PPC, Marginalist Principle

THE CENTRAL PROBLEM OF ECONOMICS AND ECONOMIC SYSTEM

1 INTRODUCTION

2 FACTORS OF PRODUCTION

3 SCARCITY, CHOICE AND OPPORTUNITY COST

4 PRODUCTION POSSIBILITY CURVE

4.1 Production possibility curve, scarcity, choice and opportunity Cost

4.2 Movement along the PPC versus shift in the PPC
4.3 Concave shape of the PPC and increasing opportunity cost
4.4 Efficient allocation of factor inputs

5 ECONOMIC SYSTEM

5.1 Market system (Free market system)

5.2 Command system (Centrally planned system)
5.3 Mixed system
5.4 Advantages and disadvantages of economic systems

 land, labour, enterprise, capital

limited resources (factor inputs)

1 INTRODUCTION needs —> food, water, shelter
unlimited human wants
satisfy these needs —> free from (absolute) poverty
Economics is the study of how society allocates limited factor inputs to produce goods and
services to satisfy unlimited human wants.
Scarcity —> central problem of economics
There are two main branches of economics: microeconomics and macroeconomics.
Microeconomics is the branch of economics which deals with the analysis of individual parts of the
economy. It concerns factors determining the behaviour of a consumer, the behaviour of a firm, the
demand for a good, the supply of a good, the price of a good, the quantity of a good, the
performance of a market, etc. Macroeconomics is the branch of economics which deals with the
analysis of the whole economy. It concerns factors determining aggregate variables such as
aggregate demand, aggregate supply, national output, unemployment, inflation, the balance of
payments, etc. As opposed to microeconomics which focuses on the individual parts of the
economy, macroeconomics looks at the big picture of the economy.

Positive and Normative Economics

Economists often distinguish between positive economics and normative economics. Positive
economics is concerned with facts. It tells us what was, what is or what will be. Disagreement over
positive economics can be settled by an appeal to facts. In other words, positive economics is
verifiable.
verified to be true or false as the variables are measurable
Consider the following statement: ‘The continued price uptrend of the property market reflects the
very low interest rate environment and continued income growth in Singapore’ true
HDB resale price (2021) —> increased 12.7%, private property price (2021) —> increased 10.6%
In the above statement, price trends of the property market, interest rate and income are
measurable components and hence the statement is verifiable. Therefore, the statement is a
positive statement. It is important to take note that a positive statement can be true or false. What
makes the statement a positive statement is not that it is true but that it is verifiable. In fact, the
statement is true. 40k / year principal
$1m loan over 25 years 1% -> 10k, 2% -> 20k
Normative economics is concerned with value judgments. It tells us what should be. Disagreement
over normative economics cannot be settled by an appeal to facts. In other words, normative
economics is not verifiable.

Consider the following statement: ‘The government should impose taxes on the use of single-
plastics as it is the most effective measure to reduce plastic usage.’

In the above statement, the words “should” and “most effective” indicate opinions and value
judgements, which can be argued based on various factors and criteria. Therefore, the statement is
a normative statement. It is important to take note that a normative statement cannot be proven to
be true or false by appealing to facts as it is not objective in nature. price Do So

Economic goods and free goods

Goods can be broadly classified into free goods and economic goods.
Qty
Free goods are goods that exist in quantities that are more than sufficient to meet demand at a
zero price. In other words, for a free good, at a zero price, the quantity supplied is larger than the
quantity demanded. Thus, free goods have a zero price. The opportunity cost of producing a free
good is zero. Examples of free goods are desert sand and sea water.

Economic goods are goods that exist in quantities that are less than sufficient to meet demand at a
zero price. In other words, for an economic good, at a zero price, the quantity demanded is larger

 So
Po
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than the quantity supplied. Thus, economic goods have a positive price. The opportunity cost of
producing an economic good is positive. Examples of economic goods are shoes and computers.

