a) Explain the principal features of a free market economy (10 marks)

A free market economy is an economic system where the allocation of resources and the pricing of goods and services are primarily determined by supply and demand, with minimal government intervention. The key features include:

1. Private Ownership of Resources: Individuals and firms own property and resources, making decisions about their use and allocation.

2. Price Mechanism: Prices are determined by the forces of supply and demand. They act as signals to producers and consumers, guiding resource allocation efficiently.

3. Limited Government Intervention: The government plays a minimal role, mainly to enforce laws, protect property rights, and maintain law and order.

4. Competition: Multiple producers and consumers operate freely, fostering competition that encourages innovation, efficiency, and lower prices.

5. Consumer Sovereignty: Consumers have the freedom to choose what to buy, influencing what is produced based on their preferences.

6. Profit Motive: Firms aim to maximize profits, which drives efficiency and innovation.

7. Flexibility and Adaptability: Prices adjust quickly to changes in supply and demand, allowing the economy to respond effectively to shocks.

Working of the Price Mechanism:
Prices act as signals; high prices indicate scarcity, prompting producers to supply more, while low prices signal surplus, leading to reduced production. Consumers respond to price changes by altering their demand, ensuring resources are allocated where they are most valued.

b) How does the exhaustion of an important natural resource, amidst technological improvements, affect the country's production possibilities curve? (15 marks)

Understanding the Production Possibilities Curve (PPC):
The PPC illustrates the maximum output combinations of two goods or services an economy can produce with its available resources and technology. It reflects trade-offs and opportunity costs.

Impact of Exhaustion of a Natural Resource:

• Shift of the PPC Inward: The depletion of a key natural resource reduces the available inputs for production, causing the PPC to shift inward, indicating a decrease in the maximum attainable output levels.
• Reduced Production Capacity: The economy cannot produce as much as before, leading to lower potential output, particularly for goods or services heavily dependent on the exhausted resource.
• Opportunity Cost of Resource Exhaustion: The loss of natural resources means that the country must forego some production of certain goods, which was previously possible, thereby reducing the overall productive capacity.

Impact of Improved Technology:

• Shift of the PPC Outward: Technological improvements increase efficiency, enabling the economy to produce more with the same resources, shifting the PPC outward.
• Counteracting Resource Exhaustion: If technological gains are significant, they can partially or fully offset the negative effects of resource depletion, maintaining or even expanding production capacity in certain sectors.

Combined Effect:

• The simultaneous occurrence of resource exhaustion and technological improvement creates a complex scenario:
  • The PPC may shift inward due to resource depletion, reflecting reduced capacity.
  • Technological progress may shift the PPC outward, indicating improved productivity.
  • The net effect depends on the relative magnitude of these changes; if technological gains are substantial, they might mitigate the effects of resource exhaustion, resulting in a less pronounced inward shift or even a net outward shift in the PPC.

The exhaustion of a vital natural resource generally causes the PPC to shift inward, indicating reduced potential output. However, technological improvements can offset this decline, either slowing the inward shift or enabling the economy to sustain higher levels of production despite resource depletion.

The Problem of Scarcity and the Role of Economics in Addressing It

1. Explanation of the Problem of Scarcity

Scarcity Defined:
Scarcity is a fundamental economic problem that arises because resources are limited or finite, whereas human wants and needs are virtually unlimited. This imbalance means that society cannot produce enough goods and services to satisfy all desires at once.

Meaning of Scarcity:
It implies that choices must be made about how to allocate scarce resources efficiently among competing uses. For example, land, labor, capital, and raw materials are limited, yet societies desire more goods, better healthcare, improved education, and environmental preservation. The challenge is deciding how to distribute these limited resources to meet various needs and wants.

Implication:
Because resources are finite, every choice involves an opportunity cost—the value of the next best alternative foregone. For example, choosing to build a new hospital might mean fewer resources for infrastructure development elsewhere.

2. Can Economics Solve the Problem of Scarcity?

Understanding the Role of Economics:
Economics is the study of how societies manage scarce resources to satisfy unlimited wants. It provides tools, theories, and frameworks to analyze choices, costs, benefits, and trade-offs involved in resource allocation.

How Economics Assists:

• Resource Allocation: Economics guides decision-makers through methods like market mechanisms, pricing, and planning to allocate resources in a way that maximizes societal welfare.
• Efficiency and Optimization: It offers models such as allocative efficiency, ensuring resources are used where they are most valued.
• Understanding Externalities: Economics helps identify external costs and benefits, enabling policies that internalize social costs, like pollution taxes.
• Trade-offs and Opportunity Costs: It emphasizes the importance of weighing alternatives, helping society make better-informed choices.

