RAFFLES INSTITUTION

YEAR 5 H2 ECONOMICS 2019

LECTURE NOTES

CENTRAL PROBLEM OF ECONOMICS

CONTENTS:
ECONOMICS

1. What is Economics?

2. Scarcity, Choice and Opportunity Costs

3. Rational Decision-Making by Economic

Agents

4. The Production Possibility Curve (PPC)

Model

This series of lectures provides an introduction to economics and the central

problem of economics: scarcity. Faced with limited resources and unlimited wants,
economic agents have to make choices. However, this results in trade-offs and
opportunity costs.
 RAFFLES INSTITUTION
YEAR 5 ECONOMICS 2019
CENTRAL PROBLEM OF ECONOMICS
Outline of Contents

1 What is Economics?
1.1 Introduction to Economics
1.2 Microeconomics vs. Macroeconomics

2 Scarcity, Choice and Opportunity Costs

2.1 Scarcity
2.2 Resources
2.3 Inevitability of Choices - Making Rational Choices

3 Rational Decision-Making by Economic Agents

3.1 Objectives of Economic Agents
3.2 The Decision-making Framework
3.3 Decision-making on an Economy-wide Perspective

4 The Production Possibility Curve (PPC) Model

4.1 Scarcity
4.2 Choice
4.3 Opportunity Cost
4.4 Efficiency
4.5 Movements from a point within to on the PPC
4.6 Factors causing shifts of the PPC

5 Conclusion

Appendix
1 The Economic Decision-making Process

References
 Sloman, J., Economics, 8th Edition, Hertfordshire: Prentice Hall*
 Beardshaw, J., Economics: A Student’s Guide, 5th Edition, Pearson Education*
 Mankiw, Quah& Wilson, Principles of Economics: An Asian Edition: Cengage Learning* Lipsey
& Courant, Economics, 11th Edition, Harper Collins
 Colin Bamford & Susan Grant, Cambridge International AS & A Level Economics, 2 nd Edition,
Cambridge
 Joycelyn Blink and Ian Dorton, IB Diploma Program, Economics (course companion),Oxford
 www.tutor2u.net
* Primary References

Lecture Objectives:
After the series of lectures, students should be able to:
- Differentiate between microeconomics and macroeconomics
- Differentiate between positive and normative statements
- Explain the central problem of economics (scarcity) and the inevitability of choice by
economic agents
- Define and explain the concept of opportunity cost and the nature of trade-offs in the
allocation of resources
- Explain rational decision making by economic agents
- Use the PPC model to explain and illustrate:
o Scarcity, choice and opportunity cost
o Attainable and unattainable points
o Efficiency
- Explain and illustrate the effects of changes on the PPC curve

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Central Problem of Economics

1 WHAT IS ECONOMICS?

1.1 INTRODUCTION TO ECONOMICS

Economics is commonly understood as a social science that is concerned with the

production, distribution and consumption of goods and services.

- The production of goods and services: how much the economy produces,
both in total and of individual items; how much each firm or person produces;
what techniques of production are used; how many people are employed.
- The consumption of goods and services: how much the population as a
whole spends (and how much it saves); what the pattern of consumption is in
the economy; how much people buy of particular items; what particular
individuals choose to buy; how people’s consumption is affected by prices,
advertising, fashion and other factors.

Economists often attempt to construct theories or models which are then used to
explain and predict. These models show simplified relationships between various
economic phenomena. For example, a model of a market shows the relationships
between demand, supply and price. Although most models can be described verbally,
they can normally be represented more precisely in graphical or mathematical form.
However, it is important to note that many of these models have shortcomings as they
are based on a set of assumptions and are unable to perfectly model what happens in
the real world all the time.

1.2 MICROECONOMICS VS. MACROECONOMICS

Economics is traditionally divided into two main branches– macroeconomics and

Note:
microeconomics, where ‘macro’ means big and ‘micro’ means small. We will be focusing on
Microeconomics in Year
- Macroeconomics is concerned with the economy as a whole. It is thus 5 and Macroeconomics
concerned with aggregate demand and aggregate supply. By ‘aggregate in Year 6.
demand’ we mean the total amount of spending in the economy, whether by
consumers, by customers outside the country for our exports, by the
government, or by firms when they buy capital equipment or stock up on raw
materials. By ‘aggregate supply’ we mean the total national output of goods
and services.

