Economics – The basic economic problem - Opportunity cost | e-Consult

(a) Consumers make decisions about allocating their income based on their wants and needs, and the relative prices of goods and services. They face a trade-off – they cannot have everything they want due to limited income. Scarcity is a key concept here.

• Budget Constraints: Consumers have a limited budget. They must choose which goods and services to purchase within that budget. For example, if the price of petrol increases, consumers may reduce their spending on leisure activities.
• Opportunity Cost: Choosing to spend money on one item means giving up the opportunity to spend it on something else. For example, buying a new phone means less money for a holiday.
• Income and Preferences: Higher income allows consumers to allocate more resources to goods and services they value. A consumer with a higher income might allocate more to luxury goods or travel.
• Price Changes: Changes in the price of goods and services directly impact consumer choices. If the price of a good falls, consumers are likely to buy more of it.

Examples could include a family deciding between buying a new car or saving for their children's education, or an individual choosing between eating out or cooking at home.

(b) Changes in income significantly affect consumer spending patterns.

• Normal Goods: As income rises, demand for normal goods increases. For example, demand for restaurant meals tends to increase with higher income.
• Inferior Goods: As income rises, demand for inferior goods decreases. Inferior goods are those consumers switch away from as they can afford better alternatives. For example, demand for cheaper brands of clothing might fall as income increases.
• Luxury Goods: Demand for luxury goods increases significantly with rising income. These are goods that are considered non-essential and are often purchased when income rises.
• Income Elasticity of Demand: The extent to which demand changes in response to a change in income. High income elasticity means demand changes a lot; low income elasticity means demand changes little.