Chapter Two

Choice,
Opportunity Costs
and Specialization
 Introduction
An economic system has to solve three
coordination problems:
What, and how much, to produce.
How to produce it.
For whom to produce it.
 Introduction
All economic knowledge can be boiled
down to a single phrase:

There aint no such thing as a free lunch.

 Introduction
Every decision has an opportunity cost
the cost in foregone opportunities.
 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.

Marginal benefits and costs: the benefits

and opportunity costs associated with one
additional unit of the good.
 Introduction
A production possibility curve is used to
illustrate opportunity cost.
 The Production Possibilities
Model
The production possibilities curve shows
the trade-offs among choices we make.
The Production Possibility Table
A production possibility table lists a
choice's opportunity costs by summarizing
what alternative outputs you can achieve
with your inputs.
The Production Possibility Table
Output an output is simply a result of an
activity.

Input an input is what you what you put

into a production process to achieve an
output.
 The Production Possibility
Curve for an Individual
A production possibility curve measures
the maximum combination of outputs that
can be achieved from a given number of
inputs.
It slopes downward from left to right.
 The Production Possibility
Curve for an Individual
The production possibility curve not only
represents the opportunity cost concept, it
also measures the opportunity cost.
 The Production Possibility
Curve for an Individual
The production possibility curve
demonstrates that:

There is a limit to what you can achieve, given

the existing institutions, resources, and
technology.
Every choice made has an opportunity cost
you can get more of something only by giving
up something else.
 A Production Possibility Curve
for a Society
The production possibility curve is
generally bowed outward.
Some resources are better suited for the
production of some goods than others.
 A Production Possibility Curve
for a Society

10
9 If the slope of the production
8 curve is -2 at A, the
A
7 2Y opportunity cost
.
6 of 1X is 2Y.
5 1X
4
3
2
1
0
1 2 3 4 5 6 7 8 9 X
McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
 A Production Possibility Curve
for a Society
Comparative advantage explains why
opportunity costs increase as the
consumption of a good increases.
Some resources are better suited for the
production of some goods than to the
production of other goods.
 A Production Possibilities Table
and Curve
% of resources % of resources
devoted to devoted to
production Number production Pounds
of guns of guns of butter of butter Row

0 0 100 15 A
20 4 80 14 B
40 7 60 12 C
60 9 40 9 D
80 11 20 5 E
100 12 0 0 F

McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

 A Production Possibilities Table
and Curve
1 pound 15 A
of butter B
14
2 pounds C
of butter 12
D
Butter

5 E
5 pounds
of butter
F
0 4 7 9 11 12 Guns
4 guns 3 guns 1 gun
McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Marginal Opportunity Cost
The Production Possibilities Curve (PPC)
illustrates the concept of opportunity cost.
Each point on the PPC means that every other
point is a forgone opportunity.

The PPC bows outward because there are

ever-increasing marginal opportunity costs to
the production of any good.
Increasing Marginal Opportunity
Cost
The principle of increasing marginal
opportunity cost states that opportunity
costs increase the more you concentrate
on an activity.
In order to get more of something, one
must give up ever-increasing quantities of
something else.
This principle is discussed but Not Named in the Boyes Text
Increasing Marginal Opportunity
Cost
A Slope is flat at A. Low
opportunity cost of
guns.

Slope is steep at B. High

opportunity cost of guns.
B

Guns
 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.

Agents do this because such choices involve

giving up the least amount of other things.
 Specialization & Trade
Comparative Advantage: the ability to
produce a good or service at a lower
opportunity cost than someone else.

Law of comparative advantage:

proposition that the joint output of trading
partners will be greatest when each good is
produced by the low opportunity cost producer.
 Efficiency
In production, wed like to have
productive efficiency achieving as
much output as possible from a given
amount of inputs or resources.
 Efficiency
Efficiency involves achieving a goal as
cheaply as possible.

Efficiency has meaning only in relation to a

specified goal.
 Efficiency
Any point within the production possibility
curve represents inefficiency.

Inefficiency getting less output from

inputs which, if devoted to some other
activity, would produce more output.
 Efficiency
Any point outside the production possibility
curve represents something unattainable,
given present resources and technology.
Efficiency and Inefficiency

Unattainable point,
10 given available technology,
resources and labor force
8
Efficient C D
Guns

6
points
B
4
A
Inefficient
2 point
0
2 4 6 8 10
Butter
 Production Possibilities Curve
The production possibilities curve shows
the maximum quantity of goods and
services that can be produced when the
existing resources are used fully and
efficiently.
 Production Possibilities
Defense Non-defense
A1 200 0
B1 175 75
Only defense
goods produced C1 130 125
Defense Goods D1 70 150
200 A1 E1 0 160
G1
Impossible F1 130 25
175 B1 G1 200 75

150 Efficient
C1 Combinations
125 F1

Underutilized 100
(Inefficient)
Only nondefense
75 goods produced
D1
0 E1
25 50 75 100 125 150 Nondefense Goods
 Shifts in the Production
Possibility Curve
Society can produce more output if:
Technology is improved.
More resources are discovered.
Economic institutions get better at fulfilling our
wants.
 Growth
The PPC moves outward (growth occurs)
as the result of:
Increased resources
Larger labor force
Change in labor force participation
Chance in labor-leisure decision
Improved technology (innovation)
Expansion of capital stock
An improvement in the rules (laws, institutions,
and policies) of the economy
 A Shift of the PPC
Defense Non-defense

225 A A2 225 0
2 B2 200 75
Defense Goods C2 175 120
200 A1 B2
D2 130 150

175 E2 70 160
B1 C2
F2 0 165
150

125 C1 D2

100
75 D1 E2
0 E1 F2
25 50 75 100 125 150 Nondefense Goods
 Shifts in the Production
Possibility Curve
More output is represented by an outward
shift in the production possibility curve.
Shifts in the Production
Possibility Curve
Neutral Technological Change

Butter

C
A

0 B D Guns
Shifts in the Production
Possibility Curve
Biased Technological Change

Butter
C
B

0
A Guns
 Distribution and Production
Efficiency
The production possibilities curve focuses
on productive efficiency and ignores
distribution.
 Distribution and Production
Efficiency
In our society, more is generally preferred
to less and many policies have relatively
small distributional effects.
 Examples of Shifts in the
Production Possibility Curve

(a) (b) (c) (d)

 Finagle A Bagel

Specialization