Chapter 1

Economics: The Study of

Opportunity Cost

McGraw-Hill/Irwin © 2012 The McGraw-Hill Companies, Inc., All Rights Reserved.

 CHAPTER OUTLINE

• ECONOMICS AND OPPORTUNITY COST

• MODELING OPPORTUNITY COST USING A (PPF)

• ATTRIBUTES OF THE PRODUCTION POSSIBILITIES FRONTIER

• THINKING ECONOMICALLY

• THE BIG PICTURE: CIRCULAR FLOW DIAGRAM

• CORRELATION & CAUSATION

• FALLACY OF COMPOSATION

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 Economics and Opportunity Cost

• Economics: is the study of the

allocation and use of scarce
resources to satisfy unlimited
human wants.

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• choices → TRADE-OFFS → forgone
alternatives

• choosing is refusing!
• the cost of something is what you give up.

OPPORTUNITY COST!
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 Choices Have Consequences

Opportunity Cost:
– The forgone alternative of the choice made
Or
– The value of the next best alternative that must be forgone
when a decision is made to allocate resources, such as time or
money, to one choice over another.

Let's take a common scenario as (Student):

-Studying for an Exam vs. Going to a Party.
-Working Part-Time vs. Participating in Extracurricular
Activities.

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 There is no such thing as a free lunch?

• Nobel Laureate Milton Friedman was fond of

saying, "There is no such thing as a free
lunch."

• Imagine that the friendly neighborhood pizza

restaurant set up a table full of pizza boxes
outside your school about lunchtime and put
up a sign that said Pizza and soda $0.00.

• Why wouldn't that be a free lunch?

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 opportunity cost in the context of international
economic issues
Explaining opportunity cost in the context of international economic
issues can help individuals understand the trade-offs involved in global
economic decision-making.

Scenario: Trade Policy and Opportunity Cost

Imagine a country, Country A, that has the opportunity to choose its
trade policy with Country B. Country A can either impose high tariffs on
imports from Country B or pursue a policy of free trade.

The immediate benefit may be the protection of local jobs and

industries, but the opportunity cost is that consumers in Country A will
have to pay higher prices for goods that could have been imported
more affordably.

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 opportunity cost in the context of
international economic issues
Scenario Free Trade:
On the other hand, if Country A chooses free trade with Country B, it
opens its markets to foreign goods and encourages trade and economic
integration.

The immediate benefit is access to cheaper imports, which can benefit

consumers through lower prices and a wider variety of products.

However, the opportunity cost could be potential job displacement in

certain domestic industries that face competition from cheaper foreign
goods.

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opportunity cost in the context of international
economic issues
• In both scenarios, understanding opportunity cost
helps you realize that every choice you make
involves trade-offs.

• By making informed decisions and considering the

value of what you're giving up, you can prioritize
your goals and make choices that align with your
preferences and objectives in our life.

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Modeling Opportunity Cost Using a Production
Possibilities Frontier Definitions

• PPF: a graph which relates the amounts of

different goods that can be produced in a
fully employed society.
• Model: a simplification of the real world that
we can manipulate to explain the real world

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 Modeling Opportunity Cost Using a Production
Possibilities Frontier Definitions

• Simplifying Assumption: an assumption

that may, on its face, be silly but allows for
a clearer explanation
• Scarce: not freely available and infinite
• Resources: anything we either consume
directly or use to make things that we will
ultimately consume.

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 Figures 1-4
Building The Production Possibilities Frontier
Soda

S
X
Y
M

0 Pizza
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A Fully Labeled Production Possibilities Frontier:
The Case When People are Different
Soda

S Unattainable
X
Y

Attainable M

Unemployment P

0
Pizza
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 Figure 5

Soda

Unattainable
(outside the curve)

Unemployment
(just inside the curve)

0 Attainable
(on the curve and on the inside)
Pizza
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A Fully Labeled Production Possibilities Frontier: The
Soda Case When People are the Same

S
X
Unattainable
Y
Attainable
M

Z
Unemployment P
0
Pizza
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 Figure 6

Soda

Unattainable
(outside the curve)

Unemployment
(just inside the curve)

0 Attainable
(on the curve and on the inside)
Pizza
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 Increasing Opportunity Cost

• Increasing Opportunity Cost

–Exists when the additional
resources required to produce
an additional unit grows as
more output is produced.
–Likely to occur when people are
different in their skills.

