Chapter 01

Economics:
The Study of
Opportunity
Cost

McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
Economics And Opportunity Cost
Modeling Opportunity Cost Using A Production
Possibilities Frontier
Attributes Of The Production Possibilities Frontier
The Big Picture
Thinking Economically
Kick It Up A Notch: Demonstrating Constant And
Increasing Opportunity Cost on a Production
Possibilities Frontier

1-2
 Economics and Opportunity Cost

Economics: the study of the allocation

and use of scarce resources to satisfy
unlimited human wants

1-3
 Choices Have Consequences

Opportunity Cost
The forgone alternative of the choice
made
Or
What you would have done had you not
done what you did.

1-4
 Modeling Opportunity Cost Using a
Production Possibilities Frontier Definitions
PPF: a graph which relates the amounts of different
goods that can be produced in a fully employed
society
Model: a simplification of the real world that we can
manipulate to explain the real world
Simplifying Assumption: an assumption that may, on
its face, be silly but allows for a clearer explanation
Scarce: not freely available and infinite
Resources: anything we either consume directly or
use to make things that we will ultimately consume

1-5
Figures 1-4 Building The Production
Soda
Possibilities Frontier

S
X
Y
M

0 Pizza

1-6
 A Fully Labeled Production Possibilities
Frontier: The Case When People are Different
Soda

S Unattainable
X
Y
M
Attainable

Unemployment P

0 Pizza

1-7
 Figure 5
Soda

Unattainable
(outside the curve)

Unemployment
(just inside the curve)

0 Attainable
(on the curve and on the inside)
Pizza

1-8
 A Fully Labeled Production Possibilities
Frontier: The Case When People are the Same
Soda

S
X
Unattainable
Y
Attainable M

Z
Unemployment P
0 Pizza

1-9
 Figure 6
Soda

Unattainable
(outside the curve)

Unemployment
(just inside the curve)

0 Attainable
(on the curve and on the inside)
Pizza

1-10
 Increasing and
Constant Opportunity Cost
Increasing Opportunity Cost
Exists when the additional resources required to
produce an additional unit grows as more output is
produced.
Likely to occur when people are different in their skills.
Constant Opportunity Cost
Exists when the additional resources required to
produce an additional unit remains the same as more
output is produced.
Likely to occur when people are identical in their skills.

1-11
 The Big Picture
circular flow model: A model that
shows the interactions of all
economic actors
Markets are where the interactions
take place
Actors are the entities interacting

1-12
Markets in a Circular Flow Diagram
Market: Any mechanism by which buyers
and sellers negotiate an exchange
Factor Market: A mechanism by which
buyers and sellers of labor and financial
capital negotiate an exchange.
Goods and Services Market: A
mechanism by which buyers and sellers of
goods and services negotiate an exchange.
Foreign Exchange Market: A mechanism
by which buyers and sellers of the
currencies of various countries negotiate an
exchange.

1-13
Actors in a Circular Flow Diagram
Households
Firms
Government

1-14
The Circular Flow Diagram

1-15
Thinking Economically: Marginal
Analysis
Optimization Assumption: an assumption
that suggests that the person in question is
trying to maximize some objective
Marginal Benefit: the increase in the benefit
that results from an action
Marginal Cost: the increase in the cost that
results from an action
Net Benefit: the difference between all
benefits and all costs

1-16
Positive and Normative Analysis

Positive Analysis: a form of analysis

that seeks to understand the way
things are and why they are that way
Normative Analysis: a form of analysis
that seeks to understand the ways
things should be

1-17
 Economics Incentives

Incentive: something that influences the

decisions we make
Examples: prices influence the amount we
buy; taxes influence how much we work
and save

1-18
 Logical Flaws

Fallacy of Composition: the mistake in logic

that suggests that the total economic impact
of something is always and simply equal to
the sum of the individual parts
Correlation = Causation: the mistake that
suggests that because two variables are
correlated that one caused the other to
happen.

1-19
 Kick it Up a Notch

Demonstrating Increasing and

Constant Opportunity Cost

1-20
Figure 7 Illustrating Increasing Opportunity
Soda Cost
Opportunity Cost of going from 0 units of
Pizza to 1 unit of pizza
10
Opportunity Cost of going from 1 unit of
9 Pizza to 2 units of pizza
8
7 Production Possibilities Frontier
6
Opportunity Cost of going from 2
5 units of Pizza to 3 units of pizza
4
3
2
1
0 1 2 3
Pizza
1-21
 Figure 8
Illustrating Constant Opportunity Cost
Opportunity Cost of going from 0 units of
Pizza to 1 unit of pizza
9
Soda

8 Opportunity Cost of going from 1 unit of

Pizza to 2 units of pizza
7
6
Production Possibilities Frontier
5
4
3 Opportunity Cost of going from 2
units of Pizza to 3 units of pizza
2
1
0 1 2 3
Pizza
1-22