Limitations:

• Scarcity Is Inevitable: Economics cannot eliminate scarcity because it is rooted in the very nature of finite resources and infinite wants.
• Uncertainty and Information Gaps: Perfect solutions are hindered by imperfect information, unpredictable preferences, and external shocks.
• Distribution and Equity Issues: Economics can suggest efficient outcomes but does not inherently resolve issues of fairness or equitable distribution.

Conclusion:
While economics cannot solve the fundamental problem of scarcity—since it is an inherent feature of human existence—it provides essential tools and insights to manage scarcity more effectively. It enables societies to make better decisions, prioritize needs, and allocate resources in ways that maximize welfare.

3. Final Assessment

• Scarcity is an unchangeable reality; no economic theory or policy can eliminate it.
• Economics serves as a decision-making aid, helping individuals, firms, and governments choose among competing wants.
• The goal of economics is not to eradicate scarcity, but to maximize the efficient and equitable use of limited resources.

Scarcity is a fundamental problem arising from limited resources and unlimited human wants. Economics does not "solve" scarcity but provides the analytical tools to manage and allocate resources more effectively, helping society to make better choices in the face of this unavoidable constraint.

Opportunity Cost and Social Cost: Explanation and Impact on Government Decision to Develop a New Oil Field in Kribi

1. Opportunity Cost

Definition and Explanation:
Opportunity cost refers to the value of the next best alternative that is foregone when a decision is made. It is not just about monetary costs but also includes the benefits that could have been obtained from the alternative use of resources. For example, if the government allocates land and capital to develop an oil field in Kribi, the opportunity cost might be the benefits from investing that same land and capital into agriculture or tourism instead.

Example:
Suppose the government chooses to develop the oil field. The opportunity cost could be the potential income from tourism if the land were preserved as a national park, or the benefits from expanding agriculture in the region.

2. Social Cost

Definition and Explanation:
Social cost encompasses all the costs to society resulting from an economic activity, including both private costs (borne directly by the producer or consumer) and external costs (costs imposed on third parties or the environment). Externalities such as environmental pollution, health hazards, and loss of biodiversity are key components of social costs.

Example:
Developing the oil field might generate economic benefits such as revenue and employment, but it could also lead to environmental degradation, air and water pollution, and health problems among local communities. These negative effects are social costs because they impact society beyond the direct stakeholders involved in the oil extraction.

3. Impact on Government Decision-Making for Developing the Oil Field in Kribi

a. Considering Opportunity Cost:

• The government must evaluate whether developing the oil field maximizes national benefits. If resources (land, capital, labor) could generate higher returns elsewhere, such as in agriculture or renewable energy, then the opportunity cost of pursuing oil development is high.
• For example, if tourism in Kribi, with its beaches and natural scenery, could generate more sustainable revenue than oil extraction, the government might decide against developing the oil field to avoid foregone tourism benefits.

b. Considering Social Cost:

• The government should also account for externalities associated with oil development. If environmental degradation leads to long-term health costs, loss of biodiversity, or climate change impacts, these social costs could outweigh short-term economic gains.
• For instance, if oil spills or pollution threaten fisheries or local livelihoods, the social costs could be substantial, prompting the government to implement strict regulations or consider alternative development options.

c. Cost-Benefit Analysis:

• The decision involves weighing the economic benefits (such as increased revenue, employment, and energy security) against the opportunity costs and social costs.
• If the social costs are high and the opportunity costs indicate better alternative uses of resources, the government might opt to delay or forego oil development, or implement measures to mitigate environmental damage.

opportunity cost helps the government recognize what they forgo when choosing oil development over other possibilities like tourism or agriculture. Social cost ensures they consider wider societal impacts, especially environmental and health-related externalities. A thorough cost-benefit analysis incorporating these costs would lead to more sustainable and informed decisions regarding the development of the Kribi oil field.

Economic theory is usually developed to help explain economic happenings around us and so we get to talk of the concept of a production possibility frontier (PPF). A PPF shows the maximum combinations of two goods or services that an economy or on economic entity can produce at a given time with its available resources and technology. It is possible to have a PPF with increasing costs, decreasing costs or constant costs. This essay focuses on the most realistic option of a PPF which is that with increasing costs.

In order to derive a PPC with increasing costs, the following assumptions are made:

That an economy can produce only two goods- capital goods and consumer goods ;

That there is a fixed quantity and quality of resources our given period of time;

That there are increasing costs of production or that there are diminishing returns to production or that resources are not perfectly adaptable between different uses.

