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Opportunity cost or economic opportunity loss is the value of the next best alternative foregone as the result of making a decision. Opportunity cost analysis is an important part of a company's decision-making processes, but is not treated as an actual cost in any financial statement. The next best thing that a person can engage in is referred to as the opportunity cost of doing the best thing and ignoring the next best thing to be done.

Opportunity cost is a key concept in economics because it implies the choice between desirable, yet mutually exclusive results. It has been described as expressing "the basic relationship between scarcity and choice."[3] The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[4] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs.

ExamplesA person who invests $10,000 in a stock denies themselves the interest they could have earned by leaving the $10,000 in a bank account instead. The opportunity cost of the decision to invest in stock is the value of the interest.

An organization that invests $1 million in acquiring a new asset instead of spending that money on maintaining their existing asset portfolio incurs the increased risk of failure of their existing assets. The opportunity cost of the decision to acquire a new asset is the financial security that comes from spending the money on maintaining their existing asset portfolio.

If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits forgone of the next best thing which might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sports center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, since those uses tend to be mutually exclusive. Also included in the opportunity cost would be what investments or purchases the private sector would have voluntarily made if it were not taxed to build the hospital. The total opportunity costs of such an action can never be known with certainty (and are sometimes called "hidden costs" or "hidden losses" as what has been prevented from being produced cannot be seen or known). Even the possibility of inaction is a lost opportunity (in this example, to preserve the scenery as-is for neighboring areas, perhaps including areas that it itself owns).

Opportunity cost is not only assessed in monetary or material terms, but can be assessed in terms of anything which is of value. For example, a person who desires to watch each of two television programs being broadcast simultaneously, and does not have the means to make a recording of one, can only watch one of the desired programs. Therefore, the

opportunity cost of watching Dallas could be enjoying Dynasty. In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. The opportunity cost for the diner of ordering both meals could be twofold - the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought gluttonous or extravagant for ordering two meals. One might decide to use a short period of vacation time to visit Disneyland rather than do household improvements. The opportunity cost of having happy children could therefore be a remodelled bathroom.

EvaluationThe consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action.

Note that opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money which could have been made from selling the land, as use for any one of those purposes would preclude the possibility to implement any of the others.

However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money.

In some cases it may be possible to have more of everything by making different choices; for instance, when an economy is within its production possibility frontier. In microeconomic models this is unusual, because individuals are assumed to maximise utility, but it is a feature of Keynesian macroeconomics. In these circumstances opportunity cost is a less useful concept.

Because goods and services are scarce, choices must be made. Scarcity - the available resources are insufficient to satisfy people's wants - is universal. All individuals, households, business firms, communities, nations - rich and poor alike - confront scarcity. The fundamental economic problem is the appropriate use of limited resources to produce the goods and services that we value most. Economics, therefore, can be defined as the study of the choices people make in order to cope with scarcity.

The resources (also called inputs or factors of production) that can be used to produce goods and services are divided into four main categories:

Land, the gifts of nature such as air, water, land surface and minerals lying beneath the earth's surface.Labor, the time and physical or mental effort devoted to producing goods and services. Capital, goods made by people that are used to produce other goods and services (factories, tractors, buildings, power plants, hand or power tools, machinery, equipment, transportation networks, etc). Human capital is the knowledge and skill people possess from education and vocational training. Enterpreneurial ability, the resource that organizes land, labor and capital. The enterpreneur is the person who sets up a firm by combining all factors of production in order to produce a good or service. While labor receives wages or salaries for the work, the enterpreneur expects to receive profits for his efforts.

The true cost of anything that is scarce is its opportunity cost, what is given up to get it. In other words, the opportunity cost of an action is the highest valued alternative forgone.

The Three Coordination Tasks of an EconomyEvery society must figure out what is referred in economics as the "how", "what" and "for whom" to produce:

1. How to utilize its resources efficiently - it is the choice among different resource combinations and techniques used in the production of a good or service. A good or service can be produced with different resource combinations and techniques; the problem is which of these to use. Since resources are limited, when a greater quantity is used to produce a particular good or service, less quantity is available for the production of another good or service. The problem facing society is choosing the right resource combination and production technique so that the cost

in terms of the resources used for each unit of the good or service it decides to produce will be minimal.

