Another important question about the basic economic problems is: How do we make choice in an economy?. At the individual level you must choose among alternatives like,
whether to watch cricket highlights in T.V. or study for another extra hour;
whether to buy a text book for Rs.50 or spend the money for a movie;
whether to help your mother in shopping or play hockey during that time;
It is important to note that choices are made due to scarcity. If there is no scarcity, there would be no need to choose. Similarly as choice must be made from alternatives, it involves comparison of cost and benefit.
When you choose a particular alternative, the next best alternative must be given up. For example, if you choose to watch cricket highlights in T.V., you must give up an extra hour study. The choice of watching cricket in T.V. results in the loss of the next best alternative-an extra hour study instead. Thus by watching T.V., you have forgone the opportunity of scoring an extra five or ten marks in examination.
Thus the 'opportunity cost' is the cost of something in terms of an opportunity forgone (and the benefits that could be received from that opportunity). In other words, the opportunity cost of an action is the value of next best alternative forgone. The consideration of opportunity costs is one of the key differences between the concepts of 'economic cost' and 'accounting cost'. Choices are mostly made on the basis of opportunity cost.
Like the individuals, a society as whole has limited resources. It has to decide what to produce with the limited resource. It has to make choice about the quantity of different commodities. Choice emanates from scarcity. Thus our choice is always constrained or limited by scarcity of our resources. Suppose we have enough resources we can produce all that we want.
All such choices can be made with help of production possibility curve. The production-possibility curve separates outcomes that are possible for the society to produce from those which cannot be produced subject to the available resources.
Let us consider an economy with only so many people, so many industries, so much of electricity and natural resources in deciding what shall be produced and how these resources are to be allocated among thousands of different possible commodities. How many industries are to produce steel? How much electricity to be provided for agriculture; how much for industries?. Whether to provide free electricity to farmer or not? Theses problems are complicated. Therefore, to simplify let us assume there are only two goods to be produced - apples and oranges.
Production Possibility Quantity of Apples Quantity of Oranges
A 4 0
B 3 2
C 2 4
D 1 6
E 0 8
In the above schedule A and E are possibilities where the economy either produces 100 percent of apples or 100 percent of oranges alone. But the production possibility curve assumes the production of two goods in different combinations. Possibilities A, B,C ,D and E are such that the economy produces 4 units of apples and 0 units of oranges in possibility A, 3 units of apples and 2 units of orange in possibility B, 2 units of apples and 4 units of oranges in possibility C, 1 unit of apple and 6 units of oranges in possibility D, 0 unit of apples and 8 units of oranges in possibility E.
Thus we see that if we are willing to have more of oranges, we should be willing to sacrifice more of apples. For instance, to reach possibility C from B, the economy produces 2 units more of oranges by sacrificing 1 unit of apples. A full employment economy must always-in producing one good be giving up something of another. This assumes of course, that at least some resources can be transferred from one good to another.
Such choice of one particular alternative involves opportunity cost of foregoing the other. Hence, the decisions of the society will be based on the comparison of costs and benefits of each alternative. In doing so, both the monetary and social cost and benefit should be the basis of any choice. Thus the one that gives the maximum benefit at minimum cost to the whole society should be the best choice. We can picture the production possibility schedule by drawing a smooth curve (Figure 2.1).
Units of oranges are measured horizontally and that of apples on the vertical axis. The curve A and E depict the various possible combinations of the two goods - A, B, C, D, and E. Thus a list of all the possible combinations of apples and oranges makes up production possibilities. The production possibility curve is also known as transformation curve or production possibility frontier. This curve shows the rate of transformation of one product into the other when the economy moves from one possibility point to the other.
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