Lecture 1. Opportunity cost: The highest valued activity sacrificed in making a choice. The...

Lecture 1

Opportunity cost: The highest valued activity sacrificed in making a choice.

The opportunity cost of college:

Opportunity Cost

Opportunity costs are incurred when a choice is made.

They are subjective and vary across persons. If an option becomes more costly, an individual will

be less likely to choose it.

Monetary cost: tuition, books. Non-monetary cost: forgone earnings. If the opportunity cost of college rises

(e.g. tuition rises), then one will be less likely to attend college.

Mutual gain is the foundation of trade. Value can be created by exchanges that

move goods to individuals who value them more.

Trade

Transactions costs: the time, effort, and other resources needed to search out, negotiate, and consummate an exchange. Transactions costs reduce our ability to

produce gains from potential trades.

Comparative Advantage: The Basis for Exchange

What Do You Think?Do the Nepalese perform their own services

because they are poor or are they poor because they perform their own services?

Exchange and Opportunity Cost

Should Joe Jamail write his own will?Jamail is the most renowned trial lawyer in

American HistoryHe is listed 195 on the Forbes list of the 400

richest Americans, with net assets over $1 billion.


Absolute AdvantageOne person has an absolute advantage over

another if he takes fewer hours to perform a task than the other person


Comparative AdvantageOne person has a comparative advantage

over another if his opportunity cost of performing a task is lower than the other person’s opportunity cost

Exchange and Exchange and Opportunity CostOpportunity Cost

The Principle of Comparative The Principle of Comparative AdvantageAdvantage Should Paula update her own web page?Should Paula update her own web page?

Time to updateTime to updateweb pageweb page

Time to complete Time to complete bicycle repairbicycle repair

PaulaPaula 20 minutes20 minutes 10 minutes10 minutes

BethBeth 30 minutes30 minutes 30 minutes30 minutes

Opportunity CostsOpportunity Costsfor Paula and Bethfor Paula and Beth

The Principle of Comparative The Principle of Comparative AdvantageAdvantage Should Paula update her own web page?Should Paula update her own web page?

Opportunity Cost of Opportunity Cost of updating a web pageupdating a web page

Opportunity Cost of a Opportunity Cost of a bicycle repairbicycle repair

PaulaPaula 2 bicycle repairs2 bicycle repairs 0.5 web page updates0.5 web page updates

BethBeth 1 bicycle repair1 bicycle repair 1 web page update1 web page update


The Principle of Comparative AdvantageShould Paula update her own web page?

How many web pages and bicycle repairs can Paula and Beth produce a day if they both work eight hour days?


The Principle of Comparative AdvantageThe Principle of Comparative Advantage (Updated)(Updated)

If they split their time evenly and produce 16 web pages

PaulaPaula

BethBeth

Web PagesWeb Pages Bicycle RepairsBicycle Repairs

1212

882424

88

TotalTotal 2020 3232


The Principle of Comparative The Principle of Comparative AdvantageAdvantage

If they specialized in their comparative advantage

PaulaPaula

BethBeth

Web PagesWeb Pages Bicycle RepairsBicycle Repairs

00

16164848

00

TotalTotal 1616 4848


The Principle of Comparative AdvantageShould Barb update her own web page?

Productivity in Productivity in programmingprogramming

Productivity inProductivity in

bicycle repairbicycle repair

PatPat 2 web page 2 web page updates per hourupdates per hour

1 repair/hr1 repair/hr

BarbBarb 3 web page 3 web page updates per hourupdates per hour

3 repairs/hr3 repairs/hr


The Principle of Comparative AdvantageEveryone does best when each person (or

each country) concentrates on the activities for which his or her opportunity cost is lowest


Economic NaturalistWhere have all the .400 hitters gone?


Sources of Comparative Advantage Individual

Inborn talent Education Training Experience


Sources of Comparative AdvantageNational Level

Natural resources Cultural Institutions


Sources of Comparative AdvantageNoneconomic

Adoption of a language Institutions


Economic NaturalistTelevisions and videocassette recorders were

developed and first produced in the U.S. Why did the U.S. fail to retain its lead in these

markets?

Comparative Advantage and Production Possibilities

The Production Possibilities CurveA graph that describes the maximum amount

of one good that can be produced for every possible level of production of the other good.


The Production Possibilities CurveAssume

A small economy that: Produces only two goods - coffee and nuts Has only one worker who works 6 hrs/day

Susan’s Production Susan’s Production PossibilitiesPossibilities

0

Coffee(lb/day)

Nuts(lb/day)

Opportunity Cost (OC)1. OC nuts = Loss in

coffee/gain in nuts

2. OC coffee = Loss in nuts/gain in coffee

16

8

4 8

24

Production Possibilities Curve: Allcombinations of coffee and nuts thatcan be produced with Susan’s labor

A

B

C

D

12

Susan’s Production Susan’s Production PossibilitiesPossibilities

The scarcity principle: Having more of one good generally means having less of another good.

