The economic problem

Human wants are unlimited; the resources available to satisfy them are finite. That is the economic problem: scarcity forces choice, and every choice has a cost. Economics is the study of how societies answer three questions: what to produce, how to produce it, and for whom.

• Economic good — scarce, so it has an opportunity cost and commands a price (a loaf of bread, a doctor's time).
• Free good — unlimited in supply at zero price, so no opportunity cost (sunlight, air on a hillside). Genuinely free goods are rare; clean air, for example, is now arguably scarce.
• Needs are required for survival (food, shelter); wants are everything else. Economics does not privilege one over the other — it studies how both are satisfied.

Three economic agents make the decisions:

• Households — supply factors of production, aim to maximise utility (satisfaction).
• Firms — combine factors to produce output, conventionally assumed to maximise profit.
• Government — taxes, spends and regulates, aiming (in theory) to maximise social welfare.

The four factors of production and their rewards:

Free good or economic good?

Positive and normative statements

Economists separate two kinds of claim, and A-level marks turn on spotting the difference.

• Positive statement — objective, factual, testable against evidence. It can be shown true or false. "A 10% rise in the price of cigarettes reduces quantity demanded by 4%."
• Normative statement — subjective, based on a value judgement. It contains an implicit or explicit "should" / "ought" / "fair" / "too much". "The government should raise cigarette duty further."

Exam habit: a statement does not have to be true to be positive — only testable. "Raising the minimum wage always destroys 500,000 jobs" is a positive statement (and almost certainly a false one). Normative statements matter because economic policy is always normative: positive analysis tells you the consequences, a value judgement decides whether those consequences are acceptable.

Positive or normative?

Opportunity cost and the production possibility curve

Opportunity cost = the value of the next best alternative forgone when a choice is made. Not the sum of everything given up — just the best single alternative. It applies to all three agents: a household choosing holiday over car, a firm choosing a new factory over a share buy-back, a government choosing hospitals over defence.

The production possibility curve (PPC) shows the maximum combinations of two goods an economy can produce with its current resources and technology, all resources fully and efficiently employed.

• On the curve = productively efficient; it is impossible to make more of one good without making less of the other.
• Inside the curve = productive inefficiency — unemployed or misallocated resources (e.g. a recession).
• Outside the curve = currently unattainable.
• Movement along the curve = reallocating resources; the opportunity cost is the output of the other good given up.
• Shift outward = economic growth: more/better factors (net investment, immigration, education, new technology). A shift inward follows war, natural disaster or emigration.

The PPC is drawn concave to the origin (bowed out) because of increasing opportunity cost: factors are not perfectly substitutable, so as you push resources into one industry, the least suitable ones have to be transferred and each extra unit costs more of the other good.

Link: the capital-goods / consumer-goods PPC is the classic trade-off between today and tomorrow. Choosing more capital goods now sacrifices consumption today but shifts the whole PPC further out later.

Your turn — opportunity cost on a straight-line PPC

Your turn — increasing opportunity cost

Reading the PPC

Rational choice — and its limits

Standard microeconomics assumes agents are rational: they have consistent preferences, they know their options, and they weigh marginal benefit against marginal cost to maximise their objective (utility for consumers, profit for firms). It is a powerful assumption — it delivers demand curves, supply curves and equilibrium — but the OCR spec asks you to evaluate it, and the evidence is not kind to it.

• Bounded rationality (Herbert Simon) — real agents have limited information, limited time and limited computing power. They do not optimise; they satisfice, taking the first option that is "good enough".
• Rules of thumb (heuristics) — simple shortcuts (buy the brand you bought last time) that usually work but produce systematic errors.
• Biases — anchoring (the "was £80, now £40" tag), loss aversion (losses hurt about twice as much as equivalent gains please), present bias / hyperbolic discounting (over-weighting today, which is why people under-save and over-eat), herding, and the availability bias.
• Altruism and fairness — people give to charity and reject unfair offers even when it costs them money.
• Nudge / choice architecture — if choices are not fully rational, the way options are framed matters. Default auto-enrolment into a workplace pension raised UK participation dramatically without banning anything or changing any price.

Evaluation: irrationality does not make the model useless — it makes it an approximation. Markets can still work well if errors are random and cancel out. The problem is that behavioural errors are systematic and in the same direction, which is precisely when they generate market failure (under-saving, over-consumption of demerit goods) and when a nudge may beat a ban.

Your turn — the true opportunity cost of a choice

Behavioural economics

Economic systems and incentives

Every society needs a mechanism to allocate scarce resources. There are three broad answers.

• Free-market economy — resources are allocated by the price mechanism. Private ownership of the means of production; profit is the incentive; consumer sovereignty decides what is made. Strengths: strong incentives, efficient signalling, innovation. Weaknesses: market failure (externalities, public goods, monopoly), and it distributes by ability to pay, not by need — so inequality can be extreme.
• Planned (command) economy — the state owns resources and directs them by plan. Strengths: can pursue equity, provide public goods, mobilise resources fast. Weaknesses: the planner cannot gather the dispersed information that prices carry (Hayek's knowledge problem), so shortages and surpluses persist; weak incentives; risk of government failure.
• Mixed economy — the real world. Markets allocate most goods; the state provides public and merit goods, regulates, and redistributes. The UK, on any measure, is a mixed economy.

Incentives are the engine. Prices are the incentive that makes firms produce more of what is profitable and consumers economise on what is dear. Change the incentive and you change behaviour — which is exactly why taxes, subsidies and fines are used as policy. But incentives can also be perverse: pay a bounty per rat tail and someone will start farming rats.

Why do planned economies struggle?

Productive and allocative efficiency

Two efficiency concepts run through the whole of Component 1.

• Productive efficiency — producing at minimum average cost; output is made using the fewest resources possible. On a diagram: the firm produces at the bottom of its AC curve; for the economy, it is any point on the PPC.
• Allocative efficiency — resources are allocated to produce the combination of goods society most wants: price = marginal cost (P = MC). The price consumers are willing to pay for the last unit exactly equals the cost of the resources used to make it, so society's welfare (consumer + producer surplus) is maximised.

Being on the PPC is not enough. Every point on the PPC is productively efficient, but only one of them is allocatively efficient — the one that matches what society actually wants. An economy churning out tanks nobody wants at minimum cost is efficient in one sense and a disaster in the other.

Allocative efficiency

Land, capital or enterprise?

Tap a card, then tap the factor of production it belongs to. (Labour is not needed here.)

Match the factor payment to the factor

Tap an item on the left, then its partner on the right.

The big ideas to know

You've now covered the introduction to microeconomics from the OCR A-level Economics (H460) specification. Press Finish to see your score.