2. What combination of goods and services to produce - Since resources are scarce, no economy can produce as much of every good or service as desired by everyone. More of a good or service means less of others. So, society must choose which goods and services to produce and in what quantities.

3. How much of each good to distribute to each person - The problem of how to divide up what has been produced among the consumers, that is, how many of the consumers' wants can be satisfied. Scarcity ensures that society cannot satisfy the wants of all its members.

SpecializationPeople, businesses and nations can produce for themselves all the goods and services they consume, or they can concentrate on producing one good or service (or, possibly, a few goods or services) and then trade with others, that is, exchange some of their own goods or services for those of others. Specialization is the concentration on the production of only one good or service, or a few goods or services.

The principle of comparative advantage states that each nation (or individual) should specialize in the production of the good or service in which he is more efficient (or less inefficient). Stated differently, an individual or a nation has a comparative advantage in producing something if he can produce it at a lower opportunity cost than anyone else. This stems from the fact that people's abilities differ and, as a result, different people have different opportunity costs of producing a particular good or service.

It should be noted that it is not possible for anyone to have a comparative advantage in everything. Thus, gains from specialization and trade are always available when opportunity costs are different. Specialization requires a system of exchange to enjoy the fruits of comparative advantage. A voluntary exchange must yield mutual gains, that is, to make both parties better off.

Markets, Prices and the Three Coordination TasksMarkets bring together buyers and sellers of goods and services. A market is any arrangement that enables buyers and sellers to get information and to do business with each other. Prices of goods and of resources, such as labor, machinery and land, adjust to ensure that scarce resources are used to produce those goods and services that society demands. 

Much of economics is devoted to the study of how markets and prices enable society to solve the problems of how, what and for whom to produce:

"How to produce": Because the price of a resource reflects its relative scarcity, the best way to produce a good or service is to ensure the least money cost of production. If the price of a resource rises relative to the price of others used in the production of the particular good or service, producers will switch to another production technique: the one that uses less of the more expensive resource. The opposite holds true when the price of resource falls relative to the price of others."What to produce": the price mechanism ensures that only those goods and services for which consumers are willing to pay a price sufficiently high to cover at least the full cost of production will be supplied by producers. A higher price induces producers to increase the quantity supplied of a good. Alternatively, a fall in price will induce producers to decrease the quantity supplied of a good."For whom to produce": The economy will produce those goods and services that satisfy the wants of those consumers who can afford them. The higher the income of consumers, the more the economy will be geared to produce those goods and services they want and are willing to pay for them.

 

Scarcity & Opportunity Cost

Wouldn't the world be a wonderful place if we could consume all the goods and services we wanted and never had to worry where the money would come from? Unfortunately, the world is not such a kind place. Each one of us has limited resources, and we must make choices as to how we will use those resources. The science of economics is concerned with the rationing of scarce resources.

Scarcity occurs when, at a zero price, quantity demanded is greater than quantity supplied. In other words, if the good were free, there would be a shortage of the good because more of the good would be demanded than supplied. Most goods and services are scarce. The concept of scarcity suggests the necessity of rationing goods and services in some manner. The most common way to do this is by using the price system. When a price is put on a good or service, people have to choose what products they will spend their income on.

There are a few things in life that are not scarce. Water and air are a few. These are two free goods for which there is usually no shortage. This statement, however, comes with certain provisios. "Clean" air may indeed be scarce. The same is true for "drinkable" water. We may be willing to pay for these resources.

Scarcity helps us to understand the idea that resources are limited and we cannot have everything that we want. Given our limited resources, we must make choices about where our resources should go. Every choice we make, then, involves a cost.

Opportunity Cost is the value of the next best alternative that is given upEvery decision we make means sacrificing some other option. What is the opportunity cost of going to college when your next best alternative is to work full time and live in an apartment? The full cost is not just the tuition. What else are you giving up? The answer is tuition ($2,000) + books ($500) + foregone income from not working. Tuition and books are the explicit resourses you must spend in order to attend college. But your time is also valuable and choosing to spend time in college means giving up time to work at a full time job.

