Opportunity Cost and Production Possibilities
Overheads
Opportunity Cost
The opportunity cost of any choice
is what we give up when we make
that choice
The opportunity cost of any good or service
is its value in its next best alternative use.
For example, the opportunity cost of the
service of an input used in the production
of any particular commodity is the
maximum amount that the input would
produce of any other commodity.
Examples of Opportunity Cost
1. Farmer who raises hogs and considers
using his own corn to feed the hogs
2. Recent college graduate who chooses
a high paying job in Chicago when his
family all live in Iowa and he plans to
visit them once or twice a month
Examples of Opportunity Cost
3. Businessman who hires a maid to clean his
house so he has time to do more consulting
in the evening
4. 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
Examples of Opportunity Cost
5. Seamstress who chooses to make blue
shirts instead of striped shirts
6. A landowner decides to farm his
own land instead of renting it to a
neighbor
Individuals who have a high value of time either due to high income,
or personal preference
- have a high opportunity cost for
alternative activities
Principle of Opportunity Cost
All economic decisions taken by individuals
or society are costly
The correct way to measure the cost of a
choice is its opportunity cost —
that which is given up to make the choice
The Process of Production
Uses Inputs
Produces Outputs
An input is a good or service that
is employed in the production
process
Inputs are denoted by x or by
x1, x2, … , xn
An output is a good or service
that is the output
of a particular production process
Outputs are denoted by y or by
y1, y2, … , ym
Production Technologies
The technology set (technology for short)
for a given production process is defined
as the set of all input and output
combinations such that the set of outputs y
can be produced from
the given set of inputs x
The technology set is the set of
feasible input and output
combinations
Inputs Used for Producing Holes in the Ground
shovel
semi
skilled labor
Output for the Digging Technology
Some number of postholes or trenches
Elements of the Digging Technology Set
1 shovel
4 postholes
1 shovel
0 postholes
1 hour semi
skilled labor
0 trenches
1 hour semi
skilled labor
2 trenches
Elements of the Digging Technology Set
1 shovel
2 postholes
1 hour semi
skilled labor
1 trenches
Inputs Used for Producing Pancakes
powdered milk
water
eggs
oil
flour
baking powder
salt
bowl
whip
measuring set
cup
spatula
small griddle
camp stove
white gas
matches
semi
skilled labor
butter
maple syrup
plate
knife
fork
The Output (single) for the Pancake Technology
Some number of pancakes served
on a plate with butter and syrup
along with a knife and fork
One Element of the Pancake Technology Set
1/3 c powdered milk
15/16c water
1egg
2Toil
1c flour
2t baking powder
1/4 t salt
1 bowl
1whip
1 measuring set
1 cup
1 spatula
1small griddle
1camp stove
1/4c white gas
2 matches
1/4 h semi
skilled labor
3 T butter
1/2c maple syrup
1 plate
1knife
1fork
10 pancakes
The Producible Output Set P(x)
The producible output set P(x)
is the set of all combinations of outputs,
that are obtainable from a fixed level of inputs.
Construction of the Producible Output Set
Fix all inputs at a specific level
x̄  ( x̄1, x̄2, x̄3, , x̄n )
Fix the level of y1 at some level, say ȳ1
For that level of y1, list all feasible
levels of y2 , then repeat this for all other
levels of y1.
Producible Output Set for Pancakes and Crepes
pancakes
10
P(x)
5
0
0
12 14 crepes
Law of Increasing Opportunity Cost
The more of something we produce,
the greater is the opportunity cost
of producing still more.
Vector of Inputs for Corn and Soybeans
200 acres land
20,000 lbs nitrogen
1 combine 1 grain head
1 corn head
15 hrs labor per month
1 tractor
1 disk
1 planter
1 rotary hoe
400 gallons diesel
1 row cultivator
1 wagon
1 hand hoe
1 butterfly net
60 bags corn seed
120 bags soybean seed
Possible Output Combinations for Corn and Soybeans
Corn
Soybeans
16,000
0
9,600
0
4,000
3,000
Producible Output Set for Corn and Soybeans
soybeans
The Boundary of the Set is Concave
4,000
3,000
P(x)
0
0
9,600
16,000
corn
Why concavity of the boundary?
Some inputs are better suited to some uses
Some allocated inputs may be shared
(between uses)
New Digging Technology Set
2 identical semi-skilled workers
1 shovel
1 post hole digger
Input-Output Coefficients
Post Holes/Hour
Trenches/Hour
Shovel
4
2
Post Hole
Digger
6
1/2
Some Efficient Sample Points
Each worker can only use one tool
10 post holes - No trenches
0 post holes - 2.5 trenches
6 post holes - 2 trenches
8 post holes -
1 trench
3 post holes -
2.25 trenches
Postholes
Postholes and Trenches
12
(0.5, 9)
10
(1,8)
(1.25,7.5)
(2,6)
8
6
(2.25, 3)
4
2
0
0
0.5
1
1.5
2
2.5
Trenches
3
Some Inefficient Sample Points
5 post holes - 1.25 trenches
(1/2 time on each)
4 post holes - 0.5 trenches
(“wrong” tasks)
3 post holes - 1 trench
(rest 1/2 time)
Postholes
Postholes and Trenches
12
(0.5, 9)
(1,8)
10
(1.25,7.5)
(2,6)
8
(1.25,
½ each
5)
1 7/8, 2.5
¼ holes
6 Wrong Tasks
4
(0.5, 4)
2
Shirk
(2.25, 3)
(1, 3)
0
0
0.5
1
1.5
2
2.5
Trenches
3
Shirts with buttons on the left and on the right
Buttons
on right
12
Linear Producible Output Set
P(x)
12
Buttons on left
Production Possibility Frontier
The boundary of the producible output set is called
the production possibility frontier
PPF
y1
P(x)
y2
Efficient and Inefficient Points
Points in P(x) that are on the frontier are called efficient points
Points in the interior of the set P(x) are called inefficient points
We say that an input-output combination is technically efficient
if the maximum possible output is being produced given the inputs.
We say that an input-output combination is technically efficient
if it is on the production possibility frontier.
Inefficient Production Points
PPF
y1
P(x)
y2
Postholes
Postholes and Trenches
12
(1,8)
10
(1.25,7.5)
(2,6)
8
6 Wrong Tasks
(2.25, 3)
4
Wrong Division
2
Shirk
0
0
0.5
1
1.5
2
2.5
Trenches
3
No Free Lunch
Once we are on the production possibility frontier,
we cannot produce more of one output,
without producing less of another output
Postholes
Postholes and Trenches
12
10
8
6
4
2
0
0
0.5
1
1.5
2
2.5
Trenches
3
Postholes
Postholes and Trenches
12
10
8
6
4
2
0
0
0.5
1
1.5
2
2.5
Trenches
3
A Free Lunch
If we are at a point in the producible output set
that is not on the boundary,
then we can get more output from the
same input bundle and thus there is a “free
lunch.”
Postholes
Postholes and Trenches
12
(0.5, 9)
(1,8)
10
(1.25,7.5)
(2,6)
8
6 Wrong Tasks
(2.25, 3)
4
Wrong Division
2
Shirk
0
0
0.5
1
1.5
2
2.5
Trenches
3
The End