Gr 12: Scarcity, choice and opportunity cost

One of the most quoted definitions of Economics today is perhaps, “Economics is a science
which studies human behavior as a relationship between ends and scarce means which have
alternative uses.”. This Definition was given by Lionell Robbins in 1935.

If we put in simple words, Economics is the study of human bahaviour in relation to their wants.
It studies how human beings manage their scare resources in trying to satisfy their wants.

Scarcity

Scarcity means limitation of the availability of resources in relation to their wants. That means
the available resources are not enough to completely satisfy all the wants.

By now, you must have already learnt that human beings have unlimited wants. And as the
resources with which these wants must be satisfied are limited, we can understand that ‘scarcity’
is the central economic problem of everyone including individuals, firms and the government,
and even the whole world.

Opportunity Cost

If we decide and choose which want to satisfy with the available resource, then there are other
wants we have to leave unsatisfied. We have to forgo something in order to satisfy a want. The
want that is forgone is called the ‘opportunity cost’. It is also known as ‘the next best
alternative’.

The concept of scarcity, choice and opportunity cost can be shown in many ways, at different
levels. For an individual, it may involve choosing the best from the choices available. For
example, a student may have to choose between doing A levels and going for a diploma right
after finishing O levels. Choosing one option means the other option has to be forgone.

A firm may have to choose between different production methods.

A government may have to choose between different development projects.

Inevitability of choices

Each and every level of economic agent (individuals, firms or government) has to make the
choices as all of them are confronted with central economic problem (scarcity). Governments
have to decide on the best possible way to allocate resources (example – where and what kind of
factories must be built), the firms have to decide how to maximize profit (what is the most
efficient way to produce goods) and individuals have to decide how to maximize their welfare
(which goods will give them most satisfaction). In the process of making this choice they have to
give up other alternative so the concept of opportunity cost is applicable for each and every level
of economic agents.

The basic economic questions

There are some basic questions faced by every society. How they are answered depends largely
on the type of economic system the country has. The questions are:

1. What to produce?
What to produce primarily depends on consumers in free market. The consumers choose
the product they like and thus their choices direct the types of production that should be
carried out. The firms will follow this because this is the most profit maximizing
combination.
Sometimes the government too can decide what to produce. The government may decide
to produce an essential good or service which everyone ought to have.

2. How to produce?
This question will be answered by those supplying the goods and services. If the supplier
is a private firm, it will seek to use the method which will give the maximum profit. For
example, production can be done using labour intensive method and capital intensive
method. The private firm will decide on the method which will give lowest average costs.
If the government is the supplier, it may try to use the method which promotes welfare of
the society rather than maximising the profit.

3. For whom to produce?

For whom to produce will also depend on the suppliers (government and private firms).
The consumers are the target of production, but the kind of consumers the firm or the
government wants to target is the question. The government usually produces for the
general public where as the private firms can seek to maximize profit by producing for
the high and rich level customers as well as the general public. In simple words, the
production is done for those who are willing to pay.

Note: among the suppliers, there will also be private individuals(sole traders). Their
objective in production is the same as that of the private firms – that is, to maximise
profit.
Ceteris paribus
Ceteris paribus is a latin phrase which translates to English as “Other things being constant”.
This is an important concept used when discussing various topics of Economics.
Let us look into a scenario. We all know that when the price of a product or a service is reduced,
the quantity demanded of that product or service will increase. Having this in mind, Fareedha
reduced the price of meals served at her restaurant. It was her belief that this would increase
sales. However, during that month, the sales fell. Therefore, could this information be used to say
that, the law of demand does not apply for restaurants? The answer is No. The reason is, that
price is not the only factor which could affect the sales. After she reduced the price, another
restaurant may have opened up nearby, giving her competition. In the meantime, the income of
the people may have fallen or any other thing that is not in her control might have happened. It is
also possible that she needs to look into the quality of the meals served at her restaurant.