The Principle of Increasing Costs

Why does the production possibilities frontier bow outward? We have intentionally drawn the curve this way to reflect the principle of increasing costs. The Principle of Increasing Costs says that as production of a good expands, the opportunity cost of producing another unit generally increases. This is because resources tend to be specialized so that some of their productivity is lost when they are transferred from what they do well to what they do poorly. One can see in the chart above that the opportunity cost of producing more and more defense goods increases.

When resources are not specialized, the principle of increasing costs does not apply and the production possibilities frontier is a straight line. This is represented in the chart below which plots the production of right shoes versus left shoes. Resources required to produce each of these products are very similar.

Graphing & Slopes

In this section, we briefly review the basics of graphing. The slope of a line is the rise over the run, or the change in y divided by the change in x, where the y axis is the vertical axis and the x axis is the horizontal axis.

In the first chart below, point A is situated at the (x,y) coordinate (2,4). Point B is at (4,8). Since we move up the Y axis four units while moving across the X axis 2 units, the slope is 4/2=2. Note that the slope is positive implying that X and Y are directly related. When X increases so does Y.

The second chart below shows point A at (5,10) while B is at (7,9). Y falls one unit while X rises by 2 units. The slope is -1/2. Here X and Y are inversely related. When X increases, Y decreases.

The third chart shows a flat line. Since the Y value does not change no matter how much X changes, the slope is zero.

The final chart shows a perfectly vertical line. This time the X value does not change, regardless of the Y value. Therefore, we divede by zero to calculate the slope which is infinite or undefined.

Use caution when reading graphs because the axis and scales can change and give misleading results when just glanced at.

Opportunity cost is one of the most frequently used tools for modern economic analysis, deriving many important economic theories and models. It is also a powerful tool in analyzing individual decision-making process. Whoever you are, an individual, a company or a nation, you face opportunity cost when making decisions.

Nearly all decisions involve trade-offs. When we are choosing, we are also giving up. Every action and choice is associated with advantages and disadvantages, costs and gains. A key concept that recurs again and again in analyzing the decision-making process is the notion of opportunity cost. The full cost of making a specific choice is what we give up by not taking the alternative. That which we forgo, when making a choice or decision is called the opportunity cost of the decision. More precisely, opportunity cost is not all that we are not choosing added up, instead, it is the most valued one among all that we let go. Sometimes opportunity cost can be measured in terms of money, although money is usually not the only part of it.

Example of Opportunity Cost What is the opportunity cost of attending college full time this year? What is the best alternative you give up to attend college? Suppose you have a job that guarantees $24,000 a year, by subtracting your summer part-time earning of $7,000 in college, you know you are giving up net earnings of $24,000 - $7,000 = $17,000 for attending college this year. In addition, you are paying $ 6,000 for tuition, various fees and books, which is unavailable for you (or your family) to spend elsewhere. Thus the opportunity cost of paying for tuition, fees and books is the value of the goods and services that could have purchased with the money. To sum up, by choosing to attend college full time this year, your opportunity cost in money would be a total of $17,000 + $6,000 = $23, 000. However, time spent on lessons may well be over and above that spent on going a routine job, leaving less time for you to go to parties or hanging out with family and friends. So you see, opportunity cost does not solely talk about money, in fact, it is usually bigger than those tangible things that we have forgone in the form of money.

Opportunity cost is subjective. Only the chooser can determine the most attractive alternative for itself from its special point of view. We each has a different list of things valued in decline from top to bottom due to our different aims of life and philosophy. Even for the same activity or good or service, different individuals take it with different opportunity cost.

Example of Subjectivity of OC I started building this website bearing the hope that it would one day become popular so that I could benefit from the commercial value. I made the decision to do this because I believe the other activities I could otherwise be involved in will generate less or no value for me in future as opposed to writing this crash course. Bill Gates, on the contrary, with much more serious and far more profitable business to do, he would have never seen any good in doing this. The opportunity cost he would have to undertake by spending his precious time on this is so huge that it is almost impossible for it to happen to a rational economic man like him.

