1. The Next Best Alternative
Opportunity Cost
The Next Best Alternative

2. The Opportunity Cost of doing something is the value of the next best alternative you give up.
What is the opportunity cost of investing $500 in a new stereo system?
What is the opportunity cost of going to college?

3. Opportunity cost varies from person to person
What would you have purchased if you did not purchase the $500 stereo system?
What could you “earn” if you don’t go to college

4. When we use resources to produce one good or service, the opportunity cost is that we cannot produce another good or service.
When we make birdcages, we cannot use the same resources to make chairs.

5. How do you get an A in this class?
Of course, hard work and fulfilling requirements
If you are unable to achieve an A by fulfilling requirements, you may be able to buy one.
The going rate is one million dollars

6. How do individuals or groups determine which specific goods or services to produce?

7. Can anyone tell me who this is. It’s “Wilson
Can anyone tell me who this is? It’s “Wilson.” Tom Hanks only friend in what movie? *

8. Castaway in which he starred as a FED EX delivery man who is stranded on a desert island for 4 years. He discovers that he must do everything in order to survive. There is no one there to help him so he has to find out the best way accomplish this task by himself. Effectively, he is forced to live a life without specialization. The irony is that before he became stranded he helped deliver important packages around the globe so that people could specialize using their comparative advantage. This movie is poignant reminder of how difficult life would be if we had to do everything for ourselves. *

9. Law of Comparative Advantage
The individual (or country) with the lowest opportunity cost of producing a particular good should specialize in producing that good.
Specialization – The concentration of the productive efforts of individuals and firms on a limited number of activities

10. Babe Ruth

11. Opportunity cost is the key to comparative advantage: Individuals and nations gain by producing goods at relatively low costs and exchanging their outputs for different goods produced by others at relatively low cost. All potential trading partners can gain enormously through appropriate specialization and exchange.

12. Comparative & Absolute Advantage
Comparative Advantage:
The ability to produce something at a lower opportunity cost than other producers face
Absolute Advantage:
The ability to produce something with fewer resources than other producers use

13. Opportunity Costs and Efficiency
Before Specialization
Hours Worked
Production and Consumption
Alaskan 4
5 pounds of salmon
1 pound of coffee
Brazilian
1 pound of salmon
5 pounds of coffee
After Specialization
Hours Worked
Production
Consumption
Alaska 8
10 pounds Salmon
5 pounds of salmon
5 pounds of coffee
Brazilian
10 pounds Coffee
Trade enables each Alaskan to consume an additional 4 pounds of coffee per day, and each Brazilian to consume an extra 4 pounds of fish per day. Each group specializes in the form of production in which it enjoys a comparative advantage, and Alaskans and Brazilians both gain from trade. *

14. Suppose, for example, that a lawyer whose fees run $250 an hour types twice as fast as her secretary, whose wage is $12 hourly. She still gains by hiring the secretary. Despite her absolute advantage in typing, the lawyer’s comparative advantage lies in practicing law.

15. Comparative Advantage in Early America
“Cash crops did not grow well in the Northern soil and climate. Southerners, on the other hand, had begun to reap huge profits from cotton by the mid-1790s. The South had very little incentive to industrialize. As a result, the North and South continued to develop two distinct economies, including very different agricultural systems.”
---The Americans

16. Comparative Advantage in Early America
Northern Comparative Advantage
Industry
Southern Comparative Advantage
Mass Cotton and Tobacco Production

17. Other Economic Principles in Early America
Cost-Benefit Analysis of Slavery
Opportunity Cost: Value of the next best alternative
North: Chose no slavery
Assume slavery (owning the laborer) is next best alternative to wage labor (renting the laborer).
South: Chose slavery
Assume wage labor is next best alternative to slave labor
Question: Why did the benefits of the choice exceed the opportunity cost?

18. Other Economic Principles in Early America
Factors influencing choice of labor type
Relatively high wages in America
Made renting labor expensive everywhere
Fixed costs of overseeing and possessing slaves
Larger firm size lowers average fixed cost
Minimum average cost for slave production occurs at larger firm size.
Climate and market differences promoted large firm size in South and small firm size in North.

19. Other Economic Principles in Early America
Trade is mutually beneficial
Northern farmers traded with Northern manufacturers
Facilitated growth of Northern industry
Relative wealth in industry ownership
Southern farmers traded with European manufacturers
Facilitated growth of Southern plantation system
Less industrial growth in South
Relative wealth in plantation ownership
Beneficial trading was separating North and South

20. Other Economic Principles in Early America
“American System”
Tariff in 1816 on imported manufactured goods from Europe
Designed by President Monroe to make North and South more interdependent
Lobbied for by Northern Manufacturers
Ushered in the “era of good feelings”
Circular Flow of Income and Expenditure
One person’s spending becomes another’s income

21. Other Economic Principles in Early America
Restricting Trade
Common Incentive:
Shift the mutually beneficial trade my way
Limit my competitors
Tariff of 1816
Shifted South-Europe trade to South-North trade
Strengthened Northern Manufacturing
Influenced outcome of Civil War

22. Illustrating Comparative Advantage
A Tootsie Roll Game
Ignore absolute advantage to keep things as simple as possible
Five “points” to use in production
Country A: Twice as productive at producing cherry tootsies.
Country B: Twice as productive at producing cherry tootsies.

23. Illustrating Comparative Advantage
Country A: Production Possibilities Using Your 5 Points
Your Choice?
Allocation of Points
Production Possibilities
Points Used
To Produce
CHERRY
ORANGE
Tootsies
Produced A 5 B 1 4 2 C 3 D 6 E 8 F 10

24. Illustrating Comparative Advantage
Country B: Production Possibilities Using Your 5 Points
Your Choice?
Allocation of Points
Production Possibilities
Points Used
To Produce
CHERRY
ORANGE
Tootsies
Produced A 5 10 B 1 4 8 C 2 3 6 D E F

25. Illustrating Comparative Advantage
Which production combination did you choose?
Cherry _________
Orange _________

26. Illustrating Comparative Advantage
Trading Opportunity
Would you like to replay the game?
Produce first
Then trade
One cherry for one orange, or
One orange for one cherry

27. Illustrating Comparative Advantage
For Replay of the Game:
Which production combination did you choose?
Cherry _________
Orange _________
After trade combination?

28. Practice:
Under current conditions, we can produce either 120 autos OR 3 aircraft, therefore: 120A = 3 B.
Dividing both sides by 3 yields: 120/3 = 3/3 or 40A = 1B
40A = 1B is the number of autos given up to produce one aircraft or the opportunity cost of one aircraft

29. To Find Which Nation has the Comparative Advantage
Find opportunity costs for both nations
Compare each product’s opportunity cost from nation to nation
Nation with the lowest opportunity cost has the comparative advantage
If U.S. has 1A=.025B & G.B. has 1A=.05B, who has the comparative advantage?

30. Importance of Comparative Advantage
To benefit from free trade, a nation does not have to be the lowest cost producer in the world
A nation only has to have the lowest opportunity cost
Remember, opportunity cost is what you give up to do something
Use all the world’s resources in the relatively most productive ways