- Microeconomics is concerned with the individual parts of the economy such

as the behaviour of individuals and firms. It is concerned with the demand and
supply of particular goods and services.

POSITIVE VS. NORMATIVE STATEMENTS

As you read deeply into economic issues, it is vital that you are able to distinguish
between positive and normative statements.

- A positive statement is a statement of fact. It may be right or wrong, but

its accuracy can be tested by appealing to the facts. Positive economics
could be defined as a branch of economics that describes and explains
economic phenomena, focusing on facts and cause-and-effect behavioural
relationships and includes the development and testing of economic
theories.

- A normative statement is a statement of value: a statement about what

ought or ought not to be, about whether something is good or bad, desirable
or undesirable. They cannot be proved or disproved by a simple appeal
to the facts. Normative economics could be defined as the branch of
economics that expresses values judgements about economic fairness.

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2 SCARCITY, CHOICE AND OPPORTUNITY COST

2.1 SCARCITY

All societies face the basic problem of scarcity which arises from limited resources
and unlimited wants.

2.2 RESOURCES Remember:

Use the acronym
At any one time the world can only produce a limited amount of goods and services. C-E-L-L to remember
This is because the world only has a limited amount of resources. These resources, or the various factors of
production.
factors of production as they are often called, are of four broad categories.

 Capital
Capital typically refers to physical capital. This refers to man-made resources and
include factories, machines, transportation and other equipment.

Physical vs. Financial Capital

Economists are only concerned with physical capital and NOT financial capital.
Financial capital refers to financial assets such as bonds, stocks or bank
deposits.

 Entrepreneurship
An entrepreneur is one who performs the functions of organising and managing
the factors of production, innovating new products and ways of production and
taking the risks of being in business. In other words, the entrepreneur takes overall
responsibility for the decision-making process in the firm so that other factors of
production could be combined to provide a good or service.

 Land
Land refers to all the natural resources available, which could be renewable or
non-renewable in nature.
Renewable resources (e.g. wind & water) renew themselves at a fast enough rate
for sustainable economic extraction.
Non-renewable resources (e.g. fossil fuels & mineral ores) do not renew
themselves at a fast enough rate to allow for sustainable economic extraction.

 Labour
Labour, also known as human capital, refers to people, including their skills and
abilities. The quantity of labour available for an economy consists of those who are
able and willing to work. This includes the employed and unemployed.

2.3 INEVITABILITY OF CHOICES – MAKING RATIONAL CHOICES

Because resources are scarce, choices have to be made. Often, choice involves the
sacrifice of alternatives. This sacrifice of alternatives in the production (or consumption)
of a good is known as its opportunity cost, the best alternative forgone as a result of
a decision made.

Evaluating the concept of opportunity cost

 Opportunity cost is subjective.

Opportunity cost differs between individuals and between societies. Only the
individual making the choice can identify the most attractive alternative.

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 Calculating the value of opportunity cost is difficult.

Firstly, we often face difficulties ranking our preferences and putting an exact value
on each one of them. When choosing one option over another, we seldom know the
actual value of what was forgone because the next best alternative is “the road not
taken”. We only know what we expected to give up but not what we actually gave
up.

Secondly, acquiring information about alternatives is often costly and time

consuming. Some choices are based on limited or even wrong information and
hence, some choices turn out to be poor ones. However, at the time we made the
choice, we thought we were making the best use of all our scarce resources,
including the time required to gather information about your alternatives.

 Opportunity cost may vary with circumstance.

Since opportunity cost depends on the alternatives, the opportunity cost of

consuming a particular good or undertaking a certain activity will vary with
circumstance. This is why you are less likely to study on a Saturday night than on a
Wednesday night. On a Saturday night the opportunity cost of studying is greater
because you have more alternative activities, and usually the expected benefit of at
least one of these alternatives exceeds the expected benefit from studying.

