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

2. 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.

3. 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, . . .

4. 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

5. “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?

6. 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.

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

8. Measuring opportunity cost
For Ricky: 1 shirt = 1/12 = papers per shirt and 1 paper = 12/1 = 12 shirts per paper
For Susan:
1 shirt = 2/6 = 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.

9. 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.

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

11. 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?

12. 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 = papers per shirt and 1 paper = 6/2 = 3 shirts per paper
Thus Ricky has still the comparative advantage in ironing shirts.

13. 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.

14. 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).

15. 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.

16. 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

17. 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.”

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

19. The Economy’s Production Possibilities Frontier10 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)

20. 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

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

22. 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

23. 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’

24. 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.

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

26. 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.