Therefore, when comparing the relationship between two variables (the quantity demanded and
price in this example), economists will usually say, “If the price of a good decreases, the quantity
demanded of that good increases, ceteris paribus.”
Do we have to always use the Latin term for this purpose? The answer is no. We can use the
English meaning instead. The Latin phrase is a shorthand that is often used for comparing one
variable’s effect on another, with other things that may affect the outcome of the second variable
remaining the same.

Different allocative mechanisms

As the countries try to allocate their resources, they are faced with the questions of what, how
and for whom to produce. The answer to these questions determine what type of an economic
system a particular country has.

Market Economies Command Economies Mixed Economies

Market Economies

Market Economies is also known as capitalist economies. In this type of economic system, the
questions facing the economy is answered by the forces of demand and supply.
What to produce – What the customer demands.
How to produce – By private companies, the companies decide the most efficient method and
competes with each other to win customers.
For whom to produce – The production is done for those who demand. It is for the customers
willing to pay money to buy the produced goods and services.
Price/ market mechanism which manipulates the allocation of resources or tries to resolve the
three fundamental questions of what, how and for whom to produce. In other words, resources
are allocated through changes in relative prices. Adam Smith referred to it as the “invisible
hands” of the market.
Producers aim at profit maximisation and rely on higher prices as a “green signal” to higher
production. The foundation is the profit motive. Evidently, the production of those commodities
will be more profitable which are demanded more by consumers. There is freedom of choice for
producers and consumers.

Everyone in a market economy acts in self-interest. The factors of production are owned by
private individuals and companies. Government has a very minimal role in the production.

Advantages of market system

1. Market system automatically responds and adjusts to the people’s wants

As we know, in a market system, the price of goods and services are determined by the forces of
demand and supply. If consumers want a particular good or a service, they simply demand for it
and the prices go up, which gives signal for the producers to produce more of that good. If
producers can produce the required amount of that particular good, the price automatically comes
down to normal. Likewise, if people no longer wants a particular good, they simply stop
demanding for it, so that it is no longer profitable for producers to produce that good, so
producers stop producing that good.

1. Wider variety of goods and services

In a market system, producers compete with each other by offering wider variety of goods,
therefore consumers have more choice, this may even lead to lower prices.

1. Competition pushes businesses to be efficient: keeping costs down and

production high.
The aim of firms in a market economy is to make as much profits as possible. In order to do this,
the firms need to be more efficient. Therefore they often use new and better methods for
production, this leads to lower costs and higher output.

1. Government does not have to take decisions on basic economic questions

The market system relies on producers and consumers to decide on what, how and for whom to
produce. Therefore it does not require the government to employ a group of people to take these
decisions

The disadvantages of market system

1. Factors of Production is not employed if it is not profitable

In a market system, producers do not produce a good or a service if it is not profitable. But
sometimes it may be necessary to produce some goods even if it is not profitable. Therefore
Market system will fail in this aspect.

1. Market system may not produce certain goods and services

Private firms in a market system will not be willing to provide certain public goods like street
lights because it is almost impossible to charge any payment from the consumers.
 1. Free market may encourage harmful goods
If there are people in the market who wish to buy dangerous goods like narcotic drugs, the
market will be ready to buy it since private firms will be willing to provide anything that is
profitable

1. Production may lead to negative externalities

When firms are always trying to maximize their profits, they may ignore external costs like
damages to the environment.

1. Free market economy may increase the gap between the rich and the poor
When firms and individuals are able to produce and consume freely, it may make the rich even
richer because they have more decision making power, and the poor may become poorer because
they have less decision making power in the market. The market system allocates more goods
and services to those consumers who have more money than others.

1. Cyclical fluctuations
Cyclical fluctuations are caused by the ever-changing demand and supply conditions.
Sometimes, when producers anticipate a rise in demand for certain goods, they raise investment
to produce more. But if demand actually does not rise, a general glut will occur, that is, stock
accumulation. Consequently, the affected producers will have to reduce investment, dismiss
workers toreduce costs. Both of these have an adverse effect in the economy as a whole. Less
investment meanslower production while lower employment means less consumption, lower
prices and profits. These cumulative effects lead to a lower national income.

