Opportunity Cost & Production Possibilities

Theory of Consumer Behaviour

 The General Picture
 Opportunity Costs, PPFs and Making Choices
 The Market
 Supply, Demand, Price and Quantity and changes
 Economic Surplus
 Elasticity
 How responsive is quantity to price, income, etc?
 Consumer Equilibrium
 Maximising utility
 Changes in price, income
Scarcity: The Core Problem

• Scarcity: lack of enough resources

to satisfy all desired uses of those
resources.
– There aren’t enough resources
available to satisfy all our desires.
• Scarcity of resources limits the
amount of goods and services that
can be produced.
 Scarcity and Choice

 Something is scarce if it is desirable and limited in quantity

 This is the basic economic problem
 Human wants and needs are infinite
 Resources are scarce
 Economics is about allocating these scarce resources to
unlimited wants and needs
 This problem leads to choices having to be made
 When a choice is made, something has to be given up
Factors of Production

• Factors of production: resource inputs

used in the production of goods and
services, the desired outputs.
• Four types.
– Land – all natural resources.
– Labor – skills and abilities of all humans at work.
– Capital – goods produced for use in further
production.
– Entrepreneurship – the assembling of resources
to produce new or improved products and
technologies.
Opportunity Cost

• When we choose to use resources to produce

one thing, we must give up producing
something else with those resources. This
trade-off comes with a cost.
• Opportunity cost: the value to you of the
next most desired good forgone to obtain
some other higher-priority good.
– What is given up to undertake a chosen activity.
• Associated with every decision:
– For example, if we choose to produce bread, then
we cannot produce pizza crust with the same
flour.
 Opportunity Cost
 With scarce resources we are forced to make choices (since we cannot
have it all)
 Let’s take an example of time – a scarce resource
 Should I stay at home and study for an exam or join my friends for a
movie?
 If you go to the movies, the OC of going to the movies is the 3 hours of
time you could have spent preparing for the exam. If you stay and work on
the exam, the OC of studying is the entertainment of watching the movie
that you gave up
 The Real Cost of something is what you must give up to get it
 Concept of OC is crucial because ALL costs are OC
 Sometimes OCs are add-ons
 Choice between courses – History of Rock Music and Economics
 Suppose there is an extra cost of $1,000 for History of Rock
 Then OC of taking HRM is giving up economics PLUS what you could
have done with $1000
Remember this about Opportunity
Cost
 Example
 The country of Maxis can produce either 5 battle tanks or 10 cans
of spinach in a day. What is the OC of one can of spinach?
 First of all, note the time period. Both goods are produced in one
day
 Next, let T stand for tanks and S for spinach
 So, 1 day = 5T or 1 day = 10S or,
 Since 1 day = 1 day, we have 5T = 10S
 To find OC of 1 can of spinach, we use the equation above
 10S = 5T, so 1S = 0.5T
 Hence, OC of 1 can of spinach is half a battle tank
 Maxis would have to give up ½ a tank to produce a can of spinach
 What is the OC of one battle tank?
Production Possibilities

• Production possibilities: the

various combinations of final
goods and services that could be
produced in a given time period
with all available resources and
technology.
 Production Possibilities Frontier
 PPF is a basic economic model which shows how an
individual or the economy (or society) makes tradeoffs
with scarce resources and factors of production
 The PPF is the curve or boundary which shows the
different combinations of two goods and/or services
that can be produced while using all of the available
factor resources efficiently for a given state of technology
 Being inside the PPF means factors of production are not
being used efficiently. Being outside the PPF is an
unattainable situation given current factor endowments
 The PPF curve can shift due to technological change or
other external factors
Trade-offs: The Production Possibilities Frontier
 OC & PPF

 The economy can produce 30 coconuts and no fish or 40

fish and no coconuts. But these are unrealistic
combinations and the economy would not be using its
factors of production efficiently
 Ideally, the economy would like to produce both fish and
coconuts
 In moving down the PPF, there is an increasing OC
 Why is the PPF bowed out? Because of increasing OC
 Law of Increasing OC: As more of a good is produced, the
opportunity costs of producing that good increase
 Because you have to give up more of something else
 OC and Slope of PPF
 Moving from A to B means that to catch 10 more fish, society
must give up 5 coconuts
 10F = 5C or 1F = ½C and 1C = 2F
 Now say the economy moves from B to some point D
 Now, society must give up 10 coconuts for 7 more fish
 7F = 10C or 1F = 10/7 C = 1.4C
 The OC of fish is the slope of the PPF curve
 As you move down the curve, you give up more coconuts for
fish
 The slope of the PPF curve increases as you move along it
 The slope of the PPF is the OC at a particular point
 This is why the PPF is bowed-out
Trucks vs. Tanks

• One factory can produce either

trucks or tanks, or some of each
with the limited resources available
to it.
• To increase truck production,
resources must be shifted away from
tank production, and vice versa.
 Production Possibilities Frontier (PPF)

A
5
OUTPUT OF TRUCKS

B Truck
4 Point s Change Tanks Change
C A 5 0
3 B 4 -1 2.0 +2
D C 3 -1 3.0 +1
2 D 2 -1 3.8 +0.8
E E 1 -1 4.5 +0.7
1 F 0 -1 5.0 +0.5
F Note that as we move from
0 1 2 3 4 5 A to F, each time we give
OUTPUT OF TANKS up the same amount but
get back less and less in
return.
The trade-off gets worse
and worse.
Law of Increasing Opportunity
Costs
• The opportunity cost of producing
additional units of one good increases.
– Each time we give up one truck, we get less
back in tank production.
• Resources are specialized to produce
one good better than another.
– Good tank resources are shifted first.
– Later shifts involve resources less good for
tank production.
– Accounts for the bowed shape of the PPC
 Law of Increasing Opportunity Costs