Nevertheless, the chooser seldom knows the actual value of the second best alternative forgone, since focusing on only the expectedly best alternative makes all other possible alternatives irrelevant. In light of this, you will never know the exact value of what you let go if you give up an evening of pizza and conversation with friends to work on a term paper.

Economics examines how people use their scarce resources in an attempt to satisfy their unlimited wants. Would you like a grand new Porsche, a sea shore villa or a luxury ocean journey aboard the Luxury Liner Hawaii? Would you like more free time, more sleeping time and more money to spend? Who wouldn't? The problem is simply that the resources available to satisfy these wants, or desires, are virtually limited. They are scarce. Economic choices arise from scarcity. If it were not scarcity, we would never bother to study economics, making choices in between, constructing economic structures and market

mechanisms to produce and distribute; and trying to maintain them work smoothly and efficiently.

2.1. Resources & Goods and ServicesResources are the inputs, or factors of production, used to produce the goods and services that human wants. Resources scarcity causes goods and services scarcity. Generally, we put resources into 3 categories: labor, capital, land. Labor is the broad category of human effort, both physical and mental included. Capital ranges from factories, machines, tools, airports and highways to human knowledge and skill, that are used to, or facilitates further production of goods and services, complementing labor. Distinguish between human effort and human capital. Human effort is the process of allocating time, transforming your skills, that is the human capital to tangible results, that is the goods or services directly consumed. Land refers not only to land in the conventional sense of tracts of ground, but all other natural resources, that is, gifts of nature, including bodies of water, oil reserves, minerals and even animals.

To use resources, wages are paid to labor, interest to capital, and rent to land.

Goods and services are produced when a variety of resources are combined in a specific way. A good is something we can see and touch, like a hamburger, whereas a service is something intangible albeit we might as well consume it and pay for it, like a concert. Since goods and services are combinations of scarce resources, they themselves are scarce. "There is no such thing as a free lunch." Because we have to continually choose among the goods and services, given that we cannot have all those we want. We are giving up one thing upon choosing another. Sometimes certain goods are mistakenly thought of as free in that they involve no apparent cost to access. Imagine that you receive free subscription cards falling out of magazines, and you get an additional season of copies. Producing the cards and offering the free copies, however, absorbs scarce resources that are drawn away from competing uses, such as promoting the quality of the magazine.

2.2. The Three Basic QuestionsDue to scarcity, all societies or economies must answer three basic questions:

1. What will be produced? 2. How will it be produced? 3. Who will get what is produced?

That is, a economic system must decide the allocation of inputs(resources) among producers, the mix of output, and the distribution of output, no matter the scale of the economy and level of development.

The Economic Problem

All societies are endowed by nature and by previous generations with scarce resources. Every society must decide how to use these inputs to satisfy human wants. Specifically, resources must be divided up among producers who transform them into goods and services that in turn must be allocated among households or members of society.

2.3. Specialization & Comparative Advantage

Suppose a weekend afternoon, the neighbor pays a total of 20 dollars for you and your friend Sam to mow the lawn and trim the bushes in his garden. You are skillful at trimming and take 1 hour to finish the given task compared to Sam's 1.5 hours, while Sam is more competent for the mowing job in that he can finish it in 2 hours compared to your 3 hours. Undoubtedly, you both want to finish the job as quickly as possible to get the money and hopefully will still have some leisure time. But how will the tasks be divided between you two? In this case, it is quite obvious from common sense. Yes, you trim and Sam mows.

Working separately   Mowing(hour) Trimming(hour)

You 3 1Sam 2 1.5

Nevertheless, common sense does not always stand its position. Since you have done the work together, each of you would receive less than the payment you would have received when you do it separately. Is it really that you both benefit from it? If so, how much more do you earn by the means of specialization? Let's now solve the problem that once made Adam Smith scratches his head(just kidding :)). Before we continue, a small notion of leisure hour is assumed that a leisure hour is an hour of leisure time for a single person. So, every hour you or Sam spend on working in the garden has a opportunity cost of a leisure hour, because you both value your time for leisure, but if you want to get paid, you have to give up some of them. In addition, your reward will be divided up based on the time each of you devotes into the work.