Conclusion: It can be concluded that price mechanism determines allocation of resources as per
what consumers want more, which initially sounds right. However, this system cannot be left to
itself because of its various imperfections which undoubtedly necessitate government
intervention.

Problems of transition

Communist countries were known to have centrally planned economic system. However,
communism collapsed in the late 1980s. The countries of the former soviet union (known to have
had communism), after their independence, began to move away from central planning towards
market system, and thus became mixed economies. Economies which are in the process of
moving away from soviet-style central planning to market system are called ‘transition
economies’.

Transition economies undergo a set of structural transformations intended to develop market-

based institutions. These include economic liberalization, where prices are set by market forces
rather than by a central planning organization. In addition to this trade barriers are removed,
there is a push to privatize state-owned enterprises and resources, state and collectively run
enterprises are restructured as businesses, and a financial sector is created to facilitate
macroeconomic stabilization and the movement of private capital.

However, the transition process has its own pains and problems.

Problems of transition when central planning in an economy is reduced

 Rising unemployment
Transition process involves in privatisation of firms. The newly privatised firms face competition
from other firms, and thus try to be efficient. This also means that they will no longer employ
workers more than what is needed and the firms also may try to shift too capital-intensive
production methods. Transition also means that the government also will not employ as much as
before. This will create unemployment at least in the early stages of transition. Whether the
country will be able to solve will depend on its success in the transition process.

 Rising inflation
Many transition economies also experienced price inflation as a result of the removal of price
controls imposed by governments. When this happened, the newly privatised firms began to
charge prices that reflected the true costs of production. In addition, some entrepreneurs
exploited their position and raised prices in an attempt to profit from the situation.

 Inequality
Transition economies probably had a fairly equal distribution of wealth(atleast in the theory)
among the people. However, when the central planning is reduced, inequality tends to increase as
as some exploited their position as entrepreneurs and traders in commodities, while others
suffered from unemployment and rising inflation.

 Corruption and consumer abuse

As the economy starts the transition, the legal system is usually not adequate to prevent
corruption. Loop-holes in the legal system would mean that the markets are not properly
regulated to protect consumers. Market-driven economies will only develop when citizens are
granted extensive property rights, and can protect these rights through the legal process. This was
largely absent in the former communist transition economies.

Production Possibility Curves

Posted by Amir on September 27th, 2014 | Updated on: July 20, 2015

Individuals are limited in what they can buy because the resources available to them are limited.
The societies and countries too are limited in what they can produce with the given amount of
resources. Production possibilities curve is a graphical representation of a combination of two
goods that a country can produce with a given amount of resources.
Production possibilities curve demonstrates that:

 There is a limit to what the society/individual can achieve, given the existing institutions,
technology and resources.
 Every choice the society/individual makes has an opportunity cost – to get more of one
good, we need to give up some of another good – every choice has a tradeoff.
Let’s assume that a country can produce either 15000 units of bags of wheat or 15000 units of
guns or a combination of two goods with the full employment of all its available resources. The
following production production possibilities table shows possible combinations of this country.

Production of Guns (1000 Production of bags of wheat (1000

guns) bags)
15 0
12 3
9 6
6 9
3 12
0 15

This production possibility table shows the opportunity cost of each production choice. It
specifies the alternative outputs that can be achieved with different levels of inputs. This
information is represented on a curve known as Production Possibility Curve as shown below.
The downward slope of the PPC represents the opportunity cost concept.

