Lecture 02 - Opportunity Cost

Lecture 2

READING MATERIAL • Sloman – Ch.1 pp. 10-14.

THE PRODUCTION POSSIBILITIES FRONTIER A Simple Model of the economy (PPF) Frontier (PPF) - Production Possibility Assume that we have any economy with: • a given quantity of productive resources (land, labour & capital) • a given state of technology This economy is capable of producing two products, namely: • bread • wine

THE PPF

Wine (Bottles)

Production Possibilities Frontier

Bread 0 1000 2000 3000 4000

26 00 24 00 22 00 20 00 18 00 16 00 14 00 12 00 10 00 8 00 6 00 4 00 2 00 0 0

500

1000

150 0

2 000

2 500

300 0

3500

4000

4 500

50 00

Bread (Loaves)

How much wine is this economy capable of producing if all its resources are dedicated to wine production ?

Wine 2000 1800 1400 800 0

THE PPF

Wine (Bottles)

Production Possibilities Frontier

Bread 0 1000 2000 3000 4000

2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0 0

500

1000

1500

2000

2500

3000

3500

4000

4500

Wine 2000 1800 1400 800 0

5000

Bread (Loaves)

How much bread is this economy capable of producing if all its resources are dedicated to bread production ?

THE PPF

Wine (Bottles)

Production Possibilities Frontier 2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0

PPF

0

500

1000

1500

2000

2500

3000

Bread (Loaves)

3500

4000

4500

5000

THE PPF

Wine (Bottles)

Production Possibilities Frontier 2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0

This economy is capable of producing any combination of bread and wine that is on or inside its PPF

0

500

1000

1500

2000

2500

3000

Bread (Loaves)

3500

4000

4500

5000

THE PPF

Wine (Bottles)

Production Possibilities Frontier 2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0

Points outside the PPF are not obtainable given current productive resources

0

500

1000

1500

2000

2500

3000

Bread (Loaves)

3500

4000

4500

5000

THE PPF

Wine (Bottles)

Production Possibilities Frontier

For this economy to be at point on its PPF, it must: • all resources must be fully employed • all resources are being used in a technically efficient way

2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0 0

500

1000

1500

2000

2500

3000

Bread (Loaves)

3500

4000

4500

5000

THE PPF

Wine (Bottles)

Production Possibilities Frontier 2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0

If the economy is at a point inside its PPF, means: • all resources are not being fully employed and/or • production is technically inefficient

0

500

1000

1500

2000

2500

3000

Bread (Loaves)

3500

4000

4500

5000

THE PPF

Wine (Bottles)

Production Possibilities Frontier

The major limitation of the PPF is that I t does not tell us what combination of output The economy should produce. This will be determined by consumer preferences (DEMAND side) considerations

2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0 0

500

1000

1500

2000

2500

3000

Bread (Loaves)

3500

4000

4500

5000

OPPORTUNITY COST Opportunity Cost is the amount of one good or service which must be Given up (forgone) in order to produce or consume additional units of another good or service

For example: students who elect to go clubbing forgo the opportunity to study Introduction to Economics

OPPORTUNITY COST

Wine (Bottles)

Production Possibilities Frontier 2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0

A

0

Assume the economy is initially at point A

Now assume that due to a change in consumer preference there is an increase in demand for bread. 500 1000 1500 2000 2500 3000 3500 Bread (Loaves)

4000

4500

5000

OPPORTUNITY COST

Wine (Bottles)

Production Possibilities Frontier 2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0

In moving from A to B A Forego 400 bottles Of wine

B + 1000 Bread

0

500

1000

1500

2000

2500

Producing +1000 loaves of bread

3000

3500

4000

4500

5000

Bread (Loaves)

Opportunity cost of additional 1000 loves of bread (1000 to 2000) = 400 bottles of wine (1800 to 1400)

OPPORTUNITY COST

Wine (Bottles)

Production Possibilities Frontier 2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0

A

In moving from B to C B

Forego 600 bottles Of wine

C + 1000 Bread

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

Producing +1000 loaves of bread Bread (Loaves)

Opportunity cost of additional 1000 loves of bread (2000 to 3000) = 600 bottles of wine (1400 to 800)

LAW OF INCREASING OPPORTUNITY COSTS Note that as you produce more of one good the opportunity cost of producing it increases. This is reflected in the shape (bowed outward) of the PPF. Opportunity cost of going from A to B was 400 wine Opportunity cost of going from B to C was 600 wine

The reason we assume that there are increasing costs (and therefore draw the PPF as being bowed outward from the origin) is because we assume that some of the economy’s resources are better suited to producing wine while other are better suited to producing bread. Therefore as you produce more bread you start using resources that are better suited to wine production and less productive (higher cost) at producing bread.

ECONOMIC GROWTH

Wine (Bottles)

Production Possibilities Frontier

Unbiased economic growth is when the PPF shifts out evenly and may result from increase in productive resources (eg an increase in population)

2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0 0

Economic Growth is represented by an outward shift an economy’s 500 of 1000 1500 2000 PPF 2500

3000

Bread (Loaves)

3500

4000

4500

5000

ECONOMIC GROWTH

Wine (Bottles)

Production Possibilities Frontier 2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0 0

Biased economic growth might occur as a result of a technological improvement 500 1000 1500 2000 2500 3000 in one industry (eg wine) Bread (Loaves)

3500

4000

4500

5000