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Chapter # 4 The Opportunity Cost Theory The Opportunity Cost Theory.

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1 Chapter # 4 The Opportunity Cost Theory The Opportunity Cost Theory

2 The PPF and Opportunity Cost Opportunity Cost: The opportunity cost of any item is whatever must be given up to obtain it. It is the relevant cost for decision making. Examples: The opportunity cost of… …going to college for a year is not just the tuition, books, and fees, but also the foregone wages. …seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater.

3 The Opportunity Cost Theory  It is the amount of a second commodity that must be given up in order to release enough resources to produce one additional unit of the first commodity (comp. cost stresses the opportunity cost).  The nation with lower opportunity cost in the production of a commodity has a comparative advantage in that commodity and a comparative disadvantage in the second commodity.

4 PPF and opportunity cost Meaning The Production Possibilities Frontier (PPF): A graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology. Example: – Two goods: computers and wheat – One resource: labor (measured in hours) – Economy has 50,000 labor hours per month available for production. Meaning The Production Possibilities Frontier (PPF): A graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology. Example: – Two goods: computers and wheat – One resource: labor (measured in hours) – Economy has 50,000 labor hours per month available for production.

5 PPF Example Producing one computer requires 100 hours labor. Producing one ton of wheat requires 10 hours labor. 5,0000 4, , , , ,00010,000 25,000 10,00040, ,000 E D C B A WheatComputersWheatComputers Production Employment of labor hours

6 Point on graph Production Com- puters Wheat A5000 B4001,000 C2502,500 D1004,000 E05,000 A B C D E PPF Example

7 A C T I V E L E A R N I N G 1 : Points on the PPF A. On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods? Why or why not? B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods? A. On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods? Why or why not? B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods? 7

8 A C T I V E L E A R N I N G 1 : Answers 8 Point F: 100 computers, 3000 tons wheat  Point F requires 40,000 hours of labor. Possible but not efficient: could get more of either good w/o sacrificing any of the other. F

9 A C T I V E L E A R N I N G 1 : Answers 9  Point G: 300 computers, 3500 tons wheat  Point G requires 65,000 hours of labor. Not possible because economy only has 50,000 hours. G

10 Exercise The PPF: What We Know So Far Points on the PPF (like A – E) – possible – efficient: all resources are fully utilized Points under the PPF (like F) – possible – not efficient: some resources underutilized (e.g., workers unemployed, factories idle) Points above the PPF (like G) – not possible

11 Explanation The PPF and Opportunity Cost Recall: The opportunity cost of an item is what must be given up to obtain that item.  Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other.  Society faces a tradeoff: Getting more of one good requires sacrificing some of the other.  The slope of the PPF tells you the opportunity cost of one good in terms of the other.

12 The PPF and Opportunity Cost Here, the “rise” is a negative number, because, as you move to the right, the line falls (meaning wheat output is reduced). Moving to the right involves shifting resources from the production of wheat (which causes wheat output to fall) to the production of computers (which causes computer production to rise). Producing an additional computer requires the resources that would otherwise produce 10 tons of wheat. – slope = = –10 Here, the opportunity cost of a computer is 10 tons of wheat.

13 Exercise : No 2 PPF and Opportunity Cost 13 In which country is the opportunity cost of cloth lower? FRANCE ENGLAND

14 A C T I V E L E A R N I N G 2 : Answers 14 England, because its PPF is not as steep as France’s. FRANCE ENGLAND

15 Answer There are two ways to get the answer. The hard way is to compute the slope of both PPFs. The slope of France’s PPF equals -600/300 = -2, meaning that France must give up two units of wine to get an additional unit of cloth. The slope of England’s PPF = -200/300 = -2/3, meaning that England only must sacrifice 2/3 of a unit of wine to get an additional unit of cloth. Thus, the opportunity cost of cloth is lower in England than France. The question, however, does not ask for the numerical values of the opportunity cost of cloth in the two countries. It only asks which country has a lower opportunity cost of cloth. There is an easy way to determine the answer. Students must remember that the slope of the PPF equals the opportunity cost of the good measured on the horizontal axis. Then, students can simply “eyeball” the two PPFs to determine which is steepest. From the graphs show, it’s pretty easy to see that England’s PPF isn’t as steep, and therefore the opportunity cost of cloth is lower in England than in France.

16 THE PPF UNDER CONSATANT COST CONDITION United state United kingdom Wheat cloth wheat cloth United state United kingdom Wheat cloth wheat cloth

17 DIAGRAMMATIC PRESENTATION If opportunity costs are constant, it will be straight-line (linear). This case reflects a situation where resources are not specialized and can be substituted for each other with no cost Cloth S U K 60 wheat A A

18 THE PF WITH INCREASING COST Increasing opp. cost means that a country must give up more & more of one good to release just enough resources to produce each additional unit of another good. In case of increasing opp. Cost,the PF would be convex from the origin. REASONS:- 1.Resources are not homogeneous, & 2.Resources are not used in the same fixed proportion. Increasing opp. cost means that a country must give up more & more of one good to release just enough resources to produce each additional unit of another good. In case of increasing opp. Cost,the PF would be convex from the origin. REASONS:- 1.Resources are not homogeneous, & 2.Resources are not used in the same fixed proportion.

19 Example of FFP increasing cost That is, as an economy specializes more and more into one product. The opportunity cost of producing that product increases, because we are using more and more resources that are less efficient in producing it. ∆y ∆x 05070X Y convex from the origin

20 THE PF WITH DECREASING COST Decreasing opp. cost means that a country must give up less & less of one good it produces each additional unit of the other good. The diagram will be in the position of concave REASONS: Resources are not homogeneous. Resources are not used in the same fixed proportion. Decreasing opp. cost means that a country must give up less & less of one good it produces each additional unit of the other good. The diagram will be in the position of concave REASONS: Resources are not homogeneous. Resources are not used in the same fixed proportion.

21 CONTED:- In this case, opportunity cost actually decreases with greater production. While opportunity cost can decrease in limited circumstances, this is unlikely to happen for the economy as a whole. ∆y ∆x Y 0decreasing cost X

22 End of Chapter 3 THANK U,


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