That technology is fixed.

On the basis of these assumptions, it is possible to envisage the following production possibility schedule and the resultant production possibilities curve.

Production possibilities.

Production possibilities curve

20 40 60 Consumer goods

Points A, B, C and D are points on the PPC while points E is within the PPC. Point F is out of the PPC. Point E can produced when resource are not fully or efficiently used while profit F cannot be produced at present.

A PPG can enable us explain the basic economic concepts of scarcity, choice and opportunity cost.

Scarcity means limited in supply. At a given time and with the resources and technology available, it is not possible to produce output combination F because of scarcity of economic resources as we see this product combination is out of the PPG.

Given that an economy cannot provide all of what it wants, it is bound to make choices. Making a choice means making a decision to take one thing out of some given possibilities. The economy can for instance chose to produce 70 capital goods and zero consumer goods or 50 capital goods and 30 consumer goods etc.

In the process of making a choice, there are opportunity costs. An opportunity cost is the cost of something in terms of the next best forgone alternative. For instance, to move from product combination B to product combination C entails an opportunity cost. Twenty 20 units of capital goods would have to be given up in order to produce 10 additional units of consumer goods. Twenty capital goods are thus the opportunity cost of 40 capital goods.

It is this seen that a PPG can be used to explain the basic economic concepts of scarcity, choice and opportunity cost and may equally be used to explain other concepts like economic growth etc.

A production possibilities frontier or curve (PPC) shows the possible combinations of goods that an economy or an economic entity like a firm or a plant can produce when all its resources are fully and efficiently utilized with its given level of technology. This concept is of prime importance in illustrating the basic economic

concepts of scarcity, choice, opportunity cost as well as the notion of economic growth .A careful explanation of the notion of a PPC with the relevant assumptions would enable us see why it is impossible for a country to increase the production of both capital goods and consumer goods once on its PPC as well as throwing lighten other related issues.

Consider a given country, say Lilyputia for which we proceed to develop its PPC. We further assume that:

The quantity and quality of economic resources available for use in Lilyputia during the year are fixed.

Two broad categories of goods are to be produced i.e capital goods and consumer goods.

Some resources are better adapted to the production of capital goods than to the production of consumer goods. (If we assume all resources are equally efficient or adapted in the production of both goods, then we would have a straight line PPC and not a concave shaped PCC as in this case).

Technology is fixed and does not advance during the year.

On the basis of the aforementioned assumptions, we can come up with the following production combinations for capital goods and consumer goods.

With the help of these production combinations, it is then possible to derive the following PPC by plotting the aforementioned product combinations as shown on

We now assume that this economy of Lilyputia is currently producing 40 units of capital goods and 300 units of consumer goods i.e point B. If the economy now

wants to increase the production of consumer goods to 500 units, it can only do so by reducing the production of capital goods to 20 units so as to produce 200 additional units of consumer goods. In other words, the opportunity cost in this case of producing 200 additional units of consumer goods is 20 units of capital goods. This is so for the simple reason that there is a limit to the amount of consumer goods and capital goods that can be produced at any given time period with available technology and resources etc. This means that more of a good can only be produced by reducing the potential output of the other good. In short, given the assumptions of a PPC as earlier outlined, it is impossible for Lilyputia or for any other country to increase the production of both capital goods and consumer goods at the same time when the country is already on its PPC.

We can further elucidate on the aforementioned point by assuming that Lilyputia is producing at point X which is NOT a point on its PPC but a point INSIDE its PPC. It then becomes possible to increase the production of both capital goods and consumer goods by moving to ANY point on its PPC and by either FULLY and EFFICIENTLY using its resources.

If again we consider another point like point Y which is NOT on Lilyputia’s PPC, it may be possible to produce more of capital goods and consumer goods if and only if there is an outward shift of the PCC. We then talk of economic growth which may have been brought about by say the discovery of additional resources, improved technology, etc.

By way of conclusion, we Can say that given the assumptions of a PPC, it is impossible to produce more of capital goods and consumer goods once on a PPC. If this were to be possible, then it would be a violation of the very concept of a PPC which concept illustrates:

(i)            Scarce resources i.e there is a limit to the amount of what we can produce at a given time with available resources and technology thus obliging us to make a choice;

(ii)            Opportunity costs i.e more of a given good can only be obtained by reducing the potential production of another goods.

