Lesson summary: Opportunity cost and the PPC

In this lesson summary, review the key concepts, key terms, and key graphs for understanding opportunity cost and the production possibilities curve.

The Production Possibilities Curve (PPC) is a model used to show the tradeoffs associated with allocating resources between the production of two goods. The PPC can be used to illustrate the concepts of scarcity, opportunity cost, efficiency, inefficiency, economic growth, and contractions.

For example, suppose Carmen splits her time as a carpenter between making tables and building bookshelves. The PPC would show the maximum amount of either tables or bookshelves she could build given her current resources. The shape of the PPC would indicate whether she had increasing or constant opportunity costs.

Key terms

Term	Definition
production possibilities curve (PPC)	(also called a production possibilities frontier) a graphical model that represents all of the different combinations of two goods that can be produced; the PPC captures scarcity of resources and opportunity costs.
opportunity cost	the value of the next best alternative to any decision you make; for example, if Abby can spend her time either watching videos or studying, the opportunity cost of an hour watching videos is the hour of studying she gives up to do that.
efficiency	the full employment of resources in production; efficient combinations of output will always be on the PPC.
inefficient use (under-utilization) of resources	the underemployment of any of the four economic resources (land, labor, capital, and entrepreneurial ability); inefficient combinations of production are represented using a PPC as points on the interior of the PPC.
growth	an increase in an economy's ability to produce goods and services over time; economic growth in the PPC model is illustrated by a shift out of the PPC.
contraction	a decrease in output that occurs due to the under-utilization of resources; in a graphical model of the PPC, a contraction is represented by moving to a point that is further away from, and on the interior of, the PPC.
constant opportunity costs	when the opportunity cost of a good remains constant as output of the good increases, which is represented as a PPC curve that is a straight line; for example, if Colin always gives up producing 2 fidget spinners every time he produces a Pokemon card, he has constant opportunity costs.
increasing opportunity costs	when the opportunity cost of a good increases as output of the good increases, which is represented in a graph as a PPC that is bowed out from the origin; for example Julissa gives up $2$ ‍ fidget spinners when she produces the first Pokemon card, and $4$ ‍ fidget spinners for the second Pokemon card, so she has increasing opportunity costs.
productivity	(also called technology) the ability to combine economic resources; an increase in productivity causes economic growth even if economic resources have not changed, which would be represented by a shift out of the PPC.

Key model

The Production Possibilities Curve (PPC) is a model that captures scarcity and the opportunity costs of choices when faced with the possibility of producing two goods or services. Points on the interior of the PPC are inefficient, points on the PPC are efficient, and points beyond the PPC are unattainable. The opportunity cost of moving from one efficient combination of production to another efficient combination of production is how much of one good is given up in order to get more of the other good.

The shape of the PPC also gives us information on the production technology (in other words, how the resources are combined to produce these goods). The bowed out shape of the PPC in Figure

1

indicates that there are increasing opportunity costs of production.

We can also use the PPC model to illustrate economic growth, which is represented by a shift of the PPC. Figure

2

illustrates an agent that has experienced economic growth. Combinations that were once impossible, such as 6 iPads and 4 watches, are now on the new PPC, thanks to the increase in resources or technology.

Key Equations and Calculations: Calculating opportunity costs:

To find the opportunity cost of any good X in terms of the units of Y given up, we use the following formula:

Opportunity cost of each unit of good X = (Y_{1} - Y_{2}) \div (X_{1} - X_{2}) units of good Y

For example, suppose we knew that the following table represented all of the possible combinations of iPads and Apple Watches that could be produced.

Number of Apple Watches	Number of iPads
$0$ ‍	$5$ ‍
$2$ ‍	$4$ ‍
$4$ ‍	$3$ ‍
$6$ ‍	$2$ ‍
$8$ ‍	$1$ ‍
$10$ ‍	$0$ ‍

If a producer is producing

6

Apple Watches and

2

iPads, but wants to make one more iPad, they can instead produce

4

Apple Watches and

3

iPads:

\begin{aligned} Opportunity cost of one iPad & = (6 - 4) \div (2 - 3) Apple Watches \\ = 2 \div - 1 Apple Watches \\ = - 2 Apple Watches \end{aligned}

Note that opportunity costs are always expressed in terms of the good that is given up.

We can use the same procedure if given a graph. Figure

3

shows a PPC that has been created from our table. The two points used in this formula are the two efficient points indicated in the graph in Figure

3

Common Misperceptions

Not all costs are monetary costs. Opportunity costs are expressed in terms of how much of another good, service, or activity must be given up in order to pursue or produce another activity or good. For example, when you head out to see a movie, the cost of that activity is not just the price of a movie ticket, but the value of the next best alternative, such as cleaning your room.
Going from an inefficient amount of production to an efficient amount of production is not economic growth. For example, suppose an economy can make two goods: chocolate donuts and cattle prods. But half of their donut machines aren’t being used, so they aren’t fully using all of their resources. Graphically, that would be represented by a combination of goods in the interior of their PPC. If they then put all of those donut machines to work, they aren’t acquiring more resources (which is what we mean by economic growth). Instead, they are just using their resources more efficiently and moving to a new point on the PPC.
On the other hand, if this economy is making as many donuts and cattle prods as it can, and it acquires more donut machines, it has experienced economic growth because it now has more resources (in this case, capital) available. This would be represented in a PPC graph as a shift outward of the entire PPC curve.

Discussion Questions

How would you show with a PPC that a country has constant opportunity costs of production?
Using a correctly labeled PPC model, show an economy that has increasing opportunity costs that can produce cattle prods and chocolate donuts that is underutilizing its labor.