Chapter Two

Choice,
Opportunity Costs
and Specialization

-Prachi Malhan
 Introduction
• An economic system has to solve three
coordination problems:
– What, and how much, to produce.
– How to produce it.
– For whom to produce it.
 Opportunity Cost
• Opportunity cost: the value of the
highest-valued alternative that must be
forgone when a choice is made. It is the
evaluation of a trade-off.

• Marginal benefits and costs: the benefits

and opportunity costs associated with one
additional unit of the good.
 Introduction
• A production possibility curve is used to
illustrate opportunity cost.
 The Production Possibilities
Model
• The production possibilities curve shows
the trade-offs among choices we make.
The Production Possibility Table
• A production possibility table lists a
choice's opportunity costs by summarizing
what alternative outputs you can achieve
with your inputs.
The Production Possibility Table
• Output – an output is simply a result of an
activity.

• Input – an input is what you what you put

into a production process to achieve an
output.
 The Production Possibility
Curve
• A production possibility curve
measures the maximum combination of
outputs that can be achieved from a given
number of inputs.
• It slopes downward from left to right.
 The Production Possibility
Curve
• The production possibility curve
demonstrates that:

– There is a limit to what you can achieve, given

the existing institutions, resources, and
technology.
– Every choice made has an opportunity cost—
you can get more of something only by giving
up something else.
 Production Possibility Curve

Y
10
9 If the slope of the production
8 curve is -2 at A, the
A
7 2Y opportunity cost
.
6 of 1X is 2Y.
5 1X
4
3
2
1
0
1 2 3 4 5 6 7 8 9 X
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All
Rights Reserved.
 A Production Possibilities Table
and Curve
% of resources % of resources
devoted to devoted to
production Number production Pounds
of guns of guns of butter of butter Row

0 0 100 15 A
20 4 80 14 B
40 7 60 12 C
60 9 40 9 D
80 11 20 5 E
100 12 0 0 F

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All

Rights Reserved.
 A Production Possibilities Table
and Curve
1 pound 15 A
of butter B
14
2 pounds C
of butter 12
D
Butter

5 E
5 pounds
of butter
F
0 4 7 9 11 12 Guns
4 guns 3 guns 1 gun
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All
Rights Reserved.
• The Production Possibilities Curve (PPC)
illustrates the concept of opportunity cost.
Each point on the PPC means that every other
point is a forgone opportunity.
 Increasing Opportunity Cost

A Slope is flat at A. Low

opportunity cost of
guns.
Butter

Slope is steep at B. High

opportunity cost of guns.
B

Guns
 Production Possibilities Curve
• The production possibilities curve shows
the maximum quantity of goods and
services that can be produced when the
existing resources are used fully and
efficiently.
 Production Possibilities
Defense Non-defense
A1 200 0
B1 175 75
Only defense
goods produced C1 130 125
Defense Goods D1 70 150
A1
200 G1 E1 0 160
B1 Impossible
F1 130 25
175
G1 200 75
150 C1 Efficient
F1 Combinations
125
Underutilized 100
(Inefficient)
Only nondefense
75 D1 goods produced

E1
0
25 50 75 100 125 150 Nondefense Goods
 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.
 Growth
• The PPC moves outward (growth occurs) as
the result of:
– Increased resources
• Larger labor force
• Change in labor force participation
• Chance in labor-leisure decision
– Improved technology (innovation)
– Expansion of capital stock
– An improvement in the rules (laws, institutions,
and policies) of the economy
 A Shift of the PPC
Defense Non-defense
A2 225 0
225 A2
B2 200 75
Defense Goods A1 B2 C2 175 120
200
D2 130 150
B1 C2
175 E2 70 160
F2 0 165
150
C1 D2
125
100
D1 E2
75
E1 F2
0
25 50 75 100 125 150 Nondefense Goods
 Shifts in the Production
Possibility Curve
• More output is represented by an outward
shift in the production possibility curve.
Shifts in the Production
Possibility Curve
Neutral Technological Change

Butter

C
A

0 B D Guns
Shifts in the Production
Possibility Curve
Biased Technological Change

Butter
C
B

0
A Guns
 Examples of Shifts in the
Production Possibility Curve

(a) (b) (c) (d)