If all of the economy’s resources such as land, labour and capital were used in producing guns,
then 15000 of guns would be produced and none of wheat would be produced.
Alternatively, if all resources were transferred to wheat production, 15000 units of wheat would
be produced and none of guns would be produced.
If resources were divided between the two industries, then a range of combinations of production
is possible.
To increase production of wheat from 0 to 3000 units, the production of guns must be decreased
to 3000. This opportunity cost remains the same even at the other extreme, where increasing the
production of guns from 12000 to 15000, it still requires that of guns to be decreased by 3000
units of wheat.
In general, along a production possibilities frontier is a straight line, the marginal opportunity
cost is constant, because, the amount of one good we have to give up in order to get the more of
the other does not change. PPF is important analytical tool used by economists to illustrate
various concepts such as, scarcity, choice, opportunity cost, economic
efficiency and economic growth.
PPF and the concept of choice

Different points of PPF denote alternative combination of two commodities that the country
can choose to produce. The points from A to F in the above diagram shows this.
PPF and the concept of production efficiency

PPF also illustrates the concept of efficiency. The combination of goods depicted on the curve
are attainable only if all the resources are fully employed, with the most efficient means of
production possible. All of the points on the frontier such as A and B are said to be productively
efficient, because they are fully utilising the economic resources that they have.
If the economy is producing a combination of products on the PPF, then it is productively
efficient. However, an economy may be operating within the frontier (for example at the point G
in the following diagram), in which case it is productively inefficient. No economy should be
operating within PPF because it would be wasting its resources.

This is because it could produce more of both products by using the existing resources
effectively. Imagine, you are driving around a country and notice lots of factories that were
closing down, high levels of unemployment and shops with very few customers in them; this
economy would be productively inefficient. This can be illustrated using a PPF diagram; for
example, if an economy produces at point C and not G, then it would be making more of both
oranges and sugar canes. Therefore, moving from point G to a point on the PPF involves 0
opportunity cost.
PPF and the concept of scarcity

All of the points in the frontier such as A and B are said to be productively efficient because they
are fully utilizing the economy’s resources that they have. This is attractive because the
resources are being used properly and not wasted. When an economy is productively efficient, it
can only produce an additional unit of one product by producing less of the other product;
resource have to be shifted from one product to the other. This happens because the resources
available in the economy are limited in numbers – meaning that resources are scarce (i.e the land,
capital and the labour in the economy are limited in any given time – and cannot be increased in
the short-run)

The point F will be unattainable. This is because the economy does not have the capacity to
reach that level of production with the available resources. Thus, PPF shows the concept of
scarcity of resources.

PPF and the concept of opportunity cost

Opportunity cost is illustrated by PPF because, along the PPF, to produce more of one good,
production of the other good has to be reduced.

At this stage we consider the difference between shapes of the PPC curves. The difference
between the different PPC curves depends on the opportunity cost. The linear PPC shows
constant opportunity cost and the concave PPC shows increasing opportunity cost.
The above PPF shows that the opportunity cost remains constant as we increase the output of one
good. For example, if we increase the production of wheat, from 3000 units to 6000 units, then
we lose 3000 (12000 – 9000) of guns. If wheat production is increased from 6000 to 9000, then
we lose, 3000 (9000-60000) units of guns once more. (thus an linear PPC will have constant
opportunity costs.
However, a typical PPF is bowed to the origin and shows that, as more of one good is produced,
an increasing amount of the other is forgone – the opportunity cost rises.
This is because, in reality, some resources are better suited for the production of certain kinds of
goods, than for others. The reasoning here is that, when the production of a good requires the use
of a resource that is well suited to its production, but poorly suited to the production of the other
good (using more verses less fertile land) then, increases in production means that resources that
are less and less suitable need to be used. Example, Evan can grow both roses and carnations in
his garden. His production possibility is given below. If he is currently producing 110 roses, his
opportunity cost of producing 40 more roses is:

Choice Number of roses Number of carnations

A 0 155

> 20 carnations

B 60 135

> 26 carnations

C 110 109

> 31 carnations

D 150 78
 > 78 carnations

E 180 0

Each choice is a point on the PPC but taking differences in quantity when moving from one
choice to another, we are actually computing the opportunity cost.

As we can see, the straight line PPC curve has constant opportunity cost. This, however, is not
realistic as no resource will be totally adjustable for the production of both the goods.

