Choice and Opportunity Cost

Scarcity forces us to make choices among a limited set of possibilities Study the logic of rational choice among competing alternatives Under scarcity, deciding to have more of one good or service means deciding to have less of something else. The relevant cost of a decision is the value of the best alternative foregone

Opportunity Cost Opportunity cost is one of the central ideas in economics. We just defined it above. Opportunity cost or economic cost of an action is the value of the next best alternative that was not chosen Examples? Society, consumer, business

If we want a missile defense system, we have to have less of other goods If an individual wants to have a higher level of consumption during working years, then the person will have to give up something –Have a lower level of consumption in retirement –Work harder and have less leisure –Get more education or training

Measuring Opportunity Cost The Jonsons own a farm in Iowa, 100 acres. They are crop farmers and the reasonable crops to consider are corn and soybeans. The major decision for the year is how much corn to grow and how much soybeans to grow. What trade-off do they face?

Production Possibilities Frontier PPF gives the maximum amount of soybeans that can be produced for any given level of corn. It gives the trade-off between corn and soybean output for the Jonsons. It tells them how many bushels of soybeans they have to give up in order to get another bushel of corn.

Measuring the Tradeoff Opportunity cost is how we measure the tradeoff between output of corn and soybeans What is the opportunity cost of a bushel of corn? It depends on how much corn is being produced at present. Let us look at the PPF table

Note that as the output of corn increases the opportunity cost of an additional unit increases. Note also that the slope of the production possibilities frontier measures the opportunity cost. It gives the rate of change in soybeans with respect to corn.

Additional Concepts Efficiency Technological change Economic growth If the firm (economy) is producing within the PPF, then the choice of outputs is inefficient. Why? Because you can increase the output of one good without reducing the output of other goods. Only points on the PPF are efficient.

Technological Change What would happen to the PPF if a new and improved variety of corn became available to the Jonsons. It would not affect the possibilities when only soybeans were being produced but it would shift the curve outward and to the right. If an improved fertilizer became available it could shift the PPF out in all directions.

Changing the PPF: Other Factors If the Jonsons became better informed about crop husbandry that could also shift the PPF outward If the became more experienced at growing these crops, that could also shift the PPF outward What would happen if they had more land?

Applying the PPF Grocery store Ford Motor company University Clothing store Allocating your time Allocating your budget

Application to the Economy The amounts of goods and services that can be produced in any given year is limited by the amount and productivity of the land, labor, and capital goods available. Choices have to made regarding the composition of output. How much national defense, food, clothing, automobiles, education, drugs, health care, capital goods, etc. The PPF can be used to capture the choices.