Lesson 2 - Scarcity, Opportunity Recognition, and Resources Allocation

Economics is a social science discipline with her own history, theoretical traditions, subjects of interest, key concepts, major figures, and methodologies. Similarly, other social science disciplines such as psychology, sociology, and political science are more or less the same. Each has her own set of constructs used in understanding our social world, unlike the natural world, in which humans and their actions in different manifestations are of primary concerns. Nevertheless, as social science disciplines they all share the same approach to put heavy emphasis on the use of quantitative and empirical methods in the study of their subject matters, which means the construction and validation of their theories have to be mathematically formulated and falsifiable by observable and repeatable procedures. Certainly, there are always exceptions to this view of human nature within the different disciplines that would adopt a more humanistic perspective that underplays the scientific approach.

In economics, the primary concerns involve the allocation of scarce resources to meet human wants and needs.

Resources are scarce because their origin or production are of limited supply. Natural resources that come from the ground or the sea such as minerals and fossil fuels are not inexhaustible. Due to environmental pollution, even fresh air and water has also become increasingly hard and costly to obtain.

Besides natural resources, there are production resources that need to be harnessed and combined to produce goods and services. These resources are factors of production (i.e. land, labor, capital, and entrepreneurship) which are also limited in supply. For example, a remote village in rural China where most young people may have gone to the cities to work will have a difficult time supplying fresh workforce to attract foreign investment to set up a factory there.

Due to scarcity in resources, three basic questions have to be answered to ensure effective and efficient allocation:

• For whom to produce
• What to produce
• How to produce

These three questions can be answered at the economy level and also at the entrepreneur level. In a centrally planned economy, the three basic questions are determined by a central government or authority. In a free economy where the entrepreneurs operate, such decisions are done by individual choice. The entrepreneurs must choose what to produce given limited resources.

As an entrepreneur, one has to know the target customers (for whom the product or service should be produced) who are willing to buy one’s products or services. Depending on the target customers, the offering can be consumer goods or capital goods. Consumer goods are produced for personal use by households, whereas, capital goods are produced for the production of other goods and services by businesses. Our toothbrush is an example of consumer good and the heavy machineries and tools used in factory assembly lines are examples of capital goods. So an entrepreneur has to determine whether one is conducting a B-to-C (business to consumer) operation selling consumer goods or a B-to-B (business to business) operation selling capital goods. Either way, the entrepreneur has to ensure the price is acceptable to the target customers and there are enough orders from them to keep the business going.

As there are always uncertainties in the demand for new product or service, being an agent of innovation, an entrepreneur has to decide what product or service to produce will yield the highest return on investment given equally high risk of failure. As a result of scarcity, every decision to produce something implies a decision to forgo the opportunity to produce other things. Preferably, an entrepreneur should choose to produce goods or services that yield the maximum return related to the opportunity cost forgone.

Profit is the return to the risk taken by entrepreneur.

Entrepreneurship is a factor of production that determines how the other factors of production such as land, labour, and capital should be combined to bring innovation to an existing market or the creation of a new market. As there are many ways to combine the factors of production, an entrepreneur has to be knowledgeable to list all the alternatives.

Should the business obtain fund from crowd funding platform, a bank’s line of credit, angel investment, or money borrowed from friends and relatives? Should the production be totally performed in-house or partially outsourced to outside contractors? If yes, which part should be outsourced? Should production be highly automated or heavily manual? Where should production take place, Hong Kong or mainland where rent and labour are cheaper? Is it possible to produce remotely? To answer these questions, knowing the alternatives and the costs associated for direct comparison will give a better picture. Cost-Benefit analysis is a useful method for comparison to determine if the total benefits outweigh total costs.

Essential to cost-benefit analysis is the determination of the break-even point where total revenue intersects with total cost. To determine the break-even point, the total revenue line and total cost line have to be plotted to find out where they overlap. The total revenue line is plotted by corresponding the number of units produced at different price point. Whereas, the total cost line is plotted by associating the total cost (fixed cost + variable cost) of production with different quantity. The area above the break-even point where total revenue exceeds total cost shows the profit.

Fixed cost is the cost incurred in production regardless of the number of units produced. For example, rent is considered a fixed cost because the amount paid for occupying the space is not dependent on quantity produced. On the other hand, variable cost is the cost incurred in producing each additional unit. For example, material is a variable cost. Each additional unit of production will consume additional unit of material.

Sunk cost is the cost that cannot be recovered once spent. The R&D expenditure into a technology that has already been patented by a competitor will incur a sunk cost that cannot be recovered. Because the competitor’s patent will prohibit the commercialization of the technology by the late comer.

Marginal cost is the cost involved in making one additional unit. For information goods, the fixed costs are usually very high but the marginal costs are very low, almost close to zero. Therefore, the use of cost-based pricing with a percentage markup on unit cost to each item sold just does not work well with this kind of business such as software and any digital content. So the use of value-based pricing is more preferable in this circumstance.

Major points to recap

d. Economics is a social science discipline that primarily concerns the allocation of scarce resources to meet human wants and needs.
e. An entrepreneur has to decide how production resources such as land, labour, and capital should be combined to bring innovation to the market to meet the needs of one’s target customers.
f. Like an economy, an entrepreneur has to respond to three basic economic questions: For whom to produce; What to produce; How to produce.
g. To an entrepreneur, opportunity cost involves comparing the return (profit) on investment relative to the other alternatives forgone under risk for maximum gain.
h. Essential to cost-benefit analysis is the determination of area above the break-even point where total revenue exceeds total cost.
i. Total cost includes fixed cost and variable cost. In addition to total cost, sunk cost is also a cost that entrepreneurs would consider in production because it can never be recovered.

Questions

a. Due to the abundant supply of free content on the network, what has become “scarce”?
b. Social entrepreneurs will not give up their social mission for profit maximization. What is the implication of this on resources allocation?
c. What is the opportunity cost of an entrepreneur who does e-learning?
d. What are the fixed costs and sunk costs of an online game? What are the risks of a game developer in entering this market?