Basic Economic Problems and Concepts
Domain 2 covers the central problems every economy faces and the analytical tools used to express them: scarcity, choice, opportunity cost, the production possibility frontier (PPF) and the allocative role of price in different economic systems.
The central problems
- What to produce - which goods and in what quantities (consumption goods versus capital goods).
- How to produce - labour-intensive or capital-intensive techniques.
- For whom to produce - distribution among households.
- Efficiency and growth - full use of resources and expansion of capacity over time.
Tools
- Opportunity cost: the value of the next best alternative forgone. It is not the same as money cost.
- PPF: shows maximum combinations of two goods given resources and technology. It slopes downward (trade-off), is concave to the origin (increasing opportunity cost) and shifts outward with growth or better technology. A point inside is inefficient; a point outside is unattainable today.
- Economic systems: market (price mechanism), socialist (state planning), mixed (India - public and private sectors coexist).
Worked example
An economy PPF gives these combinations of guns and butter: (0, 100), (1, 90), (2, 70), (3, 40). Moving from 1 to 2 guns costs 20 butter; moving from 2 to 3 guns costs 30 butter. The rising sacrifice illustrates increasing opportunity cost, which is why the curve bends away from the origin. If a new fertiliser raises butter output at every gun level, the whole curve shifts outward.
Traps
- Writing opportunity cost as the money paid; it is the alternative forgone.
- Confusing a movement along the PPF (reallocation) with a shift (growth).
- Saying a mixed economy has no price mechanism; prices operate alongside planning.
- Treating free goods such as air as having opportunity cost.