Introduction
• An economic system has to solve three
coordination problems:
Chapter Two
Choice,
Opportunity Costs
and Specialization
Introduction
• All economic knowledge can be boiled
down to a single phrase:
– What, and how much, to produce.
– How to produce it.
– For whom to produce it.
Introduction
• Every decision has an opportunity cost –
the cost in foregone opportunities.
There ain’t no such thing as a free lunch.
Opportunity Cost
• Opportunity cost: the value of the
highest-valued alternative that must be
forgone when a choice is made. It is the
evaluation of a trade-off.
Introduction
• A production possibility curve is used to
illustrate opportunity cost.
• Marginal benefits and costs: the benefits
and opportunity costs associated with one
additional unit of the good.
1
The Production Possibilities
Model
• The production possibilities curve shows
the trade-offs among choices we make.
The Production Possibility Table
• Output – an output is simply a result of an
activity.
• Input – an input is what you what you put
into a production process to achieve an
output.
The Production Possibility
Curve for an Individual
• The production possibility curve not only
represents the opportunity cost concept, it
also measures the opportunity cost.
The Production Possibility Table
• A production possibility table lists a
choice's opportunity costs by summarizing
what alternative outputs you can achieve
with your inputs.
The Production Possibility
Curve for an Individual
• A production possibility curve
measures the maximum combination of
outputs that can be achieved from a given
number of inputs.
• It slopes downward from left to right.
The Production Possibility
Curve for an Individual
• The production possibility curve
demonstrates that:
– There is a limit to what you can achieve, given
the existing institutions, resources, and
technology.
– Every choice made has an opportunity cost—
you can get more of something only by giving
up something else.
2
A Production Possibility Curve
for a Society
• The production possibility curve is
generally bowed outward.
A Production Possibility Curve
for a Society
Y
– Some resources are better suited for the
production of some goods than others.
10
9
8
7
6
5
4
3
2
1
0
If the slope of the production
curve is -2 at A, the
A
opportunity cost
of 1X is 2Y.
2Y
.
1X
1
2
A Production Possibility Curve
for a Society
• Comparative advantage explains why
opportunity costs increase as the
consumption of a good increases.
– Some resources are better suited for the
production of some goods than to the
production of other goods.
Butter
A
1 pound
of butter 15
14
2 pounds
of butter 12
B
C
D
9
5
E
5 pounds
of butter
0
4
4 guns
McGraw-Hill/Irwin
7
3 guns
9
4
5
6
7
8
9
X
A Production Possibilities Table
and Curve
% of resources
% of resources
devoted to
devoted to
production
production
Pounds
Number
of guns
of butter
of butter
of guns
0
20
40
60
80
100
McGraw-Hill/Irwin
A Production Possibilities Table
and Curve
3
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/Irwin
0
4
7
9
11
12
100
80
60
40
20
0
15
14
12
9
5
0
Row
A
B
C
D
E
F
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Marginal Opportunity Cost
• The Production Possibilities Curve (PPC)
illustrates the concept of opportunity cost.
Each point on the PPC means that every other
point is a forgone opportunity.
• The PPC bows outward because there are
ever-increasing marginal opportunity costs to
the production of any good.
F
11 12 Guns
1 gun
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
3
• The principle of increasing marginal
opportunity cost states that opportunity
costs increase the more you concentrate
on an activity.
• In order to get more of something, one
must give up ever-increasing quantities of
something else.
Increasing Marginal Opportunity
Cost
A
Slope is flat at A. Low
opportunity cost of
guns.
Butter
Increasing Marginal Opportunity
Cost
Slope is steep at B. High
opportunity cost of guns.
B
This principle is discussed but Not Named in the Boyes Text
Guns
Specialization
• Economic agents (individuals, firms, nations)
will be better off if they choose to produce
those things for which they have the lowest
opportunity costs, and trade for those with
higher costs.
• Agents do this because such choices involve
giving up the least amount of other things.
Efficiency
• In production, we’d like to have
productive efficiency – achieving as
much output as possible from a given
amount of inputs or resources.
Specialization & Trade
• Comparative Advantage: the ability to
produce a good or service at a lower
opportunity cost than someone else.
• Law of comparative advantage:
– proposition that the joint output of trading
partners will be greatest when each good is
produced by the low opportunity cost producer.
Efficiency
• Efficiency involves achieving a goal as
cheaply as possible.
• Efficiency has meaning only in relation to a
specified goal.
4
Efficiency
Efficiency
• Any point within the production possibility
curve represents inefficiency.
• Any point outside the production possibility
curve represents something unattainable,
given present resources and technology.
• Inefficiency – getting less output from
inputs which, if devoted to some other
activity, would produce more output.
Efficiency and Inefficiency
• The production possibilities curve shows
the maximum quantity of goods and
services that can be produced when the
existing resources are used fully and
efficiently.
Unattainable point,
given available technology,
resources and labor force
10
Guns
8
C
Efficient
points
6
A
Inefficient
point
0
2
4
D
B
4
2
Butter
6
8
10
Production Possibilities
Only defense
goods produced
Defense Goods
200
A1
G1
B1
175
150
F1
Production Possibilities Curve
Impossible
Defense
Non-defense
A1
200
0
B1
175
75
C1
130
125
D1
70
150
E1
0
160
F1
130
25
G1
200
75
Efficient
Combinations
C1
Shifts in the Production
Possibility Curve
• Society can produce more output if:
– Technology is improved.
– More resources are discovered.
– Economic institutions get better at fulfilling our
wants.
125
Underutilized
(Inefficient)
100
75
0
D1
E1
25 50 75 100 125 150
Only nondefense
goods produced
Nondefense Goods
5
Growth
A Shift of the PPC
• The PPC moves outward (growth occurs)
as the result of:
225 A2
– Increased resources
Defense Goods
• Larger labor force
• Change in labor force participation
• Chance in labor-leisure decision
200
A1
B2
B1
175
– Improved technology (innovation)
– Expansion of capital stock
– An improvement in the rules (laws, institutions,
and policies) of the economy
C2
C1
0
B2
200
75
C2
175
120
D2
130
150
E2
70
160
F2
0
165
D2
125
100
D1
E1
0
E2
F2
Nondefense Goods
25 50 75 100 125 150
• More output is represented by an outward
shift in the production possibility curve.
Non-defense
225
150
75
Shifts in the Production
Possibility Curve
Defense
A2
Shifts in the Production
Possibility Curve
Neutral Technological Change
Butter
C
A
0
Shifts in the Production
Possibility Curve
Biased Technological Change
Butter
C
B
D
Guns
Distribution and Production
Efficiency
• The production possibilities curve focuses
on productive efficiency and ignores
distribution.
B
0
A Guns
6
Distribution and Production
Efficiency
Examples of Shifts in the
Production Possibility Curve
• In our society, more is generally preferred
to less and many policies have relatively
small distributional effects.
(a)
(b)
(c)
(d)
Finagle A Bagel
Specialization
7