Separately, you would have to sacrifice 4 leisure hours to get the 20 dollars, thus 5 dollars compensation for each leisure hour forgone; Sam would have to give up 3.5 leisure hours to get the 20 dollars, thus 5.71 dollars compensation for each leisure hour let go. However, when you two work jointly, employing the scheme that you trim while Sam mows, it would only take you a total of 3.2

leisure hours(that is 1.6 physical hours, because you both keep working until everything is done)to complete the whole job. Why? Because you both set to work at the same time, after an hour, that is when you are finished, Sam's mowing job still have half way to go, so you join him. At your joint effort, the remainder half is done in 0.6 hours, because

where W stands for the total amount of mowing work, and 1/3 is your efficiency while 1/2 is Sam's.

Finally we have, the compensation or payment for each leisure hour sacrificed when you and Sam worked together is 20/3.2=6.25 dollars, higher than both the hourly payment you receive when working solely. Plus, instead of giving up 4 or 3.5 hours of leisure time, you each had only 1.6 hours of leisure subtracted from that weekend afternoon. Although you earn only 10 dollars each, but you could easily earn the other 10 by working an extra 1.6 hours together and still have surplus leisure time.

Very clear now, that specialization does make you better off. A somewhat astonishing fact is that, you and Sam would be far better off if you have not helped him with the remainder half mowing work. Why? See if you can find the answer by yourself.

The idea that members of society benefit by specializing in what they do best has a long history   and is one of the most important and powerful ideas in all of economics. According to the theory of comparative advantage, specialization and free trade will benefit all trading parties, even when some are "absolutely" more efficient producers than others. If you were the absolutely more efficient producer, your efficiencies in both mowing and trimming are higher than those of Sam. In this case, suppose you are able to mow the lawn within 1.5 hours, according to the theory of comparative advantage, you and Sam can still benefit from specialization. The reason is beyond our discussion, though, if you are eager to know, search comparative advantage with Google.

Scarcity and Choice for a Single FirmThe production possibilities frontier (PPF) shows the different combinations of various goods that can be produced given the available resources and existing technology. The PPF marks the boundary between combinations of goods and services that can be produced and combinations that cannot.

Figure shows a production possibilities diagram that holds constant the production of all goods except for soyabeans and wheat. The PPF line separates attainable combinations of production (all points inside and on the line) from unattainable combinations (all points beyond the line Different resources are not equally effective in producing different goods. Thus, along the PPF, producing more of one good has increasing opportunity costs. The convex (bowed-out) shape of the PPF reflects increasing costs. Most activities in the real world are subject to increasing opportunity costs.

The opportunity cost of an action is the highest valued alternative forgone. On the PPF, the the opportunity cost of producing more of one good (e.g., soyabeans) is the output of the other good that must be forgone (e.g., wheat). The opportunity cost of a bushel of soyabeans is the number of bushels of wheat that must be forgone per bushel of soyabeans; therefore, opportunity cost is a ratio. The opportunity cost of a bushel of wheat is the inverse of the opportunity cost of a bushel of soyabeans.

For example, at point C in Fig. 4-1and Table 4-1 we are producing fewer wheat and more soyabeans than at point D. If we choose point D

over point C, the additional 8,000 bushels of wheat cost 10,000 bushels of soyabeans. We can also work out the opportunity cost of chossing point C over point D in Fig. 4-1 and Table 4-1. If we move

from point D to point C, the quantity of soyabeans produced increases by 10,000 bushels and the quantity of wheat produced decreases by 8,000 bushels. So, if we choose point C over D, the additional 10,000

bushels of soyabeans cost 8,000 bushels of wheat. Opportunity cost is a ratio. It is the decrease in the quantity produced of one good divided by the increase in the quantity produced of the the other good as we

move along the PPF. Because opportunity cost is a ratio, the opportunity cost of producing soyabeans is equal to the inverse of the

opportunity cost of producing wheat. Table 1 below shows the calculation of the opportunity cost both in terms of soyabeans and

wheat.

