Opportunity cost examples
Opportunity cost is our first concept so important that we need to look at some extended examples to illustrate it. This subchapter starts with a couple of examples involving personal trade-offs, before turning to an important macroeconomic take on opportunity cost - the production possibilities curve.
Budget example
A simple example we can start with is the choice of what to buy when going out for fast food. To keep things simple let us go back to McDonald’s in 1955. Assume that we have 35 cents to spend and our our options are:
- Hamburger (15 cents)
- French fries (10 cents)
- Milkshake (20 cents)
Ignoring tax, there are a number of combinations that we could afford. Two possibilities where we spend all 35 cents are that we could get a hamburger and a milkshake () or a hamburger and two french fries ().
We could also buy a hamburger and french fry and have 10 cents leftover (). In economics we will generally focus on examples where there is nothing left over, but in real-life decisions that is often something that happens because an individual decision is just one piece of a bigger picture.
In this McDonald’s example, we can see that one milkshake and two french fries have the same cost. So the opportunity cost of one milkshake can be viewed as two orders of french fries, or one french fry being equal to half of a milkshake.
In our next subchapter we will cover trade-offs involving production, thinking about how to allocate time to produce two goods. While we will be able to (and want to) discuss the trade-off between units of the goods directly, the root of those types of trade-offs will be that each good is produced using the same resource (labor).
College versus work
A deeper example is the choice of going to college. Each year of school has various measures of cost, and this presents an opportunity to clarify the difference between net and gross. A gross value is the dollar amount without any adjustments. Conceptually, it is a sticker price, in this case the prices of tuition, fees, and room and board.
Net values, on the other hand, reflect what is paid out of pocket. So the net is the gross, adjusted for things such as discounts, rebates, or added fees. If added fees sound strange, consider one you may have seen in real life. Some stores and restaurants charge an extra percentage for using a credit card. So the net cost can be different depending on how we choose to pay.
For our tuition example, the net cost includes all gross costs, tuition, fees, and room and board, with amounts of financial aid and scholarships taken out. Thus net values are what we really need, but they will usually not be opportunity cost on their own. The full opportunity cost must also account for that value of our next best choice.
For each year we not only have to pay for school, but we also give up earning wages. The basic trade-off is that we pay now and miss out on earning, in exchange for higher wages once we graduate. To compare we will want to calculate net lifetime earnings to see which option pays better.
To be realistic, there are other factors to add. Not every school has the same costs, not every major has the same earnings, and earnings and costs are not likely to be constant each year. Importantly, a dollar today and a dollar in future years are not worth the same. If we make educated guesses, we can calculate, but changing these guesses can change our decision.
The production possibilities curve
Models will be a critical component of our study of macroeconomics and another of the “Big Ideas” that will appear throughout the course. They are simplified descriptions of behavior, making assumptions to cut down on the details we have to consider in order to say something meaningful about an economic question.
The production possibilities curve (or PPC) is our first model of the macroeconomy. We start by setting up our assumptions for our sample country.
- There are two goods that can be produced: food or microchips
- There are no prices, but trade-offs exist
- There is a fixed trade-off in production, we can costlessly switch from one good to the other
- There is no trade, we sometimes call this autarky
This leads to the graph below, which shows the production possibilities curve. Even though we are labeling this a “curve” in AP Macroeconomics most examples presented with numbers will be linear.
The curve represents the set of maximum combinations of each good we can produce at the same time. Anything inside the curve, including the curve itself, is feasible, or within our capacity to produce. All points outside of the curve are infeasible, or not possible for us to produce.
The numbers presented in this graph give us a lot of important information. The value on the x-axis tells us how many units of food we can produce if our country only makes food, 20 billion units. The value on the y-axis tells us how many units of microchips we can produce if we only make microchips, 100 billion units. Every other point on the graph gives a combination of food and microchips that we can make with the resources we have available to produce.
With food on the x-axis, the slope of the PPC is . Its absolute value gives us the opportunity cost of food in terms of microchips, . In general, that opportunity cost is what we gain of the y-axis good for giving up one unit of the x-axis good as well as what we have to give up of the y-axis good to gain one additional unit of the x-axis good. What we give up can always be viewed as a cost, and what is gained can be viewed as a benefit, as long as we keep in mind that these are in terms of physical units of goods and not money.
The opportunity cost of microchips in terms of food is the inverse of that. Every time we give up one unit of microchips we gain units of food. And to gain one unit of microchips we would have to give up 0.2 units of food. For this example have forced it to be constant, so there is a fixed trade off in production. This means that every unit “costs” the same, so to produce 10 additional units of microchips we would need to give up units of food. Only when the PPC is linear can we use this simplification.
And similarly every time we give up one unit of food, we gain units of microchips. This type of analysis can always be viewed moving in each direction along the curve.
It is possible to use PPCs for more than just countries. We could use regions, states, cities or even individual factories or workshops.
The shape of the PPC
A straight line PPC means the opportunity cost is constant, because resources move between the two goods without losing anything. That is rarely true in practice. Some resources are better suited to one good than the other. A country making more food will first move the land and workers best suited to farming, and later it has to pull in resources that are better at making microchips. So each added unit of food costs more microchips than the last. This is increasing opportunity cost, and it gives the PPC a bowed-out shape, curving away from the origin.
The less common case is decreasing opportunity cost, where each added unit costs less than the last and the PPC curves in toward the origin.
| Shape of the PPC | Opportunity cost | Slope moving right |
|---|---|---|
| Straight line | Constant | Stays the same |
| Bowed out | Increasing | Gets steeper |
| Bowed in | Decreasing | Gets flatter |
Shifts of the PPC
A PPC is drawn for a fixed amount of resources and a fixed level of technology. A change in either one moves the curve itself. More or better factors of production, such as labor, capital or natural resources, shift the PPC outward. So do improvements in technology or productivity. An outward shift is economic growth. Losing resources, for example to a war or a natural disaster, shifts the PPC inward, which is economic contraction.
A change that only helps one good moves only that end of the curve. A better way of making microchips raises the y-axis intercept and leaves the x-axis intercept where it was.
This is different from moving along the curve. Moving from one point on the PPC to another is a change in what we choose to produce, not a change in what we are able to produce.
Efficiency
For most of our discussions, efficiency is our concept of achieving the optimal or most desirable outcome.
Efficiency is often about maximizing net benefits or minimizing waste. As a starting point efficiency can be thought of as allocating all available resources when we have a decision to make. Something that will get much attention is household decisions, and in macroeconomics all available income can be split into consumption and savings. Consumption will be anything we spend in a year, on any good or service. Savings is most simply everything that we do not spend, which will be a bit broader than savings in a personal finance sense. Thus “spending” need not represent use immediately, just that goods and services are paid for.
Efficiency is a fairly general term. So we add two more specific definitions of efficiency that are relevant for our macroeconomic stories.
In terms of the PPC, productive efficiency simply requires using all of the resources available. This allows us to split the set of feasible points into efficient and inefficient points. Every combination along the curve itself is productively efficient, while every value inside of the curve is inefficient. That is because if we are ever producing inside of the curve, it is possible for us to gain more production with more effective utilization of our resources.
Examples of this categorization of different allocations are shown in the image below.
At least for the PPC, allocative efficiency is generally not shown at this level. We may be told that a point represents the ideal production for society, but if that is not given to us we simply cannot say anything at all.