Chapter 2: Opportunity costsScarcityEconomics is the study of how individuals and economies deal with the fundamental problem of scarcity. As a result of scarcity, individuals and societies must make choices among competing alternatives.

Opportunity CostThe opportunity cost of any alternative is defined as the cost of not selecting the "next-best" alternative.

What Does Opportunity Cost Mean?

•1. The cost of an alternative that must be forgone in order to pursue a certain action.

• Put another way, the benefits you could have received by taking an alternative action.

What Does Opportunity Cost Mean?

• 2. The difference in return between a chosen investment and one that is necessarily passed up.

• Say you invest in a stock and it returns a paltry 2% over the year.

• In placing your money in the stock, you gave up the opportunity of another investment - say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% - 2%).

Investopedia explains Opportunity Cost•

1. The opportunity cost of going to college is the money you would have earned if you worked instead.

• On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages.

Investopedia explains Opportunity Cost

Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.).

Investopedia explains Opportunity Cost

• In both cases, a choice between two options must be made. It would be an easy decision if you knew the end outcome; however, the risk that you could achieve greater "benefits" (be they monetary or otherwise) with another option is the opportunity cost.

Opportunity cost (Further Explanations)• is the cost of any activity measured in terms of the value of

the best alternative that is not chosen (i.e., that is foregone).

• It is the sacrifice related to the second best choice available to someone who has picked among several mutually exclusive choices.

Opportunity cost• Opportunity cost is a key concept in

economics, and has been described as expressing "the basic relationship between scarcity and choice".

Opportunity cost

• The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.

• Thus, opportunity costs are not restricted to monetary or financial costs

• the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs

Marginal analysis

• Marginal benefit = additional benefit resulting from a one-unit increase in the level of an activity

• Marginal cost = additional cost associated with one-unit increase in the level of an activity

Net benefit

• Individuals are not expected to maximize benefit; nor are they expected to minimize costs.

• Individuals are assumed to attempt to maximize the level of net benefit (total benefit minus total cost) from any activity in which they are engaged.

Production possibilities curve

• Assumptions:– A fixed quantity and quality of available resources

– A fixed level of technology

– Efficient production (i.e., no unemployment and no underemployment)

Law of diminishing returns• Law of diminishing returns: output will ultimately

increase by progressively smaller amounts when the use of a variable input increases while other inputs are held constant.

Reasons for law of increasing costLaw of diminishing returnsSpecialized resources (heterogeneous labor, land, capital, etc.)

Specialized resources in farming

• Some land, labor, and capital is better suited for wheat production and some is better suited for corn production

Specialization and tradeAdam Smith – economic growth is caused by increased specialization and division of labor.

Gains from specialization and division of labor

• specialization in areas that match the skills and talents of workers

• “learning by doing” – increase in productivity from task repetition

• less time lost while switching from task to task

Absolute and comparative advantage

• Absolute advantage – an individual (or country) is more productive than other individuals (or countries).

• Comparative advantage – an individual (or country) may produce a good at a lower opportunity cost than can other individuals (or countries).

Free trade?

• If each country specializes in the production of those goods in which it possesses a comparative advantage and trades with other countries, global output and consumption in increased.