TABLE 1 - CALCULATION OF THE OPPORTUNITY COST

OPPORTUNITY COST OF:SOYABEANS WHEAT SOYABEANS WHEAT

40 0 (38 - 0 / 40 - 30) = 38/10 -

30 38 (52 - 38 / 30 -20) = 14/10 (40 - 30 / 38 - 0) = 10/38

20 52 (60 - 52 / 20 -10) = 12/10 (30 - 20 / 52 - 38) = 10/14 

10 60 (65 - 60 / 10 - 0) = 5/10 (20 - 10 / 60 - 52) = 10/12

0 65 - (10 - 0 / 65 - 60) = 10/5

 

Scarcity and Choice for the Entire SocietyEconomic growth is the expansion in production. Two factors cause economic growth:

Technological progress is the development of new goods and services and better ways to produce goods and servicesCapital accumulation refers to the growth in a society's capital resources.

The greater the rate of capital accumulation and/or technological process, the more rapidly the PPF expands, that is, the more rapid is economic growth. Economic growth is costly. The opportunity cost is incurred because resourses are devoted to manufacturing capital goods and developing new technologies rather than to producing goods for current consumption. Nations that incur the cost of devoting more of their resources to capital accumulation or technological change (Asian Tigers - Fig. 4-4b) grow more rapidly than nations that choose not to pay the cost and thus devote fewer resources (United States - Fig. 4-4a) to such purposes.

The Concept of EfficiencyProduction efficiency means that more of one good cannot be produced without decreasing the production of another good. Production efficiency occurs only when production takes place on the frontier line. Because another good must be given up, there is a tradeoff. If we are at a point inside the PPF, such as point G in Fig. 4-3, production is inefficient because there are unused or misallocated resources.

Resources are unused when they lie idle but could be working. For example, we might leave some of the land used for the cultivation of soyabeans idle or some workers might be unemployed. Resources are misallocated when they are assigned to tasks for which they are not suitable. For example, we might assign land best suited to soyabean cultivation to wheat cultivation, or assign skilled soyabean workers to

work in wheat cultivation. We could get more soyabeans and more wheat from the same inputs (i.e., land and/or labor) if we reassigned them to tasks that closely match their skills.

If we produce at a point inside the PPF, such as G, we can use our resources more efficiently to produce more soyabeans and more wheat or more of both soyabeans and wheat. But if we produce at a point on the PPF, we are using our resources efficiently and can produce more of one good only if we produce less of the other.

Economic Growth

Economic growth is the increase in the economy's level of production. Recall that the production possibilities frontier shows the possible production of two goods given the available resources and technology. Economic growth can occur because either the resource base expands, or the level of technology increases. Economies grow when population grows because labor is an important resource. Economic growth also occurs when we learn how to use our existing resources more productively. This is what we call technological progress. For a given amount of resources, the economy's level of output increases. In either case, economic growth results in a shift outward of the production possibilities frontier.

2.4. The Production Possibility FrontierProduction possibility frontier, or PPF, is a simple graphical device used to illustrates the constrained choice and scarcity, showing all the possible combinations of goods and services that can be produced if all resources of the society are used efficiently. Below is a PPF for a hypothetical economy.

Production Possibility Frontier

Due to resources scarcity, the more capital goods are produced, the fewer consumer goods can be produced, and vice versa. Moving from possibility E to F, ΔK is the increase in the number of capital goods. To produce more capital goods, resources must be transferred from the production of consumer goods. So ΔC indicates the decrease in the number of consumer goods.

All points below and to the left of the dark green curve(the light green area) represent combinations of capital and consumption goods that are possible for the society given the resources available and existing technology. Points above and to the right of the curve such as G represent combinations that cannot be realized. Points on the production possibility frontier can be thought of as full employment and production efficiency, where resources are not going idle or wasted. If an economy ends up at the point that lies within the light green area such as D, it is suffering from unemployment and production inefficiency.

In reality, while all economies produce some of each kind of good, different economies emphasize different things, and it is usually very difficult for an economy to produce at a point on the possibility frontier. Resources misallocation and idleness such as unemployment always exist.