The meteorologist just like any other natural scientist can easily “hold other things constant” while studying the effects which changes on X may have on Y. It follows that the predictions of the meteorologist would likely be more accurate compared to those of the poor economist. Given that the economist cannot hold other things constant, the most he/she can do is to assume that other things remain constant and this explains why propositions in economics often begin with the phrase “if other things remain equal” (ceteris paribus).

Although the meteorologist is generally more accurate in predicting weather changes than the economist is at predicting what will happen to the economy, it does not follow that the predictions of the economist are that unreliable. The fact that all people are different is not so much of a handicap to the economist or to the social scientist as it may appear at first sight. While the behaviour of any one person may be unpredictable, this is not necessarily true of the whole group. It follows that the economist is capable of making generalizations about economic groups (workers, investors, producers, importers etc) which are quite dependable guides on their expected behaviour. Econometrics may in the near future render predictions in Economics a little bit more reliable although the accuracy gap between the two sciences is likely to remain

The price mechanism in a market economy is what determines what, how and for whom to produce through the interaction of buyers and sellers. The price mechanism is essentially a process by which buyers express what they want to buy and sellers respond by indicating what they are willing to sell. Their combined activities result in the prevailing market price at which the good or service is exchanged.

Consumers determine what will be produced through their spending decisions, or money votes, i.e. consumer sovereignty. Producers will then produce those goods desired, but since they are profit motivated, they will produce only those goods and services that are profitable. They will use the cheapest and most effective combinations of factors of production for maximum profit, and as such determine how the goods are produced. Those consumers, who can pay the price, get to enjoy these goods. In effect, for whom the good is produced is also decided by the market. In this way the price system acts, as it were, like a sophisticated computer, registering people’s preferences for different goods, transmitting these preferences to those responsible for producing the goods, and moving the factors to produce them. Thus the essential feature of the price mechanism or price system is the price signal.

The price system seems to be the best mechanism for allocating resources in many ways.

One advantage is that the price mechanism can run on its own. The fact that its workings are automatic means that there is no need for costly and cumbersome artificial coordination of economic decisions by the government or ruling body, and so massive bureaucratic costs are eliminated.

The aforementioned feature also means that the economy can respond rapidly to changing demand and supply conditions.

The market system is equally very efficient. The whole structure and organization of the market is the most conducive for generating wealth. People are able to work in careers of their own, and can invest in whatever businesses they want. This freedom and the pursuit of self-interest generates economic efficiency.

There is an optimal allocation of resources in that there is economic efficiency. In a highly competitive market situation, there will be both allocative and productive efficiency. This means that the right amount of every commodity is produced and they are produced at the least cost.

The market system is also argued to be the best allocator of resources for society because it allows for private ownership of wealth. This prevents the ruling body from having too much power and in so doing, safeguards the existence of personal liberty and choice. If private ownership of property were limited or controlled, then the ruling body would accumulate wealth and power at the expense of society.

There are however many instances in which the price mechanism has failed to provide the best allocation of resources. When this happens, there is said to be market failure.

One major disadvantage of the price system is that it fails to provide for the poor and the needy because the allocation of resources is based on a consumer’s purchasing power, not need. This results in the production of luxury goods for the rich at the expense of basic necessities of the starving poor. As a result of the inequality of income and wealth, the claims of consumer sovereignty and choice become questionable.

The high level of competition that is necessary for efficient production of goods is also very often absent in the real world. Monopolies and Oligopolies often dominate in markets. They often charge high prices and earn abnormal profit at the expense of consumers.

Advertising and aggressive marketing strategies also disrupt the effective functioning of the price system. This is because demand is distorted by persuading consumers to and even tricking them into buying what these firms are selling.

Another weakness of the price system or market failure arises because of the failure of the price system to take into account both the explicit and the implicit costs of production. Only private costs and benefits are taken into consideration by the price system. It follows that there wouldn’t be a socially desirable level of production of goods without external costs and/or benefits taken into consideration. The practices of some firms may therefore be socially undesirable and bringing about pollution, under and over production etc.

A free market economy will also result in the so called trade cycle, where there are periodical booms and

slumps. This will result in alternating periods of unemployment and inflation. Such instability may discourage investment.

We may end up evoking an ethical objection to the market economy. It is held that a free-market economy, by rewarding self-interested behaviour, may encourage selfishness, greed, materialism and the acquisition of power.

By way of conclusion, it can still be said that the price system or the market economy is by far the most awesome wealth generating economic system mankind has ever known. This is true both in theory and through empirical evidence. The fall of the command economies of the world further strengthens the case for the market system. The price system however has its own weaknesses as earlier pointed out. The best way to allocate resources thus seems to be to have limited government intervention in what is basically a market economy using the price system.