Choice, Opportunity Costs and Specialization Chapter Two Choice, Opportunity Costs and Specialization

Introduction An economic system has to solve three coordination problems: What, and how much, to produce. How to produce it. For whom to produce it.

Introduction All economic knowledge can be boiled down to a single phrase: There ain’t no such thing as a free lunch.

Introduction Every decision has an opportunity cost – the cost in foregone opportunities.

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. Marginal benefits and costs: the benefits and opportunity costs associated with one additional unit of the good.

Introduction A production possibility curve is used to illustrate opportunity cost.

The Production Possibilities Model The production possibilities curve shows the trade-offs among choices we make.

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 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 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 not only represents the opportunity cost concept, it also measures the opportunity cost.

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.

A Production Possibility Curve for a Society The production possibility curve is generally bowed outward. Some resources are better suited for the production of some goods than others.

A Production Possibility Curve for a Society 10 9 8 6 5 4 3 2 1 . 2Y 1X A X 1 2 3 4 5 6 7 8 9 If the slope of the production curve is -2 at A, the opportunity cost of 1X is 2Y. 7 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

A Production Possibilities Table and Curve % of resources devoted to production of guns Number of butter Pounds Row 20 40 60 80 100 4 7 9 1 12 15 14 5 A B C D E F McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

A Production Possibilities Table and Curve 4 guns 1 pound of butter 15 B 14 3 guns 2 pounds of butter C 12 D 9 Butter E 5 1 gun 5 pounds of butter F 4 7 9 11 12 Guns McGraw-Hill/Irwin © 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.

Increasing Marginal Opportunity Cost 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. This principle is discussed but Not Named in the Boyes Text

Increasing Marginal Opportunity Cost Butter Slope is flat at A. Low opportunity cost of guns. Slope is steep at B. High opportunity cost of guns. Guns B A

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.

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 In production, we’d like to have productive efficiency – achieving as much output as possible from a given amount of inputs or resources.

Efficiency Efficiency involves achieving a goal as cheaply as possible. Efficiency has meaning only in relation to a specified goal.

Efficiency Any point within the production possibility curve represents inefficiency. Inefficiency – getting less output from inputs which, if devoted to some other activity, would produce more output.

Efficiency Any point outside the production possibility curve represents something unattainable, given present resources and technology.

Efficiency and Inefficiency Guns 10 8 6 4 2 2 4 6 Butter C D A B Unattainable point, given available technology, resources and labor force Efficient points Inefficient point

Production Possibilities Curve 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.

Production Possibilities Defense Non-defense A1 200 B1 175 75 C1 130 125 D1 70 150 E1 160 F1 25 G1 Only defense goods produced Defense Goods A1 200 G1 Impossible B1 175 150 Efficient Combinations C1 F1 125 Underutilized (Inefficient) 100 Only nondefense goods produced 75 D1 E1 25 50 75 100 125 150 Nondefense Goods

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.

Growth The PPC moves outward (growth occurs) as the result of: Increased resources Larger labor force Change in labor force participation Chance in labor-leisure decision Improved technology (innovation) Expansion of capital stock An improvement in the rules (laws, institutions, and policies) of the economy

A Shift of the PPC Defense Non-defense A2 225 B2 200 75 C2 175 120 D2 130 150 E2 70 160 F2 165 225 A2 Defense Goods A1 B2 200 B1 175 C2 150 C1 D2 125 100 D1 E2 75 E1 F2 25 50 75 100 125 150 Nondefense Goods

Shifts in the Production Possibility Curve More output is represented by an outward shift in the production possibility curve.

Shifts in the Production Possibility Curve Neutral Technological Change Butter C D A B Guns

Shifts in the Production Possibility Curve Biased Technological Change Butter C B A Guns

Distribution and Production Efficiency The production possibilities curve focuses on productive efficiency and ignores distribution.

Distribution and Production Efficiency In our society, more is generally preferred to less and many policies have relatively small distributional effects.

Examples of Shifts in the Production Possibility Curve

Finagle A Bagel Specialization