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 Constant Opportunity Cost

• Constant Opportunity Cost

–Exists when the additional
resources required to produce an
additional unit remains the same as
more output is produced.
–Likely to occur when people are
identical in their skills.
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 The Big Picture

• Circular flow model: A model that shows

the interactions of all economic actors
– Markets are where the interactions take place
– Actors are the entities interacting

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 Markets in a Circular Flow Diagram

• Market: Any mechanism by which

buyers and sellers negotiate an
exchange
• Factor Market: A mechanism by which
buyers and sellers of labor and financial
capital negotiate an exchange.

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 Markets in a Circular Flow Diagram

• Goods and Services Market:

A mechanism by which buyers and
sellers of goods and services negotiate
an exchange.
• Foreign Exchange Market:
A mechanism by which buyers and
sellers of the currencies of various
countries negotiate an exchange.
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The Circular Flow Diagram

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The Circular Flow Diagram

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The circular flow diagram shows the transactions among
households, firms, governments, and the rest of the world.

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 The Circular Flow Diagram

These transactions take place in factor markets, goods

markets, and financial markets.

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 The Circular Flow Diagram

Firms hire factors of production from households. The blue

flow, Y, shows total income paid by firms to households.

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 The Circular Flow Diagram

Households buy consumer goods and services. The red flow,

C, shows consumption expenditure.

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 The Circular Flow Diagram

Households save, S, and pay net taxes, T. Firms borrow some

of what households save to finance their investment.

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 The Circular Flow Diagram

Firms buy capital goods from other firms. The red flow I
represents this investment by firms.

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 The Circular Flow Diagram

Governments buy goods and services, G, and borrow or repay

debt if spending exceeds or is less than taxes.

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 The Circular Flow Diagram

The rest of the world buys goods and services from us, X, and
sells us goods and services, M. Net exports are X – M.

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 The Circular Flow Diagram

And the rest of the world borrows from us or lends to us

depending on whether net exports are positive or negative.

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 The Circular Flow Diagram

The blue and red flows are the circular flow of expenditure and
income. The green flows are financial flows.

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 The Circular Flow Diagram

The sum of the red flows equals the blue flow.

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The Circular Flow Diagram

That is: Y = C + I + G + X – M

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 Thinking Economically: Marginal Analysis

• Optimization Assumption: an
assumption that suggests that the
person in question is trying to
maximize some objective.
• Marginal Benefit: the increase in
the benefit that results from an
action

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 Thinking Economically: Marginal Analysis

• Marginal Cost: the increase in the

cost that results from an action.

• Net Benefit: the difference between all

benefits and all costs.

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Thinking Economically: Marginal Analysis

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 Choosing at the Margin

People make choices at the margin, which means

that they evaluate the on sequences of making
incremental changes in the use of their
resources.

MB >MC Incentive to
continue activity

MB < MC Incentive to
discontinue activity
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 Economics Incentives
• Incentive: something that influences the decisions we
make.
• Understanding incentives is critical because it helps
explain why people make certain choices and how
policies and economic changes can influence
behavior. It's a fundamental concept in economics
that underlies much of economic analysis and
decision-making.
• Examples: prices influence the amount we buy; taxes
influence how much we work and save.
Positive Incentives:
Negative Incentives:

–How Incentives Influence Behavior?

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 Fallacy of Composition

• Fallacy of Composition: the mistake in logic that suggests

that the total economic impact of something is always and
simply equal to the sum of the individual parts.

