Choice, Opportunity Costs and Specialization

1. Choice, Opportunity Costs and Specialization Chapter 2

2. Opportunity Cost • Opportunity cost: the value of the highest-valued alternative that must be forgone when a choice is made. It is the evaluation of a trade-off.

3. Sample • The opportunity cost of using your own time to run a business that you own is equal to: • zero since you, as the owner, receive profits and are not paid on an hourly basis • the income that you could have received in your next-best alternative employment • minimum wage x hours worked • none of the above

4. Sample • Which of the following is not an opportunity cost of attending college • the alternative items that could have been purchased with the funds used to pay tuition • the forgone income that could have been received if the individual had been working at a full-time job • the alternative use of funds spent on textbooks • the cost of food consumed while in college

5. Marginal Benefit and Cost • It is assumed that individuals weigh the benefits against the costs when choosing alternatives. Individuals will increase the level of activities whenever the additional benefit from an additional unit of an activity outweigh the additional costs • Marginal benefits and costs: the benefits and (opportunity) costs associated with one additional unit of the good.

6. Sample • If the marginal benefit from an activity exceeds the marginal cost, then an individual should • increase the level of activity • reduce the level of activity • not change the level of this activity • stop engaging in this activity

7. Decision Making • Principle: Decision making is done at the margin. • Decision makers evaluate a fixed array of alternatives. • Decision makers compare the marginal costs to marginal benefits to determine the best alternative. • This is economic decision making.

8. Production Possibilities Curve • Works on the premise that if a society wants to increase production of one kind of good, then fewer resources are available for the production of other kinds of goods

9. Sample • Here is an economy that can only produce pizza and soda. The PPC represents all the combinations of pizza and soda that can be produced by this economy

10. Sample • You can see from the graph that as more resources are turned over to pizza, there is less soda produced. This negative relationship is why the PPC is downward-sloping

11. Sample • The PPC shows the trade-off between pizza and soda • As you move on the curve; labor, capital and natural resources are shifted away from soda and moved in pizza production. • The opportunity cost of increasing pizza production is the amount of soda production that is given up

12. Only defensegoods produced Defense Goods A1 200 G1 Impossible B1 Efficient Combinations C1 F1 Underutilized (Inefficient) Only nondefense goods produced D1 E1 Production Possibilities 175 150 125 100 75 0 150 125 25 50 75 100 Nondefense Goods

13. Marginal Opportunity Cost • The shape of the PPC illustrates the relative cost of moving productive resources from one activity to another. • The marginal opportunity cost is the amount of one good or service that must be given up to obtain one additional unit of another good or service. • The PPC bows outward because there are ever-increasing marginal opportunity costs to the production of any good.

14. The marginal opportunity cost is the amount of one good or service that must be given up to obtain one additional unit of another good or service. From A1 to B1, to get one unit of non-defense costs 1/3 of a defense unit, so the marginal opportunity cost of non-defense if 1/3 defense What is the marginal opportunity cost of one defense unit? Marginal Opportunity Cost

15. Sample • As we move from point A to point B on the PPC curve for Brazil, you can see that the resources are being shifted: • away from banana production into apple production • away from apple production into banana production • into both apple and banana production • out of both apple and banana production

16. Sample • What is the marginal opportunity cost of increasing apple production from 75 to 100 million pounds for Brazil? • 5 million lbs bananas • 5/4 million lbs bananas • 4/5 million lbs bananas • 20 million lbs bananas

17. Growth • The PPC moves outward (growth occurs) as the result of: • Increased resources • Larger labor force • Change in labor force participation • Change in labor-leisure decision • Improved technology (innovation) • Expansion of capital stock • An improvement in the rules (laws, institutions, and policies)of the economy

18. A Shift of the PPC 225 A2 Defense Goods A1 B2 200 B1 175 C2 150 C1 D2 125 100 E2 D1 75 E1 F2 0 150 125 25 50 75 100 Nondefense Goods

19. Specialization • Economic agents (individuals, firms, nations) will be better off if they choose to produce those things for which they have the lowest opportunity costs, and trade for those with higher costs. • This is called specialization. • We say that the agent specializes in a specific activity because the agent enjoys a comparative advantage in it. • Agents do this because such choices involve giving up the least amount of other things.

20. Sample • Assume that Mexico and Iran can only produce two goods, carpets and oils. • See their respective PPC’s • Should either country specialize?

21. Sample • Look at the opportunity costs of producing carpets for the two countries. Mexico gives up 80 billions of oil to produce 100 billion blankets (80/100) or 0.8 oil/blanket • Iran gives up 240 billion barrels of oil for 120 billion blankets (240/120) or 2 oil/blanket • The ability to produce at a lower opportunity cost than someone else is called a “comparative advantage”

22. Sample • Mexico and Iran gain from specializing and trading. If Mexico produces 100 billion carpets and Iran 240 billion barrels of oil, then total world production is greater than it would be if Mexico and Iran each produced both oil and carpets

23. Sample • Suppose the two countries agree to an exchange of 3 barrels of oil to 2 carpets. If Mexico gives up 60 billion carpets to Iran it will get 90 billion barrels of oil.

24. Sample • If Mexico had produced the oil, giving up 60 billion carpets would have allowed them to produce (60)(4/5) or 48 billion barrels of oil so they are ahead 42 billion barrels.

25. Sample • It would have cost Iran 60(2) or 120 billion barrels of oil to produce the 60 billion blankets so they are ahead 30 billion barrels.