Coffee(lb/day)

Nuts(lb/day)

A

B

C

D

24

0

16

8

4 8 12

Attainable and Efficient Attainable and Efficient Points on Susan’s Points on Susan’s

Production PossibilitiesProduction Possibilities

Nuts(lb/day)

A

B

Combination F: Unattainable

C

Combination E: Inefficient

D

Combinations A, B, C, and D: Efficient

Coffee(lb/day)

24

0

16

8

4 8 12


The Production Possibilities CurveAttainable Point:

Any combination of goods that can be produced using currently available resources

Unattainable Point: Any combination that cannot be produced using

currently available resources


The Production Possibilities CurveEfficient Point

Any combination of goods for which currently available resources do not allow an increase in the production of one good without a reduction in the production of the other


The Production Possibilities Curve Inefficient Point

Any combination of goods for which currently available resources enable an increase in the production of one good without a reduction in the production of the other

Tom’s ProductionPossibilities Curve

0

Nuts(lb/day)

How Individual Productivity Affects the Slope and Position of the Production Possibilities Curve

Tom’s Production Possibilities Curve for a 6 hour day

Coffee(lb/day)

4

8

8 16

A

B

C

D

12Tom’s Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Tom’s labor

24

Individual Production Possibilities Curves Compared

Nuts(lb/day)0

12

24

Tom’s PPC

Tom has an absolute and comparative advantage in

gathering nuts

24

12

Susan’s PPC

Susan has an absolute and comparative advantage in gathering coffee

Coffee(lb/day)

Production Without Specialization

Nuts(lb/day)0

12

24

12 24

Susan’s Production Possibilities Curve

Assume: Susan and Tom allocate their time so each person’s output is half nuts and half coffee

•Tom’s Output = 2 hrs picking nuts = 8 lbs 4 hrs picking coffee = 8 lbs

•Susan’s Output = 2 hrs picking coffee = 8 lbs4 hrs picking nuts = 8 lbs

Total Output = 16 lbs each

8

8

BTom’s Production Possibilities Curve

Coffee(lb/day)

Production With Specialization

Nuts(lb/day)0

12

24

12 24

Susan’s Production Possibilities Curve

Tom’s comparative advantage is in nuts so he specializes in nuts and produces 24 lbs

Susan’s comparative advantage is in coffee so she specializes in coffee and produces 24 lbs

Susan gives Tom 12 lbs of coffee for 12 lbs of nuts

E

Tom’s Production Possibilities Curve

Coffee(lb/day)

The gains from specialization grow larger as the difference in opportunity cost increasesFor Example

Susan: 5 lb coffee/hr 1 lb nuts/hr

Tom: 1 lb nuts/hr 5 lb coffee/hr

Comparative Advantageand Production Possibilities

The gains from specialization grow larger as the difference in opportunity cost increasesWithout Specialization

Tom: 5 hrs coffee = 5 lb 1 hr nuts = 5 lb

Susan: 1 hr coffee = 5 lb 5 hrs nuts = 5 lb

Total: 10 lb 10 lb


The gains from specialization grow larger as the difference in opportunity cost increasesWith Specialization

Tom: 30 lb coffee 0 lb nuts

Susan: 0 lb coffee 30 lb nuts

Total: 30 lb 30 lb

Comparative Advantageand Production Possibilities

Production PossibilitiesCurve For a Large Economy

Nuts(1000s of lb/day)

Assume: An economy that produces only two goods, coffee and nuts

100

80

Why would the Production Possibilities Curve have

an outward bow?

Coffee(1000s of lb/day)

E

AB

C

D

1520

9095

20 30 75

77

The Principle of Increasing Opportunity Cost (“The Low-Hanging-Fruit Principle”) In expanding the production of any good, first

employ those resources with the lowest opportunity costs, and only afterward turn to resources with higher opportunity costs


Economic Growth: An Outward Shift in the Economy’s PPC

Coffee(1000s of lb/day)

Nuts(1000s of lb/day)

Original PPC

New PPC

Factors Shifting the PPC1. Increases in productive resources

(i.e. labor or capital)

2. Improvements in knowledge and technology

Factors That Shift The Economy’s Production Possibilities Curve

Increasing Productive Resources Investment in new factories and equipment Population growth

Improvements in knowledge and technology Increasing educationGains from specialization


Why Have Countries Like Nepal Been So Slow to Specialize? Low population density Isolation

Factors that my limit specialization in other countries Laws Customs


Can we have too much specialization?