 Opportunity cost of a choice includes both explicit and implicit costs

Explicit costs are costs that require a money payment. Implicit costs are costs that
do not require a money payment. Consider the question, “How much does it cost to
go to college for a year?” We could add up the direct costs like tuition, books, school
supplies, etc. These are examples of explicit costs, i.e., costs that require a money
payment for choosing to go to college. However, the explicit cost may only be a
part—and sometimes just a small part—of the opportunity cost of a choice. The
implicit cost is the value of anything other than direct payment that is sacrificed. Time
is usually the biggest type of implicit cost, because time can often be spent earning
money. The amount that the student could have earned if she had worked full –time
rather than attended school is the implicit cost of attending college. Implicit costs are
largely intangible, and can thus be hard to assess.

We will revisit explicit and implicit costs in the theme ‘Firms and Decisions’.

In making decisions or choices, we assume that all economic agents are rational Key Point:
and use the marginalist approach of weighing the marginal costs and marginal Economic decision
benefits of an activity to maximise their net benefit. making involves the use
of the marginalist
principle where
- Marginal benefit refers to the additional benefit derived from undertaking an individuals will only
additional unit of an activity. undertake an activity
- Marginal cost refers to the additional cost derived from undertaking an when MB ≥ MC.
additional unit of an activity.

If the marginal benefit exceeds the marginal cost, it is rational to do the activity (or to
do more of it). If the marginal cost exceeds the marginal benefit, it is rational not to do
it (or to do less of it).

Thus, rational decision-making dictates that an individual should only undertake an

activity if the marginal benefit from taking the action is at least as great as the marginal
cost.

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3 RATIONAL DECISION-MAKING PROCESS BY ECONOMIC AGENTS

Economic agents include consumers, producers and the government. In achieving

their objectives, economic agents must be cognisant of the constraints that they are
operating within. To ensure that the decision made is the best given their constraints,
economic agents must also factor in the costs and benefits of the choices available.
Finally, economic agents actively consider information and perspectives to weigh costs
and benefits.

3.1 OBJECTIVES OF ECONOMIC AGENTS

Key Point:
 CONSUMERS/HOUSEHOLDS A consumer will
consume quantities of a
good up to the point
Faced with a limited income, consumers make decisions on the combination of goods where MU ≥ Price or
and services to consume which maximises utility (or satisfaction). MB ≥ Price. MU
diminishes with
The marginal private benefit of consuming an additional unit of a good is known as additional units of a
marginal utility (the additional satisfaction gained from consuming one extra unit good consumed due to
LDMU.
within a given period of time). Up to a point, the more of a commodity consumed, the
greater will be total utility. However, as one becomes more satisfied, each extra unit
consumed will probably give less additional utility than previous units. In other words,
as the quantity consumed increases, marginal utility falls. This is also known as the
law of diminishing marginal utility. The marginal private cost of consuming an
additional unit of a good is the price paid for the additional unit.

Thus, a rational consumer will thus consume up to the point where marginal
utility/marginal benefit is equal to price and his utility (total) is maximised.

 PRODUCERS/FIRMS Key Point:

A producer will produce
Faced with limited resources (or factors of production), firms have to decide what quantities of a good up
goods and services to produce in order to maximise its profits, where profits = total to the point where MR ≥
MC. MC rises with
revenue – total cost. Firms also have to decide on how to produce these goods and additional units of a
services (i.e. the method of production). good produced due to
LDMR.
The marginal benefit of producing an additional unit of a good is the additional revenue
that a producer receives from selling an additional unit of the good. This is otherwise
known as marginal revenue. The marginal cost of producing an additional unit of a
good is the marginal cost of production. As output rises beyond a certain threshold,
marginal cost rises as factors of production become more inefficient. This is known as
the law of diminishing marginal returns, which states that when increasing amounts
of a variable factor are used with a given amount of a fixed factor, there will come a
point when each extra unit of the variable factor will produce less extra output than the
previous unit.