Private goods are goods that are excludable and rivalrous. They have a positive price. A good is
rivalrous when the consumption of the good by a consumer will reduce the amount available to
other consumers. In other words, an extension of the good to one more consumer will reduce the
amount available to current consumers. A good is excludable when the person who pays for the
good can prevent those who do not from consuming it. Most economic goods are private goods.
However, some economic goods, known as public goods, are non-excludable and non-rivalrous.
The characteristic of non-excludability leads to the free-rider problem which results in non-
provision of public goods. Therefore, public goods are provided by the government and hence
have a zero price.

Note: In addition to private goods and public goods, economic goods also include club goods and
common resources. Club goods are goods that are excludable and non-rivalrous such as cable
television. Common resources are goods that are non-excludable and rivalrous such as fishes in the
sea.

2 FACTORS OF PRODUCTION (resources)

At any one point in time, the economy can produce only a certain amount of goods and services
because the amount of factor inputs is limited. These factor inputs fall into four categories known
as the four factors of production: land, labour, capital and enterprise.

Land
Land refers to the gifts of nature that are used to produce goods and services. It includes plots of
land, natural resources, fishes in the sea and trees in the forests.

Labour
Labour refers to the physical and mental effort that people devote to the production of goods and
services.

Capital
Capital refers to the goods that are produced for use in the production of other goods. It includes
factories and machinery.

Enterprise
Enterprise refers to the ability and the willingness to take risk.

The following shows the factor income received by owners of factors of production.

Factor of production Factor income

Land Rent financial capital to start F&B —> >200k / month
Labour Wages
Capital Interest (not capital in economics)
Enterprise Profits

Note: Students should not mix up capital in economics, which is known as physical capital, and
capital in business, which is known as financial capital. Although financial capital refers to the
money needed to start a business, physical capital refers to factories and machinery.


3 SCARCITY, CHOICE AND OPPORTUNITY COST

Although factor inputs are limited, human wants are unlimited which leads to the problem of
scarcity. Scarcity is the situation where limited factor inputs are insufficient to produce goods and
services to satisfy unlimited human wants. Scarcity necessitates choice. In other words, due to
scarcity, society must choose what goods and services to produce. The opportunity cost of a
course of action is the benefit forgone by not choosing its next best alternative. When a choice is
made, an opportunity cost is incurred. In other words, when society chooses what goods and
services to produce, it is choosing what goods and services not to produce.
e.g. scarcity of time (daily)
Scarcity -> Choice -> Opportunity Cost
24 hours (weekend) -> limited time, unlimited things

4 PRODUCTION POSSIBILITY CURVE

4.1 Production possibility curve, scarcity, choice and opportunity cost

Suppose that there are only two goods produced in the economy. The production possibility curve
(PPC) shows all the different combinations of the two goods that can be produced in the economy
when factor inputs are fully and efficiently employed, given the state of the technology. It is also
known as the production possibility frontier and the production possibility boundary.

no unemployment employed at the least cost method of production

+ 10 -2

+ 10 -3
+ 10
-5

In the above table, A, B, C, D, E and F are the different combinations of Good Y and Good X that
the economy can produce using its factor inputs fully and efficiently.


outdoor dining
restaurants
gradient of PPC —> concave to the
origin (increasing opportunity costs)

constant opp cost

decreasing opp cost

face masks

The above diagram is the PPC. The PPC reflects scarcity, choice and opportunity cost. Although
the points inside and on the PPC are attainable, the points outside the PPC are not. Scarcity is
reflected by the unattainable points that lie outside the PPC, such as point G and point H. The PPC
is a series of points rather than a single point. Choice is reflected by the need for society to choose
among the series of points on the PPC, such as point C and point D. The PPC is downward
sloping. Opportunity cost is reflected by the negative slope of the PPC which indicates that an
increase in the production of one good will lead to a decrease in the production of the other good.

4.2 Movement along the PPC versus shift in the PPC

A change in the tastes and preferences of society will lead to a movement along the PPC which
reflects a change in choice. The tastes and preferences of society may change due to several
factors such as technological advancements and campaigning. For example, the inventions of
smartphones and tablets have led to a change in the tastes and preferences of society from print
publications to digital publications. Healthy living campaigns have led to a change in the tastes and
preferences of society from non-diet soft drinks to diet soft drinks.