Production possibility frontier reveals economic growth very intuitively. As you can imagine, when an economy grows, that is, when the society acquires new resources or when society learns to produce more with existing resources, its total output increases, the PPF will expand outward, as shown below:

Economic Growth on PPF

In addition to economic growth, PPF also illustrates several other key concepts that govern economics: scarcity, unemployment, inefficiency, opportunity cost, the law of increasing opportunity cost.

2.5. The Economic ProblemEvery society has to solve the economic problem for itself. In simple statement, economic problem is the problem that how exactly do large, complex societies answer the three basic questions presented in section 2.2., that what will be produced, how will it be produced, and in turn who will get the product. Basically, all economists are working for them, in history or contemporary, they try to give the answers. In fact there are already tons of different answers to each of them, some contradict, some complement. But economists are working still, trying to shape them better and better. They have been working for the last 300 years, and very probably they will keep working the next 300 years and more.

a. Any given country in the world has been endowed by nature with a given quantity and quality of resources (land, labor, natural resources). Differences in resources endowments leads countries to decide between different combination of resources to produce the goods and services necessary for the society.

b. Scarcity is the condition that countries (and also individuals) have to face because productive resources (or factors of production) are insufficient to satisfy people’s unlimited wants and desires.

c. The level of production and the type of products in a country are related to the opportunity cost associated with this decision. Opportunity cost is defined as the ratio of what is given up divided by what is gained. Thus, in a situation of producing more of X and less of Y, the trade off that a country faces has a numerical value defined by the reduced production of good Y divided by the increased production of X. If the ratio is above unity, let us say equal to 20.9,

the choice of acquiring that additional amount of X is expensive. On the other hand, if the ratio is equal to .3, the cost of acquiring that specific amount of X is low.

d. A very visual representation of scarcity and the implications for choice and opportunity cost is available in the Production Possibilities Model. It describes the different combinations of output of any two goods (X and Y, for example) that can be produced given different combinations of the scarce inputs. The position of the PP curve illustrates the idea of the maximum amount of any combination of outputs that are available. A PP curve that occupies a position close to the origin signifies that resources are very scarce, whereas a PP curve displaced at a significant distance from zero signifies less scarcity. In this sense, the PP curve is a boundary, or a frontier.

e. Imagine a Country A that has a given amount of capital and a fixed quantity of labor. Both resources are used as production inputs. On the other hand, Country B has a different amount of both factors. Quantities are described in Visual 1.1.1.

Visual 1.1.1. Production Possibilities Frontiersf. Country A has a higher number of units of labor. Country B has a higher number of units of

Capital. If both countries decide to use only one factor for producing, Country A would use 300 units of labor and Country B would use 300 units of Capital.

g. Both PPF curves (Production Possibilities Frontier) show the trade off in the use of factors of production. It means that to achieve the same level of output, country A and B have to decide the number of labor units and capital units to use. Along the PPF, level of output does not change. What actually suffers a change along the PPF is the use of factors of production.

h. Opportunity cost under this assumption would represent the number of units of labor/capital each country decide to leave using in order to employ more units of the other factor. This change is known as the technical rate of transformation, and it represents the technology available in a country that permits the changes in the use of factors of production because an increase in the use of other.

i. For an individual, the opportunity cost would represent the value of the best alternative passed up for the chosen item or activity.

j. Many choices involve analysis of opportunity costs. For instance, the decision to attend college requires spending funds that could be used for other purposes as well as forgoing income that could have been earned from other uses of scare time.

Production Possibility Frontier (PPF)• A graph that shows all the combinations of goods and services that can be produced if allof society’s resources are used efficiently, given the existing technology.• PPF demonstrates:

o scarcity: “frontier”o choice: focus on two outputs (in this course)o opportunity cost: downward sloping• On the PPF:o full resource employment: no wasteo production efficiency: resource used at the least cost using best available production method correct allocation of production inputso economic efficiency: the right point on PPF, representing what people want(preferences of members of society)• Southwestward: possible combination but inefficiento not using all available resources for production: e.g. unemploymento not allocating resources for production correctly: e.g. rocky land and loamy landin the production of sheep and wheat. Rocky land should be used for sheep,loamy land for wheat. Another case is the improper use or overexploitation ofnatural resources.o not using the best available production methods: e.g. mismanagement• Northeastward: unreachable combination, but potential improvement• Movement along the PPFo trade-off occurso find the right point on PPF to achieve economic efficiency: combination thatpeople want and which is produced at least cost• Movement of the PPF: economic growtho Total outputs of a society increases.o It occurs when a society acquires new resources quality of resources improves (more skilled, educated workers) new technology is invented• Different countries . different PPF . trade opportunity (more discussion in the future)On the PPF• Downward slopingPage 2 of 3Department of Economics Econ 1University of California, Berkeley Fall Semester, 2006o Why negative slope: scarcity of resources, choices constrained by availableresources and existing technology, when those resources are fully and efficientlyemployedo The negative slope shows the trade-off when making a choice (moving betweenpoints on the PPF).• Opportunity Cost:o In general, it refers to the best alternative that we give up, or forgo, when wemake a choice or decision Measured in terms of the sacrifice for a choice or decision: what and

how much we have to sacrifice for what we wanto In the context of PPF1, it can be easily calculated. Let Y be the variable on thevertical axis and let X be the variable on the horizontal axis. Opportunity cost occurs when making a choice between two points onthe PPF. The opportunity cost of an additional production of X (denoted by )is the forgone production of Y (denoted by ). In another word, theopportunity cost of choosing is the sacrifice of .X ÄY ÄX Ä Y Ä The opportunity cost of an additional production of Y (denoted by )is the forgone production of X (denoted by ). In another word, theopportunity cost of choosing is the sacrifice of .Y ÄX ÄY Ä X Ä• The slope of PPF2o The slope of PPF is called the Marginal Rate of Transformation (MRT) It is negative. It is a normalized opportunity cost for choosing X Ä MRT between two points on PPF: YXÄ Ä MRT at one point (x0, y0) on PPF: dYdX|x=x0 (not required for exams)• More about the slope (MRT):o The curvature of PPF reveals the Law of Increasing Opportunity Cost.o Why this law: more X is wanted . more resources are redirected to produce X. as more and more X is produced, it becomes more and more likely that anadditional production in X will employ resources which could be more efficientat producing Y . the sacrifice of producing more X in terms of Y becomes higher. the magnitude (absolute value) of MRT, i.e. |MRT|, increases as X increasesEconomic Goals: “creation of abundance”• Efficiency3:o move onto the PPF . production efficiencyo find the right point on PPF and move there . economic efficiency• Economic growth: to induce outward shifts in PPF“PPF” types of analysis: budget constraint, preservation of natural resources (trees, houses),capital goods and consumer goods, present and future......1 Since there is only one alternative in the context of PPF, this alternative must also be the best.2 The slope of a line or curve, a measure that indicates: (1) whether the relationship between the variables is

positive or negative; (2) how much of a response there is in Y (the variable on the vertical axis) when X(the variable on the horizontal axis) changes.3 In economics, efficiency means efficiency in allocation.Page 3 of 3

Production Possibilities Frontier

We can represent the concepts of scarcity and opportunity costs

in a graphical illustration. A Production Possiblilities Frontier (PPF) represents all possible combinations of the production of two goods given

the available resources and technology.

Points on the line are efficient: absence of waste (pts. A,B,C) Points inside the line are inefficient (pt. I) Points outside the line are unattainable (pt. U) Points on the line are not better than one another in terms of efficiency, but

depend upon subjective preferences. The slope of the line represents the opportunity cost of increasing the `X' good by

one unit. For example, moving from A to B means gaining 50 defense units, but sacrificing 85 nondefense units. So the opportunity costs of moving from A to B is 85 nondefense units. This is what we have to give up.

Examples:1. Guns v. Butter debate: defense spending vs. domestic spending. 2. Crime Prevention: How much should we spend on crime prevention? The tradeoff

is between diminishing crime and sacrificing other goods & services, or having more crime and more of other goods & services. Even within a given budget for crime, decisions have to be made regarding how to spend the money, i.e. more

equipment or more officers; more for crime prevention, or more to the court system?