Thus, a rational producer will produce up to the point where marginal revenue is equals
to marginal cost and profit is maximised.

 GOVERNMENT

A government is an organisation that provides goods and services, and redistributes

income and wealth. The most important of services provided by the government is a
framework of laws and a mechanism for their enforcement. Governments also provide
services such as national defence, public health, transportation and education through
its collection of revenue from taxes, administrative charges, fines and profits of
government related companies.

Faced with government budget constraints (largely determined by tax revenue),

governments will have to prioritise their spending to maximise social welfare (so as to
maximise the number of votes) and achieve both microeconomic and macroeconomic
objectives.

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- Microeconomic objectives include efficiency and equity.

- Macroeconomic objectives include sustained economic growth, price stability,
full employment and a healthy balance of payments.

The marginal benefit of a government’s decision is marginal social benefit while the
marginal cost of a government’s decision is marginal social cost.

3.2 THE DECISION-MAKING FRAMEWORK

Figure 1 Decision-making Framework

The process of decision-making requires every economic agent to be deliberate on

the various choices that are available to the economic agent. This process takes into
account various considerations. Economic decision-making is often made in response
to an economic issue, and the impact of such decisions can be analysed in terms of
intended consequences and unintended consequences.

Economic agents might need to review their decisions should the intended
consequences not turn out as anticipated or if they decide to take account of Note:
unintended consequences, or when changes occur in either the internal or external Please refer to
Appendix 2 for further
environment. The decisions made by economic agents can have multifaceted details on the decision
implications, which have an impact on the other economic agents in the national and making framework.
international economy.

3.3 DECISION-MAKING ON AN ECONOMY-WIDE PERSPECTIVE

Because resources are scarce, choices have to be made. There are three main
Note:
categories of choice that must be made in any society: These 3 key economic
questions need to be
 What and how much to produce? explained whenever
- Since there are not enough resources to produce all the things that people you encounter
questions on how
desire, choices need to be made on what goods and services get to be scarce resources are
produced and in what quantities. Society needs to choose the composition of allocated in an
total output to be produced. For instance, should the economy devote more of economy.
its scarce resources to the production of consumer goods or capital goods?

 How to produce?
- Most goods can be produced by a variety of methods. Choices need to be
made on the composition of resources used and the technology that is to be
adopted. What resources are going to be used and in what quantities? What
techniques of production are going to be adopted?

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 For whom to produce?

- The total output needs to be distributed among members of the society. How
should this distribution be carried out? Should the good be made available for
all regardless of a person’s ability to pay or should its consumption be
restricted only to those with the ability to pay?

The way scarce resources are allocated will differ depending on the system an
economy adopts. Broadly, there are 3 main economic systems:

- Free market economy: Where markets allocate resources through the

price mechanism. An increase in demand raises price and encourages
businesses to use more resources into the production of that good or
service. The quantity of products consumed by people depends on their
income and income itself depends on the market value of an individual's
work. In a free market economy there is a limited role for the government,
indeed in a pure free market system, the government limits itself to
protecting property rights of people and businesses using the legal system
and protecting the value of money or the value of a currency.

- Planned or command economy: In a planned or command system

associated with a socialist or communist system, scarce resources are
owned by the government. The state allocates resources, and sets
production targets and growth rates according to its own view of people's
wants. Market prices play little or no part in informing resource allocation
decisions and queuing rations scarce goods.

- Mixed economy: In a mixed economy, some resources are owned by the

public sector (government) and some are owned by the private sector. The
public (or state) sector typically supplies public, quasi-public and merit
goods and intervenes in markets to correct perceived market failure.
Nearly all economies in the world are mixed although that mix changes
over time for example as some industries are privatised (sold to the private
sector) or nationalised (taken back into state ownership).

We will focus more on the free market economy in the next theme.

