Economic Tools Opportunity Cost Division of labor Comparative advantage Specialization The production possibilities frontier

Opportunity cost: The value of the next best alternative that is forgone. The condition of scarcity forces us to make choices. To choose is to give something up.

Opportunity Cost: Examples If you purchase an i-phone, you have give up something else you desire—like clothes. By putting a field to rice, the farmer is forgoing the profits that could have been earned by the next best alternative use of the land—likes soybeans. Allocating resources for the production of military aircraft will make resources unavailable for the production of commercial aircraft. Building prisons means giving up new roads, schools, sports facilities, . . .

The true (economic) cost of college Economic Cost = Explicit Cost + Opportunity Cost Tuition $10,000 Room & Board 5,400 Books 600 Total Explicit $6,000 Lost Income $12,000 Economic Cost $18,000

“Sunk” cost and decision-making A sunk cost is non-recoverable and therefore should be ignored in economic decision-making. You spent 10 minutes in a grocery checkout line and a new line comes open—should you switch lines? A pricey consultant’s report indicates that adding a new store location would not be profitable—should you add the new store?

Law of comparative advantage The individual, firm, region, or country with the lowest opportunity cost of producing a specific good should specialize in the production of that good. Comparative advantage is the ability to make something at lower opportunity cost than other producers.

Comparative Advantage: Example Person Shirts/Hour Papers/Hour Ricky 12 1 Susan 6 2

Measuring opportunity cost For Ricky: 1 shirt = 1/12 = 0.0833 papers per shirt and 1 paper = 12/1 = 12 shirts per paper For Susan: 1 shirt = 2/6 = 0.333 papers per shirt and 1 paper = 6/2 = 3 shirts per paper Thus Ricky has the comparative advantage in ironing shirts and Susan has the comparative advantage in typing papers.

Gains from specialization Without Specialization Based on 8 hours of labor time per person, divided evenly between ironing shirts and typed papers. Without Specialization With Specialization Shirts Papers Ricky 48 4 96 Susan 24 8 16 Total 72 12 By specializing according to comparative advantage, there is a gain of 24 shirts and 4 papers.

Absolute versus comparative advantage Because I can do things with fewer resources than others can, I have an absolute advantage.

Comparative Advantage: Part 2 Person Shirts/Hour Papers/Hour Ricky 5 1 Susan 6 2 Susan now has an absolute advantage –that is, she can iron shirts and type papers using less resources than Ricky. Does that mean there would be no benefits to specialization?

Measuring opportunity cost: Again For Ricky: 1 shirt = 1/5 = 0.2 papers per shirt and 1 paper = 5/1 = 5 shirts per paper For Susan: 1 shirt = 2/6 = 0.333 papers per shirt and 1 paper = 6/2 = 3 shirts per paper Thus Ricky has still the comparative advantage in ironing shirts.

Susan = 2 papers Ricky = 5 shirts Let’s give Ricky and Susan one hour of labor time. Ricky uses his hour to type one (1) paper. Susan types one (1) paper and irons three (3) shirts. Can you calculate the gains to specialization according to comparative advantage? Susan = 2 papers Ricky = 5 shirts Thus they gain one (1) paper and two (2) shirts.

Barter versus monetary exchange Barter involves the exchange of goods for other goods without using money. Successful barter exchange depends on a “coincidence of wants.” Monetary exchange facilitates specialization. “Specialization is limited by the size of the market” (Adam Smith).

The production possibilities frontier (PPF) PPF: the boundary between the combinations of goods and services that can be produced and the combinations than cannot be produced, given the available resources of production and the state of technology. The PPF brings three features of production into sharper focus: Attainable and unattainable combinations Efficient and inefficient production. Tradeoffs and free lunches.

PPF: Assumptions Production is divided between consumer goods and capital goods. Resources are fixed The state of technology is fixed. “Rules of the game”—the legal system, property rights, patents, taxes, etc.—are fixed

Technology Technology is the application of scientific or other types of know-how to practical tasks. “A sharp axe is better than a dull axe.” Improved technology enables us to produce more with the same resources. “Specialization is the inevitable counterpart of technology.”

Important technical innovations Internal combustion engine Cotton harvester Transistor Internet browser software Air conditioning Satellite communication Antibiotics Genetically modified seeds

The Economy’s Production Possibilities Frontier 10 20 30 34 43 48 50 Consumer goods (millions of units per year) A PPF (AF): Economy uses all resources and technology efficiently PPF: bowed out; law of increasing opportunity cost Inefficient: inside PPF Unattainable: outside PPF B C U Unattainable D I Inefficient E F 10 50 40 30 20 Capital goods (millions of units per year)

Law of increasing opportunity cost To produce more of one good, a successively larger amount of the other good must be sacrificed. Point-to- Point Capital Goods Gained (Units) Consumer Goods Lost (Units) Opportunity Cost/Unit of Capital Goods A → B 10 2 0.2 B → C 5 0.5 C → D 9 0.9 D → E 14 1.4 E → F 20

Why should opportunity cost increase? Productive resources are specialized—meaning, resources are more useful in some productive tasks than others.

Shifts of the economy’s PPF (a) Increase in available resources (b) Decrease in available resources Consumer goods Consumer goods A’ A A A’ Capital goods F F’ Capital goods F’ F Outward shift of PPF – increase in available resources; better technology - enhanced production of both capital and consumer goods (b) Inward shift of PPF – decrease in available resources - decreased production of both capital and consumer goods

Shifts of the economy’s PPF (c) Change in resources that benefits consumer goods (d) Change in resources, technology, or rules that benefits capital goods Consumer goods Consumer goods A’ A A Capital goods F Capital goods F F’

Economic Growth Resources and technology are fixed along the PPF. Thus, to achieve growth of production over time, we must: Discover previously unknown natural resources; Enlarge the capital stock; Grow the population; Improve methods of production and distribution.

Economic Growth Capital goods Consumer goods Technological improvement Increase in human or physical capital. Discovery of previously unknown natural resources Capital goods Consumer goods

Enlarging the Capital Stock Making new machinery and buildings takes resources. So does education and training. We must give up some consumption in the near term.