A curved PPC is more realistic as the opportunity cost of diverting resources towards product B
leads to a relatively lower increase in the output of the product B and a relatively higher loss of
the product A.

The difference between the shapes of the PPCs as we can see from the above examples, depends
on the opportunity cost. The negative slope of the PPCs indicate that, in order to increase the
output of one good, a country has to reduce the output of the other good.
There are two reasons why economists argue that the PPC must be bowed out.
 The law of diminishing marginal return states that as we add more and more
resources(variable factors in the short-run) to a particular factor (fixed factor), the output
will, at first, increase and then eventually decrease.
 Not all resources are equally suitable for all the industries. If resources are transferred
from good A to good B, initially the resources to be transferred will be those resources
that are more suitable and efficient for B, and those which could be the least efficient for
A. Later, as more of good B needs to be produced, the resources that may be very
efficient for good B and not so efficient for the good B may also have to be transferred.
In this situation the economy loses on both sides. That means the economy is usually
inefficient on both ends of the PPC curve while it is the most efficient when resources are
appropriately allocated for both the goods according to their suitability, which makes the
PPC bowed out.
PPC and the concept of economic growth

Economic growth refers to an increase in the output of goods and services produced in an
economy. The usual measurement for growth is GDP. An increase in Real GDP is therefore
considered as economic growth.
Economic growth can take place in two ways:

– In the short-run, if the economy uses more of its unemployed resources, then it will be able to
produce more goods and service. This is known as short-run economic growth. In this case,
growth can be illustrated by a move from point D to any point on the PPC such as A,B or C.
Such a move does not have any opportunity cost as the economy is not efficient at D.

– The shifts of the PPC outwards are known as long-run economic growth. Once attaining the
output to the level of PPC, that is any point on the curve, an economy can produce more of both
products only by shifting the PPF curve outwards. This means, increasing the amount of both
products that can be produced with the economy’s resources. This is what happens over time
when an economy grows. Economic growth enables more goods and services to become
available to consumers.

An outward(rightward) shift of the frontier might be due to:

=> More training of employees, enabling them to be more productive;
=> Greater investment in in capital goods such as machines and equipment;
=> An increase in the population size, for example, through immigration;
=> Improvements in technology, providing better ways of doing thiings;
=> Discovery of new resources.

Sometimes improvements could happen only in the production of one product, while the other
product could remain the same. For example, if technological improvement is specific to one
sector, but not the other, then then the effect will be biased. This will rotate the PPC outward, but
only in that specified area.
For example, if the improvement in technology only in the cheese production sector, the PPC
will shift outward only from the cheese production output, while the steel output will remain the
same.

While PPC can move outwards as mentioned above, it can also move inwards for the opposite
reasons. For example, man-made and natural disasters can shift or rotate the PPC inwards.

Positive and normative statements

As students of Economics, it is important to distinguish between facts and opinions. Certain
statements in a news article may be the opinion of the writer, while others could posted as facts.
If it is posted as a fact, we can either prove or disprove whether it is true or not. However, we
cannot do so with opinions.

Positive statements are those statements which can be either proved or disproved with reference
to facts. For example, the statement, “government-provided healthcare increases public
expenditures” is a positive economic statement, because it can be proved or disproved by
examining healthcare spending data in countries like Canada and Britain where the government
provides healthcare.
Other examples of positive statements are:

 A fall in income will lead to more people buying fake products

 Increase in advertising will increase demand for luxurious goods
 A reduction in income tax will improve the incentives of the unemployed to find work
Normative statements are those statements that cannot be either proved or disproved with
reference to facts.
For example, the statement, “government should provide basic healthcare to all citizens” is a
normative economic statement. There is no way to prove whether government “should” provide
healthcare; this statement is based on opinions about the role of government in individuals’ lives,
the importance of healthcare and who should pay for it.
The extent to which governments are involved in the economy is a normative issue, ie a matter of
opinion, requiring a value judgment. Economic analysis tends to be more concerned with
positive issues, ie statements of fact that can be tested against real-world evidence. For example,
the USA has a predominantly private healthcare system, where people have to pay directly for
their treatment, whereas the UK has a predominantly publicly-provided healthcare system (the
NHS). To say that the UK’s approach is ‘fairer’ is essentially a matter of opinion, ie a normative
issue. To say that the amount spent per head on healthcare in the UK is less than that in the US is
a positive issue.

