ECONOMICS: Principles and Applications, 4e
HALL & LIEBERMAN, © 2008 Thomson South-Western

• Opportunity cost of any choices
– What we must forego when we make that choice
– Accurate and complete concept of cost
– Used when making or analyzing decisions
– Everything you actually sacrifice in making the choice
– The next best choice is used to determine the opportunity cost of the choice
2

• When the alternatives to a choice are mutually exclusive, only the next best choice, the one that would actually be chosen, is used to determine the opportunity cost of the choice.
• Economists like to attach a monetary value to opportunity cost.
3

• The opportunity cost of a choice includes
– Explicit cost
• The dollars sacrificed - and actually paid out for a choice
– Implicit cost; e.g. foregone income
• The value of something sacrificed when no direct payment is made
4

• Arises from the scarcity of time or money
• Time is money:
– The sacrifice of time often means sacrifice of money
– The money that could have been earned during that time
5

• Jessica, a writer, decides to see a movie
• Ticket: $10; time: 3 hours.
• Assume:
– Wage rate: $20/hr;
• Opportunity cost:
$10+3*$20=$70
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FIGURE X
Hours
Studying
Physics
Score
Geology
Score
0
1
40
50
30
60
2
3
4
60
85
80
90
90 100
• 4 hours to study for two exams;
• If spending two hours studying each, what would be his opportunity cost of an additional hour studying physics?
• ANSWER: 20 points on his geology exam
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• A weapons plant can manufacture
1,000 more guns or 50 more tanks /yr.
What is the plant’s opportunity cost of an extra gun?
1/20 of a tank
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• Arises from the scarcity of society’s resources
• Our desire for goods is limitless
– Limited resources to produce them
• To produce more of one thing
– Society must shift resources away from producing something else
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• Figure 2 The Production Possibilities Frontier
Bushels of
Wheat per Year
1,000,000
950,000
850,000
A
700,000
B
C
D
E
400,000
1,000 2,000 3,000 4,000 5,000
F
Number of Tanks per Year
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• Production Possibilities Frontier (PPF)
– A curve showing all combinations of two goods that can be produced with the resources and technology available
• Points outside the PPF
– Unattainable
• Points on or inside the PPF
– Attainable
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• Figure 2 The Production Possibilities Frontier
Bushels of
Wheat per Year
1,000,000
950,000
850,000
A all resources are used for wheat
B
C
700,000
Moving from point A to point B requires shifting resources out of wheat and into tanks
D
W
400,000
E all resources are used for tanks
1,000 2,000 3,000 4,000
F
5,000
Number of Tanks per Year
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• The law of increasing opportunity cost
– The more of something we produce, the greater the opportunity cost of producing even more of it
– Explains
• The concave (upside-down bowl) shape of the PPF
• Why the PPF becomes steeper as we move rightward and downward
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• There is no such thing as a free lunch
– Even if a meal is provided for free of charge to someone, society still uses up resources to provide it
– From society’s point of view, there is no such thing as free internet service, free broadcast television.
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• A firm, an industry, or an entire economy is productively inefficient if it could produce more of at least one good without sacrificing the production of any other good
• When inefficient, we are operating inside the PPF (all resources are being used, but not in the most productive way)
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• Produce more of everything
– Increase the economy’s productive capacity
• Factors contributing to economic growth
– Increase in the quantities of available resources
• Physical capital
• Human capital
– Technological change
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Economic Growth
• Figure 4 Economic Growth and the PPF (a)
Wheat
(bushels per year)
1,200,000
1,000,000
A’
A
H
J
Additional resources or technological advance affect only the wheat production
700,000
D
3,000
F
5,000 Tanks per Year
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Economic Growth
• Figure 4 Economic Growth and the PPF (b)
Wheat
(bushels per year)
1,200,000
1,000,000
A
D
Additional resources or technological advance affect only the tank production
5,000 6,000
Tanks per Year
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Economic Growth
• Figure 4 Economic Growth and the PPF (c)
Wheat
(bushels per year)
1,200,000
Additional resources or technological advance affect the production of both goods
1,000,000
D
5,000 6,000
Tanks per Year
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• A technological change or an increase in the capital stock, even when the direct impact is to increase production of just one type of good, allows us to choose greater production of all types of goods.
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• Capital:
– a resource: produce goods and services
– a good: needs resources to be produced
• Technological change
– Needs resources – used in (R&D)
• The tradeoff: Resources
• Used to produce capital (R&D) this year
• not being used to produce consumer goods
21

