2. Scarcity, Choice and Opportunity Cost.pptx

Scarcity, Choice and Opportunity Cost Dr Shahid Bashir Senior Lecturer, Mahindra University NET, Ph.D.(Economics), Gold Medalist Three Central Problems 2 Resources Resources: Land: nat...

Scarcity, Choice and Opportunity Cost Dr Shahid Bashir Senior Lecturer, Mahindra University NET, Ph.D.(Economics), Gold Medalist Three Central Problems 2 Resources Resources: Land: natural endowments, such as arable land, forests, lakes, crude oil, and minerals. Labour: all mental and physical human resources, including entrepreneurial capacity and management skills. Capital: all manufactured aids to production, such as tools, machinery, and buildings. Economists call such resources factors of production. 3 Scarcity Scarcity implies the need for choice, so choice implies the existence of cost. A decision to have more of something requires a decision to have less of something else. The less of something else can be thought of as the cost of having the more of something. 4 Opportunity Cost - Definition The idea of opportunity cost is one of the central insights of economics. Definition: The opportunity cost of using resources for a certain purpose is the benefit given up by not using them in the best alternative way*. 5  Opportunity Cost - How choice implies cost Example from ? an individual’s perspective* Consider the choice David faces on a Saturday night when he goes out for pizza and beer with his friends. Income : $16 What is Price of pizza = $2 the cost of beer? Price of beer = $4 6  Opportunity Cost of a University Degree Direct Cost Components: Tuition fees: 2.5L per year + Books and materials: 15K per year + Food, lodging, clothing, etc.: 1.5L per year Total direct costs for 3 years: 12.45L Additional Costs: Forgone earnings if working instead: 3L per year Total forgone earnings for 3 years: 9L True Cost: Total direct costs + forgone earnings = 21.45L. If the OC is very high, Why students still choose to go to university? Enjoyment of learning Belief in increased future earning potential 7  The Production Possibility Frontier* PPF is a boundary line drawn by using the alternative combinations of goods and services that an economy is capable of producing with its given resources and state of technology. Assumptions: Fixed resources - such as labour, capital, and natural resources Fixed technology Full employment of available resources Two goods 8  The Production Possibility Frontier To illustrate the PPF, we focus on two goods at a time (smartphones and bikes) and hold the quantities produced of all the other goods and services constant. That is, we look at a model economy in which everything remains the same except for the production of the two goods we are considering. 9  Production Possibilities Frontier* This figure shows the PPF for smartphones and bikes. Each point on the graph represents a column of the table. The line through the points is the PPF.  How the PPF Illustrates Scarcity and Its The Consequences? PPF puts three distinctions in sharp focus: Attainable and unattainable combinations Efficient and inefficient production Trade-offs and free lunches 11 Attainable and Unattainable Combinations We can produce at any point inside the PPF or on the frontier. We cannot produce at any point outside the PPF such as point G. Because the PPF shows the limits to production, it separates attainable combinations from unattainable combinations. 12 Efficient and Inefficient Production Production efficiency is a situation in which we cannot produce more of one good or service without producing less of something else. The figure on the next slide illustrates the distinction between efficient and inefficient production. 13 Efficient and Inefficient Production When production is on the PPF, such as at point E or D, production is efficient. If production were inside the PPF, such as at point H, more goods could be produced without forgoing either good. Production inside PPF is inefficient (Such as point H). Trade-offs and Free Lunches A trade-off is an exchange—giving up one thing to get something else. A free lunch is a gift—getting something without giving up something else. Figure on the next slide illustrates the distinction between a trade-off and a free lunch. 15 Trade-offs and Free Lunches When production is on the PPF, we face a tradeoff (movement from E to D). If production were inside the PPF, there would be a free lunch. Moving from point H to point D (0r H to E) does not involve a tradeoff.  Opportunity Cost and PPF The Opportunity Cost of a Smartphone The opportunity cost of producing a smartphone is the decrease in the quantity of bikes divided by the increase in the number of smartphones as we move along the PPF. OCSmartphone = Figure on the next slide illustrates the calculation of the opportunity cost of producing a smartphone. 17 Opportunity Cost and PPF Moving from A to B, 1 smartphone costs 1 bike Increasing Opportunity Cost The opportunity cost of a smartphone increases as more smartphones are produced.  Opportunity Cost is a Ratio The opportunity cost of a smartphone is the quantity of bikes forgone divided by the increase in the quantity of smartphones gained. The opportunity cost of a bike is the quantity of smartphones forgone divided by the increase in the quantity of bikes gained. When the opportunity cost of a smartphone is X bikes, the opportunity cost of a bike is 1/X smartphones. 