund and which inputs to use. Governments choose between competing spending priorities and between spending now and saving for later. When the Reserve Bank of Australia or the Treasury weighs growth against inflation, it is making a scarcity-driven choice with a real opportunity cost.

Understanding scarcity, choice and opportunity cost is the foundation for everything that follows. Markets, government policy and trade are all responses to the same basic problem: how a society allocates limited resources among unlimited competing wants.