Chapter 2 notes

As noted in Chapter 1, economics is the study of how individuals and economies deal with the
fundamental problem of scarcity. Since there are not enough available resources to satisfy the
wants of individuals and societies, individuals and societies must make choices among
competing alternatives.
 

Opportunity Cost

The opportunity cost of any alternative is defined as the cost of not selecting the "next-best"
alternative. Let's consider a few examples of opportunity cost:
 Suppose that you own a building that you use for a retail store. If the next-best use of the
building is to rent it to someone else, the opportunity cost of using the business for your
business is the rent you could have received. If the next-best use of the building is to sell
it to someone else, the annual opportunity cost of using it for your own business is the
foregone interest that you could have received (e.g., if the interest rate is 10% and the
building is worth $100,000, you give up $10,000 in interest each year by keeping the
building, assuming that the value of the building remains constant over the year --
depreciation or appreciation would have to be taken into account if the value of the
building changes over time).
 The opportunity class of attending college includes:

o the cost of tuition, books, and supplies (the costs of room and board only appear if
these costs differ from the levels that would have been paid in your next-best
alternative),
o foregone income (this is usually the largest cost associated with college
attendance), and
o psychic costs (the stress, anxiety, etc. associated with studying, worrying about
grades, etc.).
 If you attend a movie, the opportunity cost includes not only the cost of the tickets and
transportation, but also the opportunity cost of the time required to view the movie.

When economists discuss the costs and benefits associated with alternative activities, the
discussion generally focuses on marginal benefits and marginal costs. The marginal benefit
from an activity is the additional benefit associated with a one-unit increase in the level of an
activity. Marginal cost is defined as the additional cost associated with a one-unit increase in the
level of the activity. Economists assume that individuals attempt to maximize the net benefit
associated with each activity.

If marginal benefit exceeds marginal cost, net benefit will increase if the level of the activity
rises. Therefore, rational individuals will increase the level of any activity when marginal benefit
exceeds marginal costs. On the other hand, if marginal cost exceeds marginal benefit, net benefit
rises when the level of the activity is decreased. There is no reason to change the level of an
activity (and net benefit is maximized) at the level of an activity at which marginal benefit equals
marginal cost.
 

Production Possibilities Curve

Scarcity implies the existence of tradeoffs. These tradeoffs can be illustrated quite nicely by a
production possibilities frontier.
For simplicity, it is assumed that a firm (or an economy) produces only two goods (this
assumption is needed only to make the representation feasible on a two-dimensional surface --
such as a graph on paper or on a computer screen). When a production possibilities curve is
drawn, the following assumptions are also made:
1. there is a fixed quantity and quality of available resources,
2. technology is fixed, and
3. there are no unemployed nor underemployed resources

Very shortly, we'll also see what happens when these assumptions are relaxed.

For now, though, let's consider a simple example. Suppose that a student has four hours left to
study for exams in two classes: introductory microeconomics and introductory calculus. The
output in this case is the exam score in each class. The assumption of a fixed quantity and quality
of available resources means that the individual has a fixed supply of study materials such as
textbooks, study guides, notes, etc. to use in the available time. A fixed technology suggests that
the individual has a given level of study skills that allow him or her to translate the review
materials into exam scores. A resource is unemployed if it is not used. Idle land, factories, and
workers are unemployed resources for a society. Underemployed resources are not used in the
best possible way. Society would have underemployed resources if the best brain surgeons were
driving taxis while the best taxi drivers were performing brain surgery.... The use of an
adjustable wrench as a hammer or the use of a hammer to pound a screw into wood provide
additional examples of underemployed resources. If there are no unemployed or underemployed
resources, efficient production is said to occur.