20 Characteristics of PPF Slopes downwards from left to right - Because a society’s choices are constrained by available resources and existing technology – there is a trade- off Concave to the origin – because of the law of increasing opportunity cost*. 21 Possible shapes of PPF 22  Slope of PPF The value of the slope of a society’s PPF is called the marginal rate of transformation (MRT). In other words, the magnitude of the slope of the PPF measures opportunity cost. MRT or Opportunity cost is simply the ratio of the change in good Y to the change in good X. It tells us how much society has to give up of one output to get a unit of second. 23 Efficiency Productive efficiency: When it is impossible to produce more of one good (or service) without decreasing the quantity produced of another good (or service). Every point on PPF is production efficient. Allocative efficiency: When the mix of goods being produced represents the mix that society most desires (MB = MC) Only one point on PPF is allocatively efficient. 24 Allocative efficiency 25 Rotation in PPF Improvement in production technology: Improvement in the production technology of one good (food), while the technology of the other good (clothing) remains unchanged – outward rotation towards Y axis (Figure a). Improvement in the production technology of one good (clothing), while the technology of the other good (food) remains unchanged - outward rotation towards X axis (Figure b). 26 Shift in PPF Outward Shift – Economic growth Improvement in technology Increase in the economy’s productive capacity/productive resources* Inward Shift - resources depletion or war. 27 Economic Systems Command Economy An economy in which a central government either directly or indirectly sets output targets, incomes, and prices. This system was in place in the Soviet Union and China some years ago. At present, for most countries in the world, private enterprise plays at least some role in production decisions. The debate today is instead about the extent and the character of government’s role in the economy. Government involvement, in theory, may improve the efficiency and fairness of the allocation of a nation’s resources. At the same time, a poorly functioning government can destroy incentives, lead to corruption, and result in the waste29of a society’s resources.  Laissez-Faire Economies: The Free Market The term laissez-faire, which translated literally from French means “allow [them] to do,” implies a complete lack of government involvement in the economy*. An economy in which individual people and firms pursue their own self-interest** without any central direction or regulation; the sum total of millions of individual decisions ultimately determines all basic economic outcomes. Market - The central institution through which a laissez-faire system works Market means an institution through which buyers and sellers interact and engage in exchange. 30  Laissez-Faire Economies: The Free Market Some markets are simple and others are complex, but they all involve buyers and sellers engaging in exchange. The behaviour of buyers and sellers in a laissez-faire economy determines what gets produced, how it is produced, and who gets it. In a free market system, the basic economic questions are answered without the help of a central government plan or directives. This is what the “free” in free market means— the system is left to operate on its own with no outside interference. 31 Consumer Sovereignty The mix of output found in any free-market system is dictated ultimately by the tastes and preferences of consumers who “vote” by buying or not buying. Economists call this consumer sovereignty*. Businesses rise and fall in response to consumer demands. 32  Individual Production Decisions: Free Under aEnterprise free market system, individual producers must determine how to organise and coordinate their production. In a free market economy, production decisions are made by private organisations acting in their own interest. Producers may be small or large. A local bakery. A regional furniture manufacturer. Technology giants like Apple and Intel. Proponents of free market systems argue that the use of markets leads to more efficient production and better response to diverse and changing consumer preferences. In a free market system, the distribution of output—who gets what—is also determined in a decentralised way. 33 Price theory The basic coordinating mechanism in a free-market system is price. A price is the amount that a product sells for per unit, and it reflects what society is willing to pay. Prices of factor inputs* determine how much it costs to produce a product. Much of economic theory focuses on the factors that influence and determine prices. This is why microeconomic theory is often simply called price theory. 34  Mixed Systems, Markets, and Governments The differences between command economies and laissez-faire economies in their pure forms are enormous. In fact, these pure forms do not exist in the world. All real systems are in some sense “mixed.” 35