An increase in the production capacity in the economy will lead to an outward shift in the PPC
resulting in a decrease in scarcity, and vice versa. When the PPC shifts outwards, some of the
points which were previously unattainable will become attainable. The production capacity in the
economy may increase due to an increase in the quantity or the quality of the factors of production
in the economy. For example, education and training which will lead to greater human capital will
increase the skills and knowledge of labour and hence the production capacity in the economy.
Research and development which will lead to technological advancement will increase the
efficiency of capital and hence the production capacity in the economy.

Note: When the economy moves into a recession, the PPC will not shift. Rather, the economy will


move from a point on the PPC to a point inside the PPC, assuming factor inputs are initially fully
and efficiently employed.

A decrease in investment expenditure will not lead to a leftward shift in the PPC. Rather, it will
cause the PPC to shift outwards at a slower rate as firms are still producing new capital. However, if
the amount of new capital falls below the level necessary to replace the amount of worn-out capital,
the PPC will shift inwards.

4.3 Concave shape of the PPC and increasing opportunity cost

The PPC is concave to the origin because the opportunity cost of producing each good increases
as its quantity increases as resources are not equally suitable for producing different goods. As the
economy produces more and more of a good, it has to use resources that are less and less
suitable for producing the good to actually produce the good. This means that increasingly more
units of resources are needed to produce each additional unit of the good. Therefore, increasingly
more units of other goods have to be forgone to produce each additional unit of the good resulting
in an increase in the opportunity cost.

4.4 Efficient allocation of factor inputs

Due to the problem of scarcity, all economies must make three fundamental economic decisions:
what and how much to produce, how to produce and for whom to produce. In making these three
fundamental economic decisions, the objective is to maximise the welfare of society. Efficiency is
one of the criteria used to determine whether this objective is achieved. Economic efficiency is
achieved when productive efficiency and allocative efficiency are achieved.

Productive Efficiency

The economy is productively efficient when it is impossible to increase the production of one good
without decreasing the production of other goods, given the quantity and the quality of the factors
of production in the economy. This happens when resources in the economy are fully and
efficiently employed. In other words, the economy is producing on the PPC. Resources in the
economy are efficiently employed when all firms are productively efficient and are fully employed
when there is no unemployment of resources.

Allocative Efficiency

The economy is allocatively efficient when it is impossible to change the allocation of resources in a
way that will make someone better off without making anyone else worse off. This happens when
the economy is producing the combination of goods and services that maximises the welfare of
society which is determined by the tastes and preferences. In other words, the economy is
producing at the point of tangency between the PPC and the social indifference curve. Productive
efficiency is a necessary condition for allocative efficiency at the level of the economy. In other
words, for the economy to be allocatively efficient, it must be productively efficient. Therefore, the
economy is economically efficient when it is allocatively efficient.

Note: Productive efficiency and allocative efficiency can be discussed at the level of the firm and
this will discuss in the chapter of “Market Structure”. However, they are not the same as the
concepts discussed in this chapter.


5 ECONOMIC SYSTEM

As discussed previously, all economies face the problem of scarcity and hence are required to
make the three fundamental economic decisions of what and how much to produce, how to
produce and for whom to produce. However, economies vary in the way they make these three
fundamental economic decisions in terms of the degree of government intervention. An economic
system is a way of making the three fundamental economic decisions of what and how much to
produce, how to produce and for whom to produce. There are three types of economic systems:
the market system, the command system and the mixed system.

5.1 Market system (Free market system)

The market system is an economic system in which the three fundamental economic decisions of
what and how much to produce, how to produce and for whom to produce are made by private
individuals with no government intervention. The market system is also known as the free market
system, the free enterprise system and the laissez-faire system. The market system was first
advocated by Adam Smith in his famous book, ‘An Inquiry into the Nature and Causes of the
Wealth of Nations’, which was published in 1776. He argues that the pursuit of self-interest will
lead to the benefit of society.