The table below represents possible outcomes from each various combinations of time studying each
subject:
 

# of # of
hours hours
calculus economics
spent spent
grade grade
studying studying
calculus  economics
0 4 0 60
1 3 30 55
2 2 55 45
 3 1 75 30
4 0 85 0

Notice that each additional hour spent studying either calculus or economics results in smaller
marginal improvements in the grade. The reason for this is that the first hour will be spent
studying the most essential concepts. Each additional hour is spent on the "next-most" important
topics that have not already been mastered. (It is important to note that a good grade on an
economics examination requires substantially more than four hours of study time.) This is an
example of a general principle known as the law of diminishing returns. The law of
diminishing returns states that output will ultimately increase by progressively smaller amounts
as additional units of a variable input (time in this case) are added to a production process in
which other inputs are fixed (the fixed inputs here include the stock of existing subject matter
knowledge, study materials, etc.).

To see how the law of diminishing returns works in a more typical production setting, consider
the case of a restaurant that has a fixed quantity of capital (grills, broilers, fryers, refrigerators,
tables, etc.). As the level of labor use increases, output may initially rise fairly rapidly (since
additional workers allow more possibilities for specialization and reduces the time spent
switching from task to task). Eventually, however, the addition of more workers will result in
progressively smaller increases in output (since there is a fixed amount of capital for these
workers to use). It is even possible that beyond some point workers may start getting in each
others way and output may decline ("too many cooks may spoil the broth...."  sorry.... I couldn't
resist).

In any case, the law of diminishing returns explains why your grade will increase by fewer points
with each additional hour that you spend studying.

The points in the table above can be represented by a production possibilities curve (PPC) such
as the one appearing in the diagram below. Each point on the production possibilities curve
represents the best grades that can be achieved with the existing resources and technology for
each alternative allocation of study time.
Let's consider why the production possibilities curve has this concave shape. As the diagram
below indicates, a relatively large improvement in economics grade can be achieved by giving
up relatively few points on the calculus exam. A movement from point A to point B results in a
30-point increase in economics grade and only a 10-point reduction in calculus grade. The
marginal opportunity cost of a good is defined to be the amount of another good that must be
given up to produce an additional unit of the first good. Since the opportunity cost of 30 points
on the economics test is a 10-point reduction in the score on the calculus test, we can say that the
marginal opportunity cost of one additional point on the economics test is approximately 1/3 of a
point on the calculus test. (If in doubt, note that if 30 points on the economics exam have an
opportunity cost of 10 points, each point on the economics test must cost approximately 1/30th
of 10 points on the calculus test  -- approximately 1/3 of a point on the calculus test).
Now, let's see what happens a second hour is transferred to the study of economics. The diagram
below illustrates this outcome (a movement from point B to C). As this diagram indicates,
transferring a second hour from the study of mathematics to the study of economics results in a
smaller increase in economics grade (from 30 to 45 points) and a larger reduction in calculus
grade (from 75 to 55). In this case, the marginal opportunity cost of a point on the economics
exam has increased to approximately 4/3 of a point on the calculus exam.

The increase in the marginal opportunity cost of points on the economics exam as more time is
devoted to studying economics is an example of the law of increasing cost. This law states that
the marginal opportunity cost of any activity rises as the level of the activity increases. This law
can also be illustrated using the table below. Notice that the opportunity cost of additional points
on the calculus exam rises as more time is devoted to studying calculus. Reading from the
bottom of the table up to the top, you can also see that the opportunity cost of additional points
on the economics exam rises as more time is devoted to the study of economics.

One of the reasons for the law of increasing cost is the law of diminishing returns (as in the
example above). Each extra hour devoted to the study of economics results in a smaller increase
in the economics grade and a larger reduction in the calculus grade because of diminishing
returns to time spent on either activity.

A second reason for the law of increasing cost is the fact that resources are specialized. Some
resources are better suited for some some types of productive activities than for other types of
production. Suppose, for example, that a farmer is producing both wheat and corn. Some land is
very well suited for growing wheat, while other land is relatively better suit for growing corn.
Some workers may be more adept at growing wheat than corn. Some farm equipment is better
suited for planting and harvesting corn.

