Opportunity Cost

Definition of Opportunity Cost
Opportunity cost is the value of the next-best choice available to someone who has picked between several mutually exclusive choices.[1]

Examples of Opportunity Cost
  1. The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages. [1]
  2. The idea of going on vacation for a week and missing one week of work.----

[1] http://www.investopedia.com/terms/o/opportunitycost.asp

Opportunity cost is the "cost" of choosing the second option. It is what you would have gained if you chose option A, when you choose option B.

SS.D.1.4 Identifies how every economic choice involves tradeo-offs and opportunity costs.

Production Possibilities Frontier

PPF represents the point at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible.

If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the production of society will dwindle. The production possibility frontier shows there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can be produced.

external image economics1.gif

Imagine an economy that can produce only wine and cotton. According to the PPF, points A, B and C - all appearing on the curve - represent the most efficient use of resources by the economy. Point X represents an inefficient use of resources, while point Y represents the goals that the economy cannot attain with its present levels of resources. Basically, outside of the PPF curve, where Y is, represents the impossible and inside the PPF curve represents the possibilities.


With a limited amount of resources, there is a limited amount of goods that can be produced. This limit is known as the Production Possibility Frontier.