4 THE PRODUCTION POSSIBILITY CURVE (PPC) MODEL

The Production Possibility Curve (PPC) model is a useful tool to use when Note:
explaining the concepts of scarcity, choices and opportunity cost. It shows all the The PPC curve is
maximum attainable combinations of two goods that a country can produce within a sometimes known as
the Production
specified time period with all its resources fully and efficiently employed, at a given Possibility Frontier
state of technology. (PPF).

Assume that some imaginary country X devotes all its resources to producing just two
goods – capital goods and consumer goods. Various possible combinations that could
be produced over a given period of time (e.g. a year) are shown in the table below:

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Units of capital goods Units of consumer goods Note:

(millions) (millions) There is typically no
need to illustrate the
8 0 PPC with numbers
when you are using
7 2.2 them to explain
concepts
6 4

5 5

4 5.6

3 6

2 6.4

1 6.7

0 7

Figure 2 Maximum Output Combinations for Country X

Figure 3 PPC for Country X

4.1 SCARCITY

Given the quantity and quality of resources available and state of technology in a Key Point:
country, attainable combinations of the two goods include Points A, B, C, D, E and G. International trade
allows consumers to
consume points
Scarcity is illustrated by the country being able to produce only one of the points on or beyond an economy’s
within the PPC at a given point in time as well as by the unattainable points outside PPC.
the boundaries of the PPC such as Point F. Without trade, consumption is constrained
by the availability of resources in an economy. However, international trade may allow
countries to consume at these points.

4.2 CHOICE

Countries may choose to produce along various points of the PPC. E.g. If Country X
chooses to devote all of its resources to produce capital goods (Point A) or consumer
goods (Point E). It cannot produce at Points A and E at the same time.

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4.3 OPPORTUNITY COST

Reallocating scarce resources from producing one good to another involves Key Point:
opportunity cost. As Country X increases its production/output of consumer goods, Opportunity cost is
fewer resources are available for the production of capital goods. As such, the negative illustrated by the
gradient of the PPC.
gradient of the PPC illustrates the concept of opportunity cost.

The PPC for Country X in Figure 3 is concave to the origin. The opportunity cost
of expanding output of consumer goods measured in terms of lost units of
capital goods increases. Moving from Point B to Point C along the PPC, 1 million
consumer goods are produced at the expense of 1 million capital goods. Thus the
opportunity cost of the 1 million extra units of consumer goods would be the 1 million
units of capital goods forgone. Moving from Point C to Point D, an additional 1 million
of consumer goods produced are now at the expense of 2 million capital goods. Thus
the opportunity cost of the next 1 million extra units of consumer goods would be the 2
million units of capital goods forgone.

This is because resources in an economy are not perfectly suited to the

production of both goods. As the country concentrates on the production of one
good (e.g. consumer good), it has to start using resources that are less and less
suitable i.e. resources that would have been better at producing other goods (in this
case, capital goods). To produce an additional unit of one good means having to move
increasingly greater amounts of resources from the production of the alternative good,
hence the greater amount of alternative good that has to be forgone. There is
increasing opportunity cost of production.

Under what circumstances would the PPC be a straight line?

Since a concave PPC illustrates increasing opportunity cost, a straight-line PPC would
arise when constant opportunity cost exists and all factors of production are perfectly
suited to produce both goods. This is highly unlikely in the real-world.

4.4 EFFICIENCY

Efficiency is a key concept in the study of microeconomics. Given the problem of

scarcity, it is vital that resources are fully and efficiently utilised to meet the unlimited
wants of people as best as possible.

Economic Efficiency = Allocative Efficiency + Productive Efficiency

 Productive Efficiency

The economy achieves productive efficiency when all the available resources are fully Key Point:
and efficiently employed. It is achieved when society produces at any point on the All points on the PPC
production possibility curve (PPC). With reference to Figure 3, Points A, B, C, D and E curve are productively
efficient. However, all
are productive efficient. points within the PPC
are not.
On the other hand, all points inside the PPC are productive inefficient. Point G is
an example of an attainable but inefficient combination. Resources have not been fully
and efficiently employed and the economy is experiencing unemployment or
underemployment. More goods can be produced by increasing the employment of the
idle resources or use them more efficiently.