What do you think?What are the costs of specialization?

Comparative Advantage and International Trade

Economic Naturalist If trade between nations is so beneficial,

why are free-trade agreements so controversial?

for Susan’s grades in English and Economics (10 hrs of study)

A

AB

B

C

CD

D

Expected grade in Economics 101

Expected grade in English 101

Production Possibilities Curve• Susan is a student who only has 10 hours of study to divide between her economics and English classes.

FF

Production PossibilitiesCurve ( PPC )• If she spends most of her time

studying economics, she can earn an A in economics … and a D in her English class.• If she splits her time between the two, she can earn a B in economics … and a B in her English class.• If she spends most of her time studying English, she can earn a D in economics … and an A in her English class.• Mapping out all the possibilities of how Susan can divide her time (limited resources) between these activities shows us her Production Possibilities Curve ( PPC ).

- Inefficiency -

Output of clothing

Outputof food

A

DB

C

T

S

Production Possibilities Curve for a nation’s economy (given limited resources)

Production PossibilitiesCurve ( PPC )Only clothing

is produced

Only foodis produced

All output combinations on the frontier curve are efficient.

• Consider an economy which has limited resources to divide between the production of clothing and food.• If it allocates all of its resources toward the production of clothing, then it can produce at point S.• If the it allocates all of its resources toward the production of food, then it can produce at point T.• Mapping out all the possibilities of how an economy can divide the use its resources gives us the economy’s Production Possibilities Curve.• Output combinations A, B, & C are all on the PPC and are, therefore, efficient allocations of resources.• D is within the PPC and represents an inefficient resource allocation. Combination B delivers more food with the same output of clothing.

Shifting the Production Possibilities Curve Outward

An increase in the economy’s resource base would expand our ability to produce goods and services.

Advancements in technology can expand the economy’s production possibilities.

By working harder and giving up current leisure, we could also increase our production of goods and services. This requires us to give up something else we value:

leisure.

An improvement in the rules (laws, institutions, and policies) of the economy can increase output.

Investmentgoods

Consumptiongoods

IA

CA

A

Investment and Production Possibilities in the Future

PPC 2005

PPC 2015 with A

• The long-term benefits of investment include greater output in the future. Thus, decisions we make today regarding how much to save (investment) and consume determine the shape of the PPC 10 years from now.• If we choose to produce a mixture of consumption and investment goods which corresponds to bundle A … then the future PPC might move out to PPC 2015 with A – due to the new buildings, equipment, training, and other forms of investment goods that IA represents.

Investmentgoods

Consumptiongoods

IA

CA

A

Investment and Production Possibilities in the Future

PPC 2015 with B

PPC 2005

PPC 2015 with A

BIB

CB

• If we choose to produce a mixture of consumption and investment goods which corresponds to bundle B, with fewer consumption goods (CB < CA) and more investment (IB > IA) …

• The level of investment (savings) in an economy is only one determinant of the movement outward (or inward) of the production possibilities curve.

then the future PPC might move out to PPC 2015 with B instead.

Law of comparative advantage: The proposition that the joint output of trading partners will be greatest when each good is produced by the low opportunity cost producer.

Implies that trading partners can gain by specializing in the production of goods they can produce at a relatively low opportunity cost and trade for goods they could only produce at a relatively high opportunity cost.

The principle of comparative advantage is universal as it applies across individuals, firms, regions and countries.

Law of Comparative Advantage

Economic Organization:Markets vs. Political Planning

Market organization: A method or organization that allows for unregulated prices and the decentralized decisions of private property owners to resolve the basic economic problems. Sometimes called capitalism.

Market Organization

Political Planning Political organization is the major

alternative to the use of markets. Political organization involves the use of

collective decision making (government) to decide what, how, and for whom goods and services will be produced. An economic system in which the

government owns the income-producing assets and directly determines what goods they produce is called socialism.

In a democracy, political decision makers have to consider how their actions will influence their election prospects.

Questions for Thought:

1. Suppose Amy is a doctor who has records that need to be entered. Doing this work herself would take 10 hours per week. She is thinking about hiring an assistant who could do the same work in 40 hours. If Amy can make $80 per hour seeing patients, should she hire the assistant at $10 an hour?

2. Do you make the food that you consume and clothing you wear for yourself? What are the sources of gains from trade? Would modern living standards be possible without trade?

Questions for Thought:

3. What does a production-possibilities curve demonstrate? Can the production possibilities of an economy be increased? If so, how?

4. “Modern living standards are primarily the result of brain power, capital formation, and the quality of institutions.” What is the meaning of this statement? Is it true?

Lecture 1. Opportunity cost: The highest valued activity sacrificed in making a choice. The...

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