Chapter 2: Opportunity costs
Scarcity
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Economics is the study of how
individuals and economies deal
with the fundamental problem of
scarcity.
As a result of scarcity, individuals
and societies must make choices
among competing alternatives.
Opportunity Cost
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The opportunity cost of any alternative is
defined as the cost of not selecting the "nextbest" alternative.
Example: Suppose that you own a building
that is worth $100,000 today and is expected
to be worth $100,000 one year from today. If
the interest rate is 10%, what is the
opportunity cost of using this building for one
year?
Example II
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The opportunity cost of college
attendance includes:
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the cost of tuition, books, and supplies,
foregone income (this is usually the largest
cost associated with college attendance),
and
psychic costs.
What about room and board?
Example III:
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Opportunity cost of attending a movie:
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opportunity cost of tickets
opportunity cost of time
Marginal analysis
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Marginal benefit = additional benefit
resulting from a one-unit increase in the
level of an activity
Marginal cost = additional cost
associated with one-unit increase in the
level of an activity
Net benefit
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Individuals are not expected to
maximize benefit; nor are they
expected to minimize costs.
Individuals are assumed to attempt to
maximize the level of net benefit (total
benefit minus total cost) from any
activity in which they are engaged.
Marginal analysis
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MB > MC  expand the activity
MB < MC  contract the activity
optimal level of activity: MB = MC
(Net benefit is maximized at this point)
Marginal benefit
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MB generally declines as the level of an
activity rises, ceteris paribus.
Consider the MB of time spent studying:
Marginal cost
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For most activities, marginal cost rises
as the level of the activity increases.
Optimal study time
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The optimal amount of study time
occurs at the point at which MB = MC
Production possibilities curve
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Assumptions:
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A fixed quantity and quality of available
resources
A fixed level of technology
Efficient production (i.e., no
unemployment and no underemployment)
Example: study time
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4 hours left to study for two exams:
economics and calculus
Output = grades on each exam
Fixed resources?
Fixed technology?
No unemployed nor underemployed
resources?
Alternative uses of time
Law of diminishing returns
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Law of diminishing returns: output will
ultimately increase by progressively
smaller amounts when the use of a
variable input increases while other
inputs are held constant.
Does this apply in this example? What
are the fixed inputs?
Production possibilities curve
Marginal opportunity cost
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Marginal opportunity cost = the amount
of another good that must be given up
to produce one more unit of a good.
Calculating marginal
opportunity cost
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In the interval
between points A
and B, the marginal
opportunity cost of
1 point on the
economics exam is
1/3 of a point on
the calculus exam.
Marginal Opportunity Cost
(continued)
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In the interval
between points B
and C, the marginal
opportunity cost of
one point on the
economics exam
equals 4/3 of a point
on the calculus
exam.
Law of increasing cost
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Law of increasing cost – marginal opportunity cost
rises as the level of an activity increases
Reasons for law of increasing cost
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Law of diminishing returns
Specialized resources (heterogeneous
labor, land, capital, etc.)
Specialized resources in farming
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Some land, labor, and capital is better suited
for wheat production and some is better
suited for corn production
Unemployed or underemployed
resources
Points outside of the PPC
Economic growth
Commodity-specific
technological change
Specialization and trade
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Adam Smith – economic growth is
caused by increased specialization and
division of labor.
Gains from specialization and
division of labor
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specialization in areas that match the
skills and talents of workers
“learning by doing” – increase in
productivity from task repetition
less time lost while switching from task
to task
Specialization and trade
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As noted by Adam Smith, specialization
and trade are inextricably linked.
Adam Smith and David Ricardo used
this argument to support free trade
among nations.
Absolute and comparative
advantage
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Absolute advantage – an individual (or
country) is more productive than other
individuals (or countries).
Comparative advantage – an individual
(or country) may produce a good at a
lower opportunity cost than can other
individuals (or countries).
Example: U.S. and Japan
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Suppose the U.S. and Japan produce
only two goods: CD players and wheat.
Absolute advantage?
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Who has an absolute advantage in
producing each good?
Comparative advantage?
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Who has a comparative advantage in
producing each good?
Gains from trade
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Opportunity cost of CD player in U.S. = 2
units of wheat
Opportunity cost of CD player in Japan = 4/3
unit of wheat
If Japan produces and trades each CD player
to the U.S. for more than 4/3 of a unit of
wheat but less than 2 units of wheat, both
the U.S. and Japan gain from trade and can
consume more goods than they could
produce by themselves.
Gains from trade (continued)
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Note that the U.S. has a comparative
advantage in producing wheat.
Countries always expand their
consumption possibilities by engaging in
trade (since they acquire goods at a
lower opportunity cost than if they
produced them themselves).
Free trade?
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If each country specializes in the
production of those goods in which it
possesses a comparative advantage and
trades with other countries, global
output and consumption in increased.