Factors of Production

Factors of Production are the resources used for the production of goods and services.

Production is known as any type of activity that has an economic value. Any activity that
generates money or income.

Land
In Economics, land has a wider meaning compared to the English meaning of the word ‘land’. In
economics, land consists of all the natural resources. For example, the atmosphere, the seas, soil,
everything on the seabed etc.

The price given for the land is usually called ‘rent’

Labour

Labour is the all human efforts in the production. Labour does not only mean the labourers in an
industrial site. If we take an example of a tourist resort, labour includes the receptionists, bell
boys, bartenders, waiters, admin assistants, telephone operators etc.

The price given for the labour is usually called salaries and wages

Capital

Capital is the investment given to the business by the owner. It includes money input by the
owner plus the fixed assets such as machinery and tools used for the production.

The price of the capital usually is interest payments.

Entrepreneur

An entrepreneur is a person or a group of people who bring together all the other factors of
production. For example, the manager in a company gives direction to the plumbers, supervisors,
admin assistants. He also manages the finance in the business and thinks of ways of increasing
profit. The manager here is the entrepreneur.

Division of Labour/Specialisation

Division of labour enabled workers to become specialised for specific jobs. Division of labour
means the work is divided into smaller tasks and each task becomes the work of one individual
or group of workers. When this happens, each worker who took that special task becomes
specialised at that task and quickly masters the art of performing that work.
Benefits of specialisation for the individual

1. More goods and services can be produced.

When workers become specialists in the jobs they do, repetition of the same operations increases
skill and the speed of the worker and as a result, more is produced.
2. Full use is made of everyone’s abilities.
With specialisation, there is greater chance that people will be able to do things at which they are
best and which interest them most. This means people can become perfect in their special
abilities.
3. Time is saved.
If a person has to do many different tasks or operations, then much time will be wasted switching
from one task to another. With specialisation time is saved by not having to move around.
Time also can be saved when training people. It would be difficult and time consuming to train
somebody to do all the tasks required to build a complete car, but a person can be trained quickly
to fulfil one operation of the process.
4. Use of machinery.
As labour is divided into specialised tasks, specialised machinery can be used which is further
increase the productivity.
Disadvantages of specialisation to the individual

1. Work may become boring.

A worker who performs the same operation each and every day is likely to get very bored.
2. People become too dependent upon each other.
Due to specialisation, no single person alone is able to complete the production process. It also
means that people have to rely on others for the provision of goods and services.
3. Lack of variety.
Though the number of goods produced increases but they are identical or standardized.
4.Lack of mobility
Due to specialisation workers might find it difficult to switch between occupations.

Money and Exchange

Definition: Money is anything which is universally acceptable as a medium of exchange.

Therefore if we can buy goods and services with it then it could be seen as money.
In ancient age, before people started to use money, barter system was used to exchange goods for
one another. Barter system was useful because it allowed people to exchange what they had in
excess for things which they did not have. However, there were problems of barter system. For
example, how many goats would be exchanged for one cow? How many bags of rice for one bag
of wheat flour?

There was also another problem, if A has rice, and wants wheat flour, B has wheat flour but
wants only fish, then barter system cannot satisfy their wants, unless there is C who has fish and
wants rice. So A has to go to C and exchange rice for fish and then only A can go to B to get the
fish exchanged for wheat flour.
The creation of money solved this problem.

