Introduction to Microeconomics Lecture 2: Scarcity and Choice Matthew Weinberg January 9, 2014 Abstract 1.5 110-Minute Classes 1. Opportunity Cost • Example 1: Spending the Season Catching Lobster vs. Fish 2. The Production Possibilities Frontier • Example 2: Spending an Hour Catching Lobster vs. Fish • Points on the PPF are Efficient, Points inside are Inefficient, Points Outside are Infeasible • The Slope of the PPF Measures Opportunity Costs • Linear and Bowed-Out PPFs • Example 3: Guns and Butter • Example 4: Origami Economy 3. Gains From Trade • Absolute Advantage • Comparative Advantage • Example 5: Trade on an Island 1 Opportunity Cost Example 1: Spending the Season Catching Lobster vs. Fish A fisherman needs to deciding what seafood to catch this year, lobster or fish. Lobster: He already caught lobster last year, so he already has all the equipment for lobster catching. If he spends the year catching lobster, he can catch and sell $1000 worth of lobster. Fish: If he switches to fish, he will need to pay $1000 to buy fishing equipment, but he will ultimately catch and sell $2500 worth of fish. What is the cost of catching fish? (Ans: $2,000) 1
If we were only to consider the monetary expenditures involved in catching fish, we would say that the cost was $1000, the money spent on the fishing equipment. This is an explicit cost – a cost than involves an expenditure of cash. But since we are good economists, we think in terms of opportunity cost . In addition to having to buy fishing equipment, he is giving up what he would have earned if he had stuck with catching lobster, since he can’t spend time (the scarce resource) to catch lobster at the same time that he catches fish. So the true (opportunity) cost is the money spent on fishing equipment ($1000 - the explicit cost) plus the profit that he would have earned from lobster ($1000 - an implicit cost), which is $2000 in total. Should the fisherman switch to fish? (Ans: Yes) What is the total gain in profit from switching to fish from lobster? The total gain in profit is the profit he earns from fish minus the opportunity cost of catching fish, 2500-2000=$500 ( not the difference in profits from fish versus lobster, 2500-1000=1500!). Should he switch to fishing? Yes. To understand the full cost of a decision, you need to understand both market prices and the value of what you’ve given up (i.e., opportunity cost). Fisherman’s decision: lobster or fish? Lobster profits: 1000 Price of fishing equipment: 1000 Fish profits: 2500 cost of fish? Money spent on fishing equipment: 1000 Forgone profits from lobster: 1000 → True cost = 1000 + 1000 = 2000 Gain in profits from fish? Profit gain from fish = Fish profits - cost of fish = 2500 - 2000 = 500 2
2 Production Possibilities Frontier We can represent the trade-off between lobsters and fish graphically by drawing a production possibilities frontier (PPF), a graph that shows the maximum quantities of outputs that it is possible to produce with a given set of resources.