 Allocative Efficiency

Allocative efficiency is the situation in which society produces and consumes a Key Point:
combination of goods and services that maximises its welfare. It is achieved when the Not all points that are
goods and services that are wanted by the economy are produced in the right productive efficient
quantities. Though Points A, B, C, D and E are productively efficient, only 1 point on are allocative efficient.
the PPC is allocative efficient.

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4.5 MOVEMENTS FROM A POINT WITHIN TO ON THE PPC

Actual economic growth refers to an increase in real national output (quantity of

Key Point:
goods and services produced by an economy). This may lead to greater and more Economic growth
efficient use of existing resources. refers to both actual
and potential
Diagrammatically, this may be illustrated by a movement from a point within to a point economic growth.
on the PPC (e.g. Point G to Point B).

4.6 FACTORS CAUSING SHIFTS OF THE PPC

Potential economic growth refers to an increase in an economy’s ability to produce Key Point:
goods and services (otherwise known as productive capacity). As productive capacity Potential Growth is
increases, the maximum quantities and combinations of both capital and consumer affected by a change
in
goods produced increases thus causing an outward shift of the PPC. Shifts in the - Quality of FOP
PPC may be either in a parallel or non-parallel manner, depending on whether - Quantity of FOP
the change affects the production of both goods or only one good. - Level of Technology

Factors that may affect a country’s productive capacity include: A change in any of
these factors may
also cause an inward
 A change in a country’s quantity of resources shift of the PPC.

An increase in capital stock, inward or outward migration and a government’s efforts

to build infrastructure are examples of factors that may increase the quantity of factors
of production (FOP) in a country. Similarly, a war may decrease a country’s resources.

 A change in a country’s quality of resources

Quality of resources refer to the efficiency or productivity of the factors of production.

E.g. skills upgrading may raise the productivity of workers.

 A change in technology

Technological improvement represents new and better methods of producing goods,

for example, through the use of computers. Technology can increase the productivity
of resources/inputs such that for a given amount of resources/input, more output can
be produced. If the technological change can enhance the production of both goods
equally, there will be a parallel outward shift of the entire PPC (Figure 4). However, if
the technological improvement is in the capital goods industry only, the PPC will shift
in a skewed manner, as shown in Figure 5.

Figure 4 Parallel Shift of PPC Figure 5 Skewed Shift of PPC

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So what affects the extent of Economic Growth in a country?

As mentioned earlier, capital stock plays a significant role in determining the extent of
economic growth that an economy enjoys in the future. However, the production of
capital goods involves postponing current consumption as resources used for the
production of capital goods cannot be used to produce consumer goods, which are for
current consumption. Hence, an economy must decide between producing goods for
current consumption and producing goods for future production and consumption. The
opportunity cost of current consumption is future consumption and production forgone.

5 CONCLUSION

All societies are faced with the problem of scarcity. They differ considerably, however,
in the way they tackle the problem. One important difference between societies is in
the degree of government control of the economy: the extent to which government
decides ‘what’, ‘how’ and ‘for whom’ to produce. At the one extreme lies the completely
planned or command economy, where all the economic decisions are taken by the
government. At the other extreme lies the completely free-market economy. In this
type of economy there is no government intervention at all. The pattern of production
and consumption that results depend on the interactions of all these individual
demand and supply decisions in free markets. In reality, however, all economies
are a mixture of the two. It is therefore the degree of government intervention that
distinguishes different economic systems. Scarcity, however, will remain an issue that
cannot be solved entirely.

TOPIC SUMMARY:

 The central economic problem is scarcity. There is a limited supply of factors of

production (labour, land and capital), and unlimited wants.
 Choices have to be made regarding the allocation of scarce resources and this
incurs an opportunity cost.
 All economic agents are assumed to be rational and weigh the marginal benefits
of each activity against its marginal costs.
 A rational economic agent will consume/produce where their marginal benefit =
marginal costs.
 The decision-making framework shows the process of decision-making which
takes into account various considerations.
 The PPC is an economic framework that illustrates the central problem of
economics.

