Opportunity Cost
The consumption choice opportunity frontier or budget constraint is a graph that displays every possible combination of two goods, such as ice cream and books.
The y-intercept represents that maximum quantity of good A if one would spend their entire budget on A. The x-intercept represents the maximum quantity of good B.
The true cost of A is the quantity of B one gives up.
The Budget Constraint Formula
This can be rearranged into the slope-intercept form
Identifying Opportunity Cost
The opportunity cost of one thing is the value of the best forgone alternative. For example, if a coffee costs $5 at a cafe and $1 to make at home, the opportunity cost of the cafe-made coffee is $4. Over a year (250 working days), this becomes $1000.
Utility
Utility is the satisfaction that one receives from the consumption of a good. When conducting marginal analysis, we examine the cost and utility gained from the next unit of a good.
The Law of Diminishing Marginal Utility
Marginal utility is diminishing. For each marginal (additional) unit consumed, the utility gained is less than the last. For example, the first slice of pizza tastes extra good when you are hungry, but the tenth may make you sick.
Sunk Costs
Sunk costs are costs incurred that cannot be recovered. If you purchase a movie ticket and decide half-way through the show that it sucks, you may either leave or stay, but you cannot get your money back.
When making forward-looking decisions, sunk costs should not be taken into consideration. Although you paid for the ticket, doing something else in the remaining half of the movie may have a higher utility.
Production Possibilities Frontier
The PPF is a representation of what quantities of two products a society can produce, given its limited resources. Unlike budget constraints which are linear, PPFs are curved. PPFs demonstrate the tradeoff between two goods, such as education and national defence.
The Law of Increasing Opportunity Cost
When a nation is spending almost all of its resources on education, a lot can be gained in terms of defence by moving down the PPF to allocate a bit for defence. However, not much education can be gained by moving up, since so much is already being spent.
Productive and Allocative Efficiency
Any point that falls on the PPF curve is productively efficient. This means that society is producing the maximum amount of education and defence at that point.
Points that fall inside the area bound by the PPF are productively inefficient, since more goods could still be produced with the available resources. Points outside are better, but impossible.
Allocatively efficient combinations produce the optimal combination of goods based on the society’s desires. When allocative efficiency is reached, producers supply the quantity demanded by consumers. Allocative efficiency requires productive efficiency, but not vice-versa.
As economies grow over time, the PPF may shift outwards as a result of increased resource availability. Demands change as well, moving to different points on the PPF.
Comparative Advantage
Nations benefit from global trade through comparative advantage, since one nation can give up less of one good to produce the other compared to its trade partners. This is different from absolute advantage, where the nation can produce more units altogether.
Comparative advantage can be represented in tables:
| Wheat | Iron | |
|---|---|---|
| Rhodesia | 50 | 70 |
| Czechoslovakia | 50 | 20 |
While Rhodesia can produce more wheat or iron, it cannot do both (see: PPFs). It makes much more sense for Rhodesia to specialize in iron and trade for wheat with Czechoslovakia, since both countries give up less of the other good to specialize. Calculating CA appears often in microeconomics.
The Economic Approach
The purpose of economics is to describe economic behaviour rather than guide it. Economists use positive statements, which are factual and testable to describe the world as it is, and normative statements, which are subjective opinions.