Choice, Opportunity Cost and Specialization - Lecture 2 (Kawaye).pptx

This chapter we are going to understand Choice, Opportunity Cost and Specialization in micro economics

1. Choice, Opportunity Cost and Specialization By H. Kawaye ( BsocEco & M.A.Eco )

2. Choice As noted in the previous lecture, 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, therefore individuals and societies must make choices among competing alternatives.

3. 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 building for your business is the rent you could have received .

4. 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 .

5. 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 .

6. 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. When a production possibilities curve is drawn, the following assumptions are also made : T here is a fixed quantity and quality of available resources, T echnology is fixed, and T here are no unemployed nor underemployed resources

7. 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.

8. UNEMPLOYED & UNDEREMPLOYED 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. If there are no unemployed or underemployed resources, efficient production is said to occur .

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

10. Notice that each additional hour spent studying either calculus or economics results in smaller marginal improvements in the grade. ( 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 .).

11. 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.

12. 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 ).

13. 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 .

14. 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 .

15. 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.

16. A second reason for the law of increasing cost is the fact that resources are specialized . Some resources are better suited for 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.

17. The diagram below illustrates the PPC curve for this farmer.

18. 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

19. 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).

20. 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.

21. An increase in the quantity or quality 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.

22. Specialization and trade In The Wealth of Nations , Adam Smith argued that economic growth occurred as a result of specialization and division of labo u r . 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 .

23. 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 .

24. Absolute Advantage and Comparative Advantage 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 .

25. 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....)

26. 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.

27. 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 .

28. 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 .

29. End of chapter two