THE ECONOMIC PROBLEM
Opportunity Cost
1. The opportunity cost of any choice is what we give up when
we make that choice
2. The opportunity cost of any good or service is its value in its
next best alternative use.
3. Opportunity cost is defined as the next best alternative
given up by making a choice.
Example
1. Businessman who hires a maid to clean his house so he has
time to do more consulting in the evening
2. Woman who is considering whether to stay home and take
care of her children or work at a job paying $9.50 per hour
and hire a baby sitter
Opportunity cost cont..
• Business apply opportunity cost and tend to
call it economic cost.
• Costs exists in general because scarce
resources compete for different uses.
ie Total revenue= economic profit-opportunity
cost
Opportunity cost cont..
• The key to see the how business see the
opportunity cost is to understand the concept
of economic profit.
• For business the economic profit is the
amount of money made after deducting both
explicit and implicit costs.
• Generally business need to earn revenue in
excess of its opportunity cost for the benefits
to accrue the owners of the business.
Opportunity cost cont..
• For example you have two job opportunities.
That is work as a mechanic and get paid $50 a
day or work as bartender and earn $25 a day.
• So what are you giving up by working as a
bartender versus working as a mechanic?
• Opportunity cost=
what you sacrifice/what you gain
Opportunity cost cont..
• In other words you face a trade-off between
working as a bartender or as a mechanic.
• Since there are certain number of working
hours a day, time is the scarce resource, this
scarcity limits the amount of total production
and hence in limits you in the job you ought to
take.
Allocative efficiency
• Allocation efficiency is a situation in which the
quantities of goods/services produced are those
that people value most highly.
• It is not possible to produce more of a good or
service without giving up some of another good
that people value more highly.
Two conditions for Allocative Efficiency:
1. Production efficiency—producing on the PPF.
2. Producing at the highest value point on the PPF.
Production Possibilities Frontier (PPF)
• The production possibilities frontier is a tool for
illustrating the problem of scarcity and its
consequences
• PPF is a curve depicting all maximum output
possibilities for two goods, given a set of inputs
(resources and other factors).
• PPF is a curve that measures the maximum
combination of outputs that can be obtained with a
given number of inputs.
The PPF brings three features of production into sharper
focus:
1. Attainable and unattainable combinations
2. Efficient and inefficient production.
3. Tradeoffs and free lunches.
Assumptions in PPF
1.Only 2 products produced
2.Resources are fixed.
3.The state of technology is fixed: • Technology is the application of scientific
or other types of know-how to practical
tasks.
• Improved technology enables us to
produce more with the same resources
Two products (CDs and Bottle of
Water)
Attainable and Unattainable Combinations
Production efficiency
• Based on the concept of PPT, production
efficiency occurs when an organization cannot
produce/offer more of one product/service
without producing/offering less of the other.
• Necessary condition for production efficiency
1.Full employment of all available factors of
production; and
2.Each resource is employed in the task in which
it performs comparatively better than other
resources.
Tradeoff and Free lunch
• Economists say “there is no free lunch” from
society’s point of view. Preparing the lunch took
resources that could have been used to produce
something else.
• But if you can produce more with the same resource
is like you getting free lunch.
• Every choice along the PPF involves a tradeoff—we
must give up something to get something else
- For instance, we must give up some bottles to get
more CDs or give up some CDs to get more bottles