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APPENDIX 1: THE ECONOMIC DECISION-MAKING PROCESS

The process of decision-making requires every economic agent to deliberate on the

various choices that are made available to them. This process takes into account
various considerations. In achieving their objectives, economic agents must be
cognisant of the constraints they are operating within. To ensure that the decision made
is the best given their constraints, economic agents must also factor in the costs and
benefits of the choices available. In addition, economic agents actively consider
information and perspectives to weigh the costs and benefits.

 Constraints – Due to the fundamental economic problem of scarcity, choices have

to be made. Economic agents have to consider the constraints they are currently
experiencing because this will determine the choices available for them. Based on
these choices, economic agents will decide on the best-ranked choice that enables
them to maximise their self-interest.

 Costs and benefits – Every economic decision is motivated by a set of benefits

as well as a set of costs. In making any decision, every economic agent would
consider the monetary and non-monetary costs and benefits of every available
choice. Economic agents must also consider opportunity cost, defined as the value
of the next best alternative forgone. In weighing the costs and benefits, the
economic agent has to take into account the opportunity cost of a decision and
undertake a decision that offers the maximum net benefits.

 Information – In order to make sound decisions, economic agents have to gather

information, both quantitative and qualitative, on the costs and benefits of every
available choice. It serves the economic agents well to attain a fairly accurate
understanding of the costs, benefits, trade-offs and intended consequences
pertaining to each choice, before making a decision.

 Perspectives – Economic agents do not make decisions in isolation of others,

since the impact on and subsequent reaction of those affected by the decisions
may in turn affect the intended outcome of the decision made. The profit-driven
producer considers the perspectives of the consumers in analysing the
effectiveness of strategies employed, while governments consider the perspectives
of stakeholders in their policy decisions. When attempting to predict how incentives
and disincentives influence human behaviour, economists tend to assume that
economic agents are rational. However, the rationality of economic agents in
maximising their self-interest is not completely free from political or social
perspectives, which raises thought-provoking questions on inclusiveness and
fairness in the decision-making process.

Economic decision-making is often made to tackle or mitigate an economic issue, and

the impact of such decisions can be analysed in terms of intended and unintended
consequences:

 Intended consequences of the economic decision – When economic agents

encounter an economic problem, they would gather information and perspectives
and adopt a marginalist approach, keeping in mind constraints, benefits and costs
to arrive at a decision. This is performed with the expectation that the decision will
achieve its intended outcome and hence resolve the economic issue. The intended
positive and/or negative consequences of an economic decision are assumed to
occur because economists assume rational behaviour and economic conditions
remain unchanged.

 Unintended consequences of the economic decision – While most economic

decisions that have intended consequences, these decisions may result in
unintended consequences as well. Unintended consequences refer to the

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Central Problem of Economics

outcomes that are not intended in the economic decision, and could be anticipated
or unanticipated. Unanticipated unintended consequences may occur because
economic agents may not have made their decisions under perfect information,
due to an inability to have access to complete information or consider all
perspectives, especially when local and global conditions are subject to constant
and unpredictable change.

When unintended consequences occur, the economic decision-making process is

made more complex. In the case of anticipated unintended consequences, economic
decisions may have to factor in measures to manage any adverse impact of these
consequences. In the case of unanticipated unintended consequences, economic
decisions may have to be changed to mitigate any adverse impact of unintended
consequences. As such, in order to maximise their self-interests, economic agents
would have to review their decisions when the intended outcomes are not achieved,
when there are adverse unintended consequences or when there are changes in the
internal and external environment.

 Internal changes – The goals, constraints, information and perspectives of

economic agents can change over time. These are termed as internal changes.
When changes occur, the economic decision undertaken by an agent may no
longer be optimal, calling for the need for the decision-making process to take place
again.

 Changes in the external environment – The decisions made by economic agents

are very much shaped by their external environment. As the external economic
environment is constantly changing because producers and governments seek to
remain competitive in the global arena, economic agents have to undertake the
decision-making process again to ensure that the intended outcomes can be
achieved

Raffles Institution
Economics Department 14