1.3 Opportunity Cost

• Opportunity Cost


  The value or benefits forgone of the next best alternative when a choice is made
• Economic agents

  • Households
  • Firms
  • Governments
• Rational decisions

  Assumption in economics that people make rational decisions
• Objectives

  What the economic agents are trying to achieve, which sets the incentives that will affect their behaviour
• Households' objectives

  Maximise satisfaction (utility) from their expenditure and income from working (supplying labour)
• Firms' objectives


  Maximise profit
• Governments' objectives


  Maximise welfare for society
• The existence of the 'economic problem' - limited resources (factors of production) and how society chooses to allocated these resources among competing uses
• How can the 3 main economic agents achieve their respective aims

  • Households/consumers - maximise the satisfaction gained from consuming goods and services
  • Firms - maximise profit
  • Government - maximise the total welfare of its citizens
• Opportunity cost

  Measures the cost of obtaining a good in terms of the quantity of other goods that could have been obtained instead
• When an economic choice is made opportunity cost is the nest best alternative forgone as a result of that decision
• Production Possibility Frontier or Curve (PPF/PPC)


  A simplified view of reality that is used by economists as a means of explaining economic relationships
• Production Possibility Curve


  • Shows the maximum quantities of different combinations of output of two products, given current resources and the state of technology
  • Can also show: trade offs, opportunity costs, inefficient and unobtainable levels of production, increase/decrease in productive potential (economic growth), difficult economic choices - consumption v investment
• A PPF is normally drawn as concave to the origin because the extra output resulting from allocating more resources to one particular good may fall, due to the law of diminishing returns and factor resources not being perfectly mobile between different uses
• Capital goods


  Used to increase the future capacity of the economy
• Consumer goods


  For present use
• Expenditure on capital goods is known as investment, while expenditure on consumer goods is known as consumption
• A shift to the right of the PPC indicates an increase in productive potential of an economy leading to long run economic growth


  A shift to the left indicates productive capacity has decreased
• Advances in technology over time can also shift a PPC
• Opportunity cost is a very important concept in economics as it focuses on the true cost of making a decision, which applies to all economic agents