Economic Growth
• Figure 5 How Current Production Affects Economic Growth
(a) High Consumption, Low Growth (b) Low Consumption, High Growth
Consumer Goods
(units per year)
This year’s PPF
Consumer Goods
(units per year)
This year’s PPF
Next year’s
PPF
A
Next year’s PPF
A’
Capital Goods
(units per year)
Capital Goods
(units per year)
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• Economic system
– The way our economy is organized
• Specialization
– Each person specializes in a limited number of activities
• Exchange
– Trading with others to obtain what we want
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Enable us to enjoy
– Greater production
– Higher standards of living
– All economies exhibit high degree of specialization and exchange
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• Why?
– Human capabilities
– Time needed to switch from one activity to another
– Individual differences
• Comparative advantage
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• Absolute Advantage
– Produce a good or service using fewer resources
Person A
Person B
1 Fish
1 hour
3 hours
1 Cup of Berries
1 hour
1.5 hours
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• Comparative Advantage
– Produce a good or service at a lower opportunity cost
Person A
Person B
One More Fish
1 cup berries
2 cups berries
One More
Berries
1 fish
0.5 fish
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• Specialization
– Individuals should specialize according to their comparative advantage
Person A
Person B
Total Island
Change in Fish
Production
+1
-1
0
Change in Berry
Production
-1
+2
+1
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1. Which goods and services should be produced with society’s resources?
– Where on the PPF should the economy operate
2. How should they be produced?
– Combination of capital with labor
3. Who should get them?
– Distribution of the goods and services produced
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1.
–
Traditional Economy
Long-lived practices from the past
2.
Command Economy (Centrally-
Planned)
– Explicit instructions from a central authority
3.
Market Economy
– Individual decision making
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• Market
– Buyers and sellers with the potential to trade
• Global markets
– Buyers and sellers - spread across the globe
• Local markets
– Buyers and sellers - within a narrowly defined area
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• Price
– the amount of money that must be paid to a seller for a good, service, or resource
• Markets
– create a sensible allocation of resources
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• Market economy – the traders determine
• The goods that are traded
• The way they are traded
• The price at which they trade
• Traditional economy - Families
• Command economy - The government
• Market economy
• dominant method of resource allocation in
United States
• Not a pure market economy
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1. Communism
– Most resources are owned in common
2. Socialism
– Most resources are owned by state
3. Capitalism
– Most resources are owned privately
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• System of resource allocation and resource ownership
– Resource allocation
• Market
• Command
– Resource ownership
• Private
• State
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Types of Economic Systems
• Figure 6 Types of Economic Systems
Resource Allocation
Market Command
Centrally
Planned
Capitalism
Private
Resource
Ownership
Market
Capitalism
State
Market
Socialism
Centrally
Planned
Socialism
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• The market is
– the most simple way to allocate resources
• Individual buyers and sellers
– the most complex way to allocate resources
• Economists
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• Saving a life requires use of resources
• Resources sell at a price
– Some methods of lifesaving are highly cost effective
– Productive inefficiency also exists in lifesaving
• Allocating lifesaving resources efficiently
– Benefits of lifesaving efforts - not fully captured by “life-years saved”
– Uncertainty
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Are We Saving Lives Efficiently?
• Figure 7 Efficiency and Inefficiency in Saving Lives
Quantity of
All Other Goods per Year inefficient efficient
B A Eliminating inefficiency:
-save more lives; have more of other goods; or both
Number of Lives Saved per Year
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