5 Step 1: give up one truck

4 B
OUTPUT OF TRUCKS

Step 3: give up another truck

Step 2: get two tanks
3 A C
Step 4: get one more tank
2 D

1 E

F
0 1 2 3 4 5
OUTPUT OF TANKS

1-18
Production Possibilities
Curve (PPC)
 The PPC illustrates two essential principles:
 Scarce resources: there is a limit to the
amount we can produce in a given time
with available resources and technology.
 This limitation positions the PPC.
 Opportunity costs: we can obtain
additional quantities of one of the goods
only by reducing production of another
good.
 Shifts in the PPF
 A PPF shows the production possibilities of an economy
producing two goods
 Anywhere along the frontier is where the economy can
produce a combination of both goods with its available
factors of production
 A PPF can shift outwards if any of the following happen
 An increase in one or more factors of production
 More land, more labour, more capital, etc
 An increase or application of new technology
 In our example, this could mean a new way to climb coconut
trees, a new type of fishing net, more land to grow coconut
trees, more coconut tree climbers or all of these
Economic Growth

• Economic growth: an increase in output;

an expansion of production possibilities.
– Raises our standard of living.
– Satisfies more wants and needs.
– Creates more jobs.
• Economic growth is caused by increasing
the resources available or by producing
better technology.
– The PPF pushes outward.
Economic Growth
Economic
At point E growth
the economy
resultscan
in
nowoutward
an produceshift
more
of of
the PPF
because production
everything.
possibilities are expanded.
Production is initially
at point A (20 fish
and 25 coconuts), 
it can move to point
E (25 fish and 30
coconuts).
 Characteristics of the PPF

 Why is the production possibility frontier not a straight line?

 Because of increasing opportunity cost as you move along it
 You have to give up more to get less
 Hence it is not linear
 A point lying outside the PPF can only be reached if the PPF
shifts outwards
 The PPF will only move outwards if
 There is an increase in factor resources (e.g. more land,
labour, etc)
 There is an increase in the efficiency or productivity of
factor resources
 There is an improvement in technology
 This is called Economic Growth
 What is Technology in
Economics?
 Technology (in the context of economics) is
 The body of skills and knowledge involved in
the use of factors of production
 Technology increases the ability to produce more
output with a fixed amount of resources (factors of
production)
 Technology is the ability to produce the same
output with fewer resources
 Technology can be biased – i.e. focused on
increasing production of one good, or it can be
neutral – i.e. production of both goods increase
Shifts in the Production Possibility
Curve
Biased Technological Change

Butter
C
B

0
A Guns
Shifts in the Production Possibility
Curve
Neutral Technological Change

Butter

C
A

0 B D Guns
 Some Assumptions

 In economics, we frequently use the ceteris

paribus assumption
 Ceteris Paribus is Latin for “Other Things
Being Equal”
 When we explain economic concepts with
graphs, we can only show 2 variables. So
we frequently apply the CP principle in
economics.
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.
 Factors of production are used more
efficiently
 Preferences & Marginal Benefit
 Preferences are description of a person’s likes & dislikes
 The marginal benefit of a good or service is the benefit
received from consuming one more unit of it.
 Marginal Benefit is measured by the amount a person is
willing to pay for an additional good or service
 In general
 More we have of any good, the lower its marginal benefit
and
 The less we are willing to pay for an additional unit of it
 This is called the Principle of Diminishing Marginal
Benefit
Efficiency
 Any point on the PPF is productively efficient
 Any point within the PPF is inefficient
 Any point beyond the PPF is unattainable
 There is only one point somewhere on the PPF
which is both productively efficient and
allocatively efficient
 Economists over the ages have struggled to find
this point
 The allocatively efficient point is also called the
point of Pareto Optimality
 Production & Allocative Efficiency

 If we cannot produce more of any one good without giving up

some other good, we have achieved production efficiency
 Any point on the PPF is a production efficiency point
 When we cannot produce more of any one good without giving up
some other good that we value more highly we have achieved
allocative efficiency
 AE means we are producing at the point on the PPF that we prefer
to all other points
 The point of allocative efficiency is the point on the PPF where
marginal benefit equals marginal cost
 Pareto defined allocative efficiency as a situation where nobody
can be made better off without making somebody else at least as
worse off
PE & AE

 Any point along the PPF is a point of

productive efficiency

 But there exists only ONE point

somewhere along the PPF which is a
point of allocative efficiency
Example

 On Monday Max baked 3 loaves of bread and 18

cakes. On Tuesday Max baked 4 loaves of bread
and 18 cakes. Which of the following is true about
what changed between Monday and Tuesday?
 Max has more resources to produce both goods
 Max has moved along his PPF
 Max’s PPF has shifted outwards
 Max’s PPF has rotated outwards
Problem
 Country A has 200 workers and country B has 400 workers. In A, each worker
can make 20 pairs of socks or 30 canoes in a year. In B each worker can make
30 pairs of socks or 40 canoes in a year. Which country has the lower OC in
producing which good?

 Step 1: Equalize everything using data given

Country A can make 200x20=4000 socks or 200x30=6000 canoes
Country B can make 400x30=12000 socks or 400x40=16000 canoes
 Step 2: Set up the OC equation for each country
Country A: 4000S=6000C or 1S = 1.5C and 1C = 0.67S
Country B: 12000S=16000C or 1S = 1.33C and 1C = 0.75S
 Step 3: Evaluate
B gives up fewer canoes for 1 sock and hence has a lower OC for socks
A gives up fewer socks for 1 canoe and hence has a lower OC for canoes