Chapter # 4

The Opportunity Cost Theory

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.

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.

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.

PPF Example

• Producing one computer requires 100 hours labor.• Producing one ton of wheat requires 10 hours labor.

5,0000

4,000100

2,500250

1,000400

50,0000

40,00010,000

25,00025,000

10,00040,000

0500050,000

E

D

C

B

A

WheatComputersWheatComputers

ProductionEmployment of

labor hours

Point on

graph

Production

Com-puters

Wheat

A 500 0

B 400 1,000

C 250 2,500

D 100 4,000

E 0 5,000 0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

A

B

C

D

E

PPF Example

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?

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A C T I V E L E A R N I N G 1: Answers

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• 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.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

F

A C T I V E L E A R N I N G 1: Answers

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0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

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

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

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.

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.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

–1000100

slope = = –10

Here, the opportunity cost of a computer is 10 tons of wheat.

Exercise : No 2PPF and Opportunity Cost

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In which country is the opportunity cost of cloth lower?

0

100

200

300

400

500

600

0 100 200 300 400Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400Cloth

WineFRANCE ENGLAND

A C T I V E L E A R N I N G 2: Answers

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England, because its PPF is not as steep as France’s.

0

100

200

300

400

500

600

0 100 200 300 400Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400Cloth

WineFRANCE ENGLAND

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.

THE PPF UNDER CONSATANT COST CONDITION

United state United kingdom Wheat cloth wheat cloth180 0 60 0150 20 50 20120 40 40 40 90 60 30 60 60 80 20 80 30 100 10 100 0 120 0 120

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.

120

180

120

60

Clot

h

S

U

K

60

wheat 90

40

40

A A

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.

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

0 50 70 X

Yconvex from the origin

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.

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

0 decreasing cost X

End of Chapter 3

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