Read the story “The Goldsmith Who Became a Banker — A True Story” to get an idea of how
people started using money in ancient days.
Also read A brief history of Money
Functions of money

Medium of Exchange – When money is used to intermediate the exchange of goods and
services, it is performing a function as a medium of exchange. It thereby avoids the inefficiencies
of a barter system. Exchange is easier and less time consuming in a money economy than in a
barter economy.
Measure of Value / Unit of Account – e.g. 1 apple = MVR5, while a can of Redbull = MVR25.
In a barter system (as described above), even if a double co-incidence of wants is found, there is
no common unit of measure. In today’s world, each and every country has money. Therefore,
determining the relative prices is very easy and quick.
Store of Value – To act as a store of value, a money must be able to be reliably saved, stored,
and retrieved – and be predictably usable as a medium of exchange when it is retrieved. The
value of the money must also remain stable over time.
Standard for deferred payments – Money is also inevitably used as the unit in terms of which
all future or deferred payments are stated. Future transactions can be carried on in terms of
money. The loans, which are taken at present, can be repaid in money in the future. The value of
the future payments is regulated by money.
Characteristics of money

1. Durability
Money must be durable, which means it should be usable for a long time and must be of good
quality. It should not be something that gets damaged easily or spoiled in a short period of time.
Since money is durable, it can be used as a store of wealth/value.

1. Scarcity
Since anything to have economic value, it must be scarce. Money is scarce and that’s why it has
value. People can accept something as money only if it has value.

1. Portability
Money must be something that people can easily carry with them from one place to another.
Today paper currency is used instead of gold and silver because paper currency is more portable.

1. Acceptability
Money must be something that everyone can accept for a unit of account and medium of
exchange.

1. Divisibility
Money must be something that can measure all the goods and services accurately. For this
purpose, money must be something that we can divide into small denominations.

1. Stability
Money must be something which has a relatively stable value over time. It should not lose its
value over time. Its function as a store of value can be fulfilled only if its value is stable.

Classification of goods and services

Goods and services can be classified into various categories based on their nature of scarcity.

Free Goods

A free good is available in abundance to people. Consumption of a free good does not arise in an
opportunity cost.
Examples of free goods are air, water etc. Sometimes, a good maybe a free good in one country
where as it may become an economic good in another country in which the consumers have to
pay to use it.
Sometimes a good may be given away free of charge, but it still may not be a free good if the
production and the use of that good involves opportunity cost. For example, free gifts given
away in promotions by companies. Sometimes a consumer may not have to pay for a good
because it is already paid by the taxes, in that case it still involves opportunity cost, and therefore
it is not a free good.

Private Goods (Economic Goods)

A private good or an economic good is a good which is scarce and the consumer has to pay a
price to get that good. Most of the goods which satisfies human wants are economic goods.
Anything that has money value, and anything that is scarce, and which satisfies human wants is
an economic good.

Public Goods

There certain goods and services which cannot be produced by the private sector (which is
driven by the profit motive. For the private sector to supply something, the consumers need to be
charged so that the costs can be covered and the profit achieved.
The use of these cannot be charged from the consumer because the consumer who refuses to pay
cannot be excluded from using the good or service. Once provided, everyone can use the good.
This is known as non-excludability. There is also non-rivalry in consumption of such goods.
One person consuming the good does not reduce the amount available for others to consume the
same good.
Merit Goods

A good where people underestimate the benefits of consuming. Merit goods usually
have positive externalities. These are the goods, the consumption of which, are good for the
society as a whole.
These goods maybe under consumed because of the lack of information. In the same way, people
maybe consuming demerit goods because they don’t know that those goods are not so beneficial
to the society and even to them.
Eg. Education is a merit good. People underestimate benefits of studying and so there is under-
consumption.

Merit goods may be provided in a free market – but in insufficient quantities.

Merit good should not be confused with ‘public goods’. Merit goods do not have the
characteristics of non-rivalry and non-excludability.

Demerit goods

Demerit goods are the opposite of merit goods. A demerit good is defined as a good which can
have negative effects on the consumer – but these damaging effects may be unknown or ignored
by the consumer. Demerit goods usually have negative externalities – where consumption of
them causes harmful effect to a third party or to the society as a whole. Cigarette, other tobacco
products, alcohol and narcotic drugs are examples of demerit goods.