The diagram below illustrates the PPC curve for this farmer.
At the top of this PPC, the farmer is producing only corn. To produce more wheat, the farmer
must transfer resources from corn production to wheat production. Initially, however, he or she
will transfer those resources that are relatively better suited for wheat production. This allows
wheat production to increase with only a relatively small reduction in the quantity of corn
produced. Each additional increase in wheat production, however, requires the use of resources
that are relatively less well suited for wheat production, resulting in a rising marginal opportunity
cost of wheat.

Now, let's suppose that this farmer either does not use all of the available resources, or uses them
in a less than optimal manner (i.e., either unemployment or underemployment occurs). In this
case, the farmer will produce at a point that lies below the production possibilities curve (as
illustrated by point A in the diagram below).

In practice, all firms and all economies operate below their production possibilities frontier.
Firms and economies, however, generally attempt to get as close to the frontier as possible.

Points above the production possibilities cannot be produced using current resources and
technology. In the diagram below, point B is not obtainable unless more or higher quality
resources become available or technological change occurs.
An increase in the quantity or quantity of resources will cause the production possibilities curve
to shift outward (as in the diagram below). This type of outward shift could also be caused by
technological change that increases the production of both goods.

In some cases, however, technological change will only increase the production of a specific
good. The diagram below illustrates the effect of a technological change in wheat production that
does not affect corn production.
Specialization and trade

In The Wealth of Nations, Adam Smith argued that economic growth occurred as a result of
specialization and division of labor. If each household produced every commodity it consumed,
the total level of consumption and production in a society will be small. If each individual
specializes in the productive activity at which they are "best," total output will be higher.
Specialization provides such gains because it:
 allows individuals to specialize in those activities in which they are more talented,
 individuals become more proficient at a task that they perform repeatedly, and

 less time is lost switching from task to task.

Increased specialization by workers requires a growth in trade. Adam Smith argued that growing
specialization and trade was the ultimate cause of economic growth.

Adam Smith and David Ricardo argued that similar benefits accrue from international
specialization and trade. If each country specializes in the types of production at which they are
best suited, the total amount of goods and services produced in the world economy will increase.
Let's examine these arguments a bit more carefully.

There are two measures that are commonly used to determine whether an individual or a country
is "best" at a particular activity: absolute advantage and comparative advantage. These two
concepts are often confused. An individual (or country) possesses an absolute advantage in the
production of a good if the individual (or country) can produce more than can other individuals
(or countries). An individual (or country) possesses a comparative advantage in the production of
a good if the individual (or country) can produce the good at the lowest opportunity cost.

Let's examine an example illustrating the difference between these two concepts. Suppose that
the U.S. and Japan only produced two goods: CD players and wheat. The diagram below
represents production possibilities curves for these two countries. (These numbers are obviously
hypothetical....)

Notice that the U.S. has an absolute advantage in the production of each commodity. To
determine who has a comparative advantage, though, it is necessary to compute the opportunity
cost for each good. (It is assumed that the PPC is linear to simplify this discussion.)

The opportunity cost of one unit of CD players in the U.S. is 2 units of wheat. In Japan, the
opportunity cost of one unit of CD players is 4/3 of a unit of wheat. Thus, Japan possesses a
comparative advantage in CD player production.

The U.S. however, has a comparative advantage in wheat production since the opportunity cost
of a unit of wheat is 1/2 of a unit of CD players in the U.S., but is 3/4 of a unit of CD players in
Japan.

If each country specializes in producing the good in which it possesses a comparative advantage,
it can acquire the other good through trade at a cost that is less than the opportunity cost of
production in the domestic economy. For example, suppose that the U.S. and Japan agree to
trade one unit of CD players for 1.6 units of wheat. The U.S. gains from this trade because it can
acquire a unit of CD players for 1.6 units of wheat, which is less than the opportunity cost of
producing CD players domestically. Japan gains from this trade since it's able to trade one CD
player for 1.6 units of wheat while it only cost Japan 4/3 of a unit of wheat to produce a unit of
CD players.

If each country produces only those goods in which it possesses a comparative advantage, each
good is produced in the global economy at the lowest opportunity cost. This results in an
increase in the level of total output.