Opportunity cost and the production possibility curve

Last time

Before we start: last time, in The factors of production and their rewards, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

What you give up

You have one free evening. You can revise economics, or go to a cricket match with your friends. Whichever you choose, you give up the other. The next best thing you give up is called the opportunity cost of your choice.

The definition

Opportunity cost is the next best alternative forgone. The mark scheme gives one mark for next best alternative and one mark for forgone, or given up. It is only the next best option, not every option. If you would have gone to cricket, not to a film, then the cricket is the opportunity cost. And it is not money. The opportunity cost of a new road might be a hospital that cannot now be built.

Opportunity cost for everyone

A consumer with a limited income who buys a new phone may give up new clothes. The clothes are the opportunity cost. A worker with limited time who takes a better paid job may give up leisure, or a job they would enjoy more. A producer who uses a factory to make cars cannot use it to make vans. A government that spends on defence may give up spending on schools. In each case, say why the choice had to be made: income, time or resources were limited.

The production possibility curve

A production possibility curve, or PPC, shows the maximum combinations of two goods an economy can make with all its resources, used fully and efficiently. Here the two goods are consumer goods and capital goods. It curves outwards because resources are not equally good at making both goods.

On, inside and outside

Point A is on the curve, point B is inside it, and point C is outside it. A point on the curve is maximum output with full employment of resources. A point inside means some resources are unemployed or used inefficiently. A point outside cannot be reached with today's resources.

Moving along the curve

Moving from A to D along the curve, the economy makes 2 more units of consumer goods, from 6 to 8. But capital goods fall from 8 to 6. The 2 units of capital goods given up are the opportunity cost of the extra consumer goods.

Why the curve bends

As the economy makes more and more consumer goods, it has to move resources that are better at making capital goods. Each extra unit costs more. That is why the PPC is curved, bowed outwards from the origin. If resources were equally good at both, the PPC would be a straight line. In the exam, a curve or a straight line sloping down to both axes is accepted for the diagram marks.

The curve shifts outwards

When the quantity or quality of resources increases, the whole PPC shifts outwards to the right, from PPC1 to PPC2. The economy can now make more of both goods. This is an increase in productive capacity, which is economic growth.

What shifts it out

More resources: a larger labour force, discoveries of oil or minerals, or more capital goods from investment. Better resources: education and training, better health care, and new technology that lets each worker make more. Moving from a point inside the curve to a point on it is not a shift. It is using resources that were unemployed, so output rises up to the curve.

The curve shifts inwards

A serious storm, a war or an earthquake destroys roads, factories and power lines. Resources are lost, so the PPC shifts inwards, to the left, from PPC1 to PPC2. The economy can now make less of both goods.

Capital goods today, growth tomorrow

Look at the choice between the two goods. Consumer goods, such as food and clothes, are enjoyed now. Capital goods, such as machines and roads, make more goods later. An economy that chooses more capital goods today gives up some consumer goods now. That is its opportunity cost. But the extra capital raises productive capacity, so its PPC shifts outwards faster in the future.

Mistakes that lose marks

Mistake one: defining opportunity cost as the cost of a product, or as every alternative given up. It is only the next best one. Mistake two: on a PPC diagram, leaving the axes unlabelled or labelling them price and quantity. Each axis is the output of one good. Mistake three: showing a movement along the curve when the question is about a storm or growth, which shift the whole curve. The fix: label both axes with goods, draw both curves, and show the shift with an arrow.

The full-marks tip

The full-marks tip: define opportunity cost as the next best alternative forgone, and give a real example. On a PPC diagram, label both axes with goods, draw both curves, and mark the shift with an arrow.

On one card

So, on one card: opportunity cost and the PPC. Keep it for revision.