• Economic decisions and policies often require a holistic

understanding of how individual actions aggregate and
interact at the macroeconomic level.

• See the video:

https://www.youtube.com/watch?v=-7diFiX3cYk

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 Fallacy of Composition

• The fallacy of composition occurs when individuals

mistakenly assume that what is true for one part (or
individual) of a whole must also be true for the whole (or
group).

• In economics, the fallacy of composition occurs when

people assume that if something benefits an individual or
a small group, it will also benefit the entire economy or a
larger group. Conversely, if something harms an
individual, it doesn't necessarily mean it will harm the
entire economy.

• Example: Savings
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 The fallacy of causation
• Correlation & Causation: the mistake that suggests that
because two variables are correlated that one caused
the other to happen

• Suppose there is a strong positive correlation between

the number of ice cream sales and the number of
drownings at a beach over the summer months. The
mistake would be to assume that selling more ice cream
somehow causes more drownings, or vice versa.

• Just because two events appear to be related in

some way (correlation) does not necessarily
mean that one event caused the other
(causation).
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 Correlation & Causation

• Scenario: Suppose a government increases the

minimum wage in a certain region, and shortly
afterward, there is an increase in the
unemployment rate.
• Fallacy of Causation: Assuming that the
minimum wage increase directly caused the rise
in unemployment without considering other
factors is an example of the fallacy of causation.
• See the video:
https://www.youtube.com/watch?v=7bT17r_yIrw

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 Examples

Demonstrating Increasing and

Constant Opportunity Cost

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 Figure 7
Illustrating Increasing Opportunity Cost
Soda

10
9
8
7 Production Possibilities Frontier
6
5
4
3
2
1
0 1 2 3
Pizza
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 Figure 7
Illustrating Increasing Opportunity Cost
Soda
Opportunity Cost of going from 0 units of
Pizza to 1 unit of pizza
10
9
8
7 Production Possibilities Frontier
6
5
4
3
2
1
0 1 2 3
Pizza
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 Figure 7
Illustrating Increasing Opportunity Cost
Soda
Opportunity Cost of going from 0 units of
Pizza to 1 unit of pizza
10
Opportunity Cost of going from 1 unit of
9 Pizza to 2 units of pizza
8
7 Production Possibilities Frontier
6
5
4
3
2
1
0 1 2 3
Pizza
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 Figure 7
Illustrating Increasing Opportunity Cost
Soda
Opportunity Cost of going from 0 units of
Pizza to 1 unit of pizza
10
Opportunity Cost of going from 1 unit of
9 Pizza to 2 units of pizza
8
7 Production Possibilities Frontier
6
Opportunity Cost of going from 2
5 units of Pizza to 3 units of pizza
4
3
2
1
0 1 2 3
Pizza
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 Figure 8
Illustrating Constant Opportunity Cost
9
Soda

8
7
6
Production Possibilities Frontier
5
4
3
2
1
0 1 2 3
Pizza
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 Figure 8
Illustrating Constant Opportunity Cost
Opportunity Cost of going from 0 units of
9 Pizza to 1 unit of pizza
Soda

8
7
6
Production Possibilities Frontier
5
4
3
2
1
0 1 2 3
Pizza
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 Figure 8
Illustrating Constant Opportunity Cost
Opportunity Cost of going from 0 units of
Pizza to 1 unit of pizza
9
Soda

8 Opportunity Cost of going from 1 unit of

7 Pizza to 2 units of pizza

6
Production Possibilities Frontier
5
4
3
2
1
0 1 2 3
Pizza
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 Figure 8
illustrating Constant Opportunity Cost
Opportunity Cost of going from 0 units of
Pizza to 1 unit of pizza
9
Soda

8 Opportunity Cost of going from 1 unit of

7 Pizza to 2 units of pizza

6
Production Possibilities Frontier
5
4
3 Opportunity Cost of going from 2
units of Pizza to 3 units of pizza
2
1
0 1 2 3
Pizza
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