Learning objectives
Explain why scarcity forces choices, identify the four factors of production and distinguish macroeconomics from microeconomics
Define opportunity cost and calculate it from a production possibilities table or curve
Interpret points inside, on and beyond a production possibilities curve (PPC)
Explain why a bowed-out PPC shows increasing opportunity cost and a straight-line PPC constant opportunity cost, and show growth as an outward shift
Determine absolute and comparative advantage from output or input data
Identify mutually beneficial terms of trade and calculate the gains from trade
Key definitions
Scarcity
The permanent condition in which limited resources cannot satisfy unlimited wants, so every choice involves a trade-off.
Opportunity cost
The value of the next best alternative given up when a choice is made.
Production possibilities curve (PPC)
A curve showing the maximum combinations of two goods an economy can produce when its given resources and technology are fully and efficiently employed.
Comparative advantage
The ability to produce a good at a lower opportunity cost than another producer.
Explanation
Economics exists because of scarcity: wants are unlimited but the resources that satisfy them are limited, so individuals, firms and governments must choose. Those resources are the four factors of production: land (natural resources), labor (human effort), capital (tools, machines and buildings made to produce other goods) and entrepreneurship (the organizing and risk-taking that combines the other three). Every choice has an opportunity cost, the value of the next best alternative given up, not the sum of all the alternatives. If a city spends $5 million on a park, the opportunity cost is the next best use of that money, perhaps a new fire station. Microeconomics studies individual households, firms and markets, such as the price of gasoline; macroeconomics studies the economy as a whole (real GDP, unemployment, inflation and growth) and the policies that influence it. Every later model in the course, from the PPC to AD–AS, is a way of analyzing trade-offs.
A production possibilities curve (PPC) shows the maximum combinations of two goods an economy can produce with its given resources and technology. Points on the curve are productively efficient; a point inside it means unemployed or misallocated resources, as in a recession; a point beyond it is unattainable with current resources. Moving along the curve shows opportunity cost: the slope measures how much of the vertical-axis good is given up for each extra unit of the horizontal-axis good. A PPC bowed outward (concave to the origin) shows increasing opportunity cost, because resources are specialized: the first workers moved into making computers are the ones best suited to it, so each extra computer costs more food. A straight-line PPC shows constant opportunity cost, because resources are equally suited to both goods. More or better resources, or improved technology, shift the PPC outward, which is economic growth. A move from inside the curve onto it is recovery, not growth.
Absolute advantage means producing more of a good with the same resources, or the same output with fewer resources. Comparative advantage means producing a good at a lower opportunity cost, and it is comparative advantage that decides who should specialize. With output data (units produced per worker or per day), the opportunity cost of one unit of X is the output of Y divided by the output of X. With input data (hours or workers needed per unit), the opportunity cost of one unit of X is the input needed for X divided by the input needed for Y. A country can have an absolute advantage in both goods but never a comparative advantage in both, because its two opportunity costs are reciprocals of each other. When each country specializes in the good it makes at the lower opportunity cost and then trades, total output rises and both countries can consume at points beyond their own PPCs.
Terms of trade are the rate at which one good is exchanged for another, and trade benefits both partners only if the terms lie between their opportunity costs. Suppose a worker in Alpha makes 10 bikes or 20 radios, so 1 bike costs 2 radios, and a worker in Beta makes 4 bikes or 16 radios, so 1 bike costs 4 radios. Alpha has the comparative advantage in bikes and Beta in radios, even though Alpha has the absolute advantage in both. Any terms between 2 and 4 radios per bike help both countries, for example 3 radios per bike. Alpha then receives 3 radios for each bike it exports instead of the 2 radios it could make itself with those resources, a gain of 1 radio per bike. Beta pays 3 radios per bike instead of the 4 radios it would give up to make a bike itself, also a gain of 1 radio per bike. These gains let each country consume beyond its own PPC.
Formulae
Opportunity cost of 1 unit of X (output data) = units of Y given up ÷ units of X gained
Opportunity cost of 1 unit of X (input data) = input needed per unit of X ÷ input needed per unit of Y
Mutually beneficial terms of trade lie between the two producers' opportunity costs
Worked examples
q: Farmland can produce 60 tons of corn and 0 tractors, 50 tons and 10 tractors, 30 tons and 20 tractors, or 0 tons and 30 tractors. Calculate the opportunity cost of one tractor when output rises from 10 to 20 tractors, and state what the table shows about the shape of the PPC.
steps: Moving from (10 tractors, 50 tons) to (20 tractors, 30 tons) gains 10 tractors and gives up 20 tons of corn.
Opportunity cost of one tractor = 20 ÷ 10 = 2 tons of corn.
The first 10 tractors cost 10 tons (1 ton each) and the last 10 cost 30 tons (3 tons each), so the opportunity cost of tractors rises as more are made.
Answer: 2 tons of corn per tractor; rising opportunity cost means the PPC is bowed outward (concave to the origin).
In context
During a war an economy moves along its PPC toward military goods and civilian output falls: the opportunity cost of defense.
Countries rich in skilled labor tend to export high-tech services and import labor-intensive manufactures, as comparative advantage predicts.
Common misconceptions
Thinking a country that is better at producing everything cannot gain from trade; the gains depend on comparative, not absolute, advantage.
Treating a move from inside the PPC to the curve as economic growth; growth is an outward shift of the curve itself.
Adding up every alternative given up; opportunity cost is only the next best alternative.
Study tips
Label both axes of a PPC with the two goods, never price and quantity.
State terms of trade as units of one good per unit of the other, and check they lie strictly between the two opportunity costs.
Evaluate the idea
The comparative advantage model assumes constant opportunity costs and ignores transport costs, the cost of retraining displaced workers and the risk of depending on a few exports, so real gains from specialization can be smaller than the model predicts.
Reasoning
Scarcity → choice → opportunity cost → specialization by comparative advantage → trade → consumption beyond the PPC
Summary
Scarcity forces choices, and every choice has an opportunity cost.
On the PPC is efficient, inside is inefficient, outside is unattainable; bowed out means increasing opportunity cost.
Specialize where opportunity cost is lowest; terms of trade between the two costs benefit both partners.
Check your understanding
Question 1: A point inside a PPC shows…
1. economic growth
2. unemployed or underused resources
3. unattainable output
Question 2: In one hour Ana makes 6 cakes or 3 shirts, and Ben makes 4 cakes or 4 shirts. Who has the comparative advantage in shirts?
1. Ana
2. Ben
3. Neither