In the market system, all the factors of production in the economy are owned by private individuals.
All economic decisions are made by private individuals. Private individuals can engage in
productive activities, choose what to buy, where to work, etc. There is total economic freedom and
the role of the government is confined to the provision of national defence, maintaining law and
order, issuing currency, etc. Private individuals pursue self-interest. Firms seek to maximise profit,
consumers seek to maximise satisfaction and owners of factors of production seek to maximise
factor income. Competition exists in all economic activities. Firms compete for resources and
sales, consumers compete for goods and services and owners of factors of production compete
for employment of their resources.

In the market system, the three fundamental economic decisions of what and how much to
produce, how to produce and for whom to produce are made by private individuals with no
government intervention.

What and how much to produce?

The fundamental economic decision of what and how much to produce is determined jointly by
consumers and firms through the price mechanism.

Consumers indicate to firms the types and amounts of goods that they want by the prices that they
are able and willing to pay for them. Firms that seek to maximise profit will only produce the types
and amounts of goods that consumers are able and willing to pay for. Therefore, prices signal the
types and amounts of goods that are in demand and hence, the profitability of producing these
goods. This signalling role of prices is the essence of the price mechanism. For instance, when
consumers demand more of a good, the price will rise which will induce firms to produce more of
the good. When this happens, more factor inputs will be allocated to the market. Conversely, when
consumers demand less of a good, the price will fall which will induce firms to produce less of the
good. When this happens, less factor inputs will be allocated to the market. In this way, the
decisions of consumers and the decisions of firms interact to determine what and how much to
produce and hence the allocation of factor inputs.


How to produce?

The profit motive of firms implies that they will choose the least-cost method to produce any
amount of output and this is determined by relative factor prices.

If labour is cheaper than capital, firms will use more labour and less capital in production. However,
if capital is cheaper than labour, firms will use more capital and less labour in production.
Therefore, relative factor prices determine the ways in which goods are produced.

The production process usually involves a high degree of specialisation in the use of factor inputs,
known as division of labour, whereby individuals specialise in particular economic activities – bus
drivers, technicians, electricians, plumbers etc.

For whom to produce?

The market system distributes goods to consumers with the ability and the willingness to pay for
the goods and this is determined by their preferences and factor income.

5.2 Command system (Centrally planned system)

The command system is an economic system in which the three fundamental economic decisions
of what and how much to produce, how to produce and for whom to produce are made by the
government with no involvement of private individuals. The command system is also known as the
centrally planned system. The command system was first advocated by Karl Marx in his famous
book, ‘Das Kapital’, which was published in 1867. He argues that capitalism will fall which will lead
to the rise of socialism and eventually to communism.

In the command system, all the factors of production in the economy are owned by the
government. All economic decisions are made by the government. Private individuals cannot
engage in productive activities, choose what to buy and where to work, etc. There is no economic
freedom. Private individuals cannot pursue self-interest and competition does not exist.

In the command system, the three fundamental economic decisions of what and how much to
produce, how to produce and for whom to produce are made by the government with no
involvement of private individuals. In other words, economic decision-making is centralised. To do
this, the government must choose the combination of goods that it thinks will maximise the welfare
of society, direct resources to produce the goods by planning the output level of each industry,
decide on the method of production and how the goods are to be distributed. The government can
distribute goods directly which is usually done through the issue of rationing coupons, or it can
decide on the distribution of income, in which case, it will decide who should be paid what.

5.3 Mixed system

The mixed system is an economic system in which the three fundamental economic decisions of
what and how much to produce, how to produce and for whom to produce are partly made by
private individuals and partly made by the government. Therefore, a mixed economy is comprised
of the private sector and the public sector. In reality, every economy is a mixed economy. Due to
the flaws of both the market system and the command system, all economies in the world are a
mixture of both economic systems. Even command-oriented economies such as North Korea and
Cuba rely on the market system to some extent and market-oriented economies such as Singapore
and Hong Kong have some degree of government intervention.


In the mixed system, some of the factors of production in the economy are owned by private
individuals and some are owned by the government. Economic decisions are partly made by
private individuals and partly made by the government. Although private individuals can engage in
productive activities, choose what to buy and where to work, they are restricted by the
government. Although there is economic freedom, it is restricted by the government. Although
private individuals can pursue self-interest, they are restricted by the government. Although
competition exists, it does not happen in all forms of economic activities.

In the mixed system, the three fundamental economic decisions of what and how much to
produce, how to produce and for whom to produce are partly made by private individuals and
partly made by the government.

5.4 Advantages and disadvantages of economic systems

Advantages of the Market System and Disadvantages of the Command System

In the market system, allocative efficiency may be achieved as private individuals themselves are in
the best position to know what they want. There will be incentive for workers to work hard and for
firms to be efficient as they will be rewarded with high income and profit. There will fast decision-
making as each private individual only needs to make economic decisions pertaining to their
interest. There will be liberty as private individuals are allowed to choose their ways of life.

The advantages of the market system are the disadvantages of the command system.

Advantages of the Command System and Disadvantages of the Market System

In the command system, allocative efficiency may be achieved as externalities will be taken into
consideration by the government. There will be no unemployment as the government will provide a
job for every private individual. The distribution of income will be equitable as no private individuals
will earn very high or very low income. Public goods will be produced by the government through
taxation. There will be no private firms with substantial market power which can charge high prices.

The advantages of the command system are the disadvantages of the market system.

The Central Problem of Economics and Economic Systems

Question

Using the production possibility curve, explain the concepts of scarcity, choice and opportunity
cost. [10]

Suggested Answer

The concepts of scarcity, choice and opportunity cost can be explained with reference to the
production possibility curve.

Scarcity leads to choice and choice leads to opportunity cost. Although resources are limited,
human wants are unlimited. Scarcity is the situation where limited resources are insufficient to
produce goods and services to satisfy unlimited human wants. Scarcity necessitates choice. In
other words, due to scarcity, society must choose what goods and services to produce. The
opportunity cost of a course of action is the benefit forgone by not choosing its next best
alternative. When a choice is made, an opportunity cost is incurred. In other words, when society
chooses what goods and services to produce, it is choosing what goods and services not to
produce.

The production possibility curve (PPC) reflects scarcity, choice and opportunity cost.
Suppose that there are only two goods produced in the economy. The PPC shows all the different
combinations of the two goods that can be produced in the economy when resources are fully and
efficiently employed, given the state of the technology.


The above diagram is the PPC. Although the points inside and on the PPC are attainable, the
points outside the PPC are not. Scarcity is reflected by the unattainable points that lie outside the
PPC, such as point A and point B. The PPC is a series of points rather than a single point. Choice
is reflected by the need for society to choose among the series of points on the PPC, such as point
C and point D. The PPC is downward-sloping. Opportunity cost is reflected by the negative
gradient of the PPC.

An increase in the production capacity in the economy will lead to an outward shift in the
PPC resulting in a decrease in scarcity, and vice versa. When the PPC shifts outwards, some of
the previously unattainable points will become attainable. The production capacity in the economy
could increase due to an increase in the quantity or the quality of factors of production. For
instance, education and training which will lead to greater human capital will increase the skills and
knowledge of labour and hence the production capacity in the economy.

A change in the tastes and preferences of society will lead to a movement along the PPC
which reflects a change in choice. The tastes and preferences of society may change over time
due to technological advancements. For instance, the inventions of smartphones and tablets have
led to a change in the tastes and preferences of society towards electronic publications.

The PPC is concave to the origin because the opportunity cost of producing each good
increases as its quantity increases as resources are not equally suitable for producing
different goods. As the economy produces more and more of a good, it has to use resources that
are less and less suitable for producing the good to actually produce the good. This means that
increasingly more units of resources are needed to produce each additional unit of the good.
Therefore, increasingly more units of other goods have to be given up to produce each additional
unit of the good.

In conclusion, scarcity is the central problem of economics which every economy faces. The
government should move the economy closer to the PPC and shift the PPC outwards to reduce the
problem.