Friday, 1 April 2011

Opportunity Cost and the Production Possibility Curve (Microeconomics)

The term opportunity cost refers to the cost of one good in terms of the next best alternative. A very basic example is Tommy has £100 to spend and decides to use it to buy a new television, meaning he cannot spend the money on anything else. The opportunity cost of buying the television is the two pairs of jeans he could have bought with the money.

A production possibility curve (PPC) shows us the maximum quantities of different combinations of two goods that can be produced with the current resources, labour force and technology available. The theory of opportunity cost can be applied using one of these production possibility curves.

This is a basic PPC curve in action. This one is resembling the number of cars produced against the number of bikes produced with the given resources, labour and technology. Any point that lies on the curve itself shows a combination of the two products that maximises output. Take point A on the diagram, at this point 750 cars and 1000 bikes can be produced. Now take point B, here only 500 cars can be produced but 1500 bikes can now be made. So, the opportunity cost of operating at point A on the diagram and producing 250 more cars is 500 bikes. The production forgone of these bikes is the opportunity cost. The opportunity cost of operating at point B and producing 500 more bikes is 250 cars.

Finally, we can analyse point C on the diagram. This point is well above the PPC, and thus is impossible to achieve with the current resources available. Hence point C resembles a position of scarcity. 

But, the position of the curve isn't set in stone and it can fluctuate... shifting outwards as well as in. If the curve were to shift outwards it would show us that the firm/individual/economy has expanded and thus is able to produce more. Reasons for this shift could be an increase in available resources, an increase in labour available or a technological advancement. If the curve shirts inwards, it means less of each good is able to be produced. Reasons for this could be a decrease in available labour (natural disaster may have reduced the population) or less available resources. 

This is a very basic look at the PPC curve, to give you the general idea of how it works. I will do a more detailed post sometime in the future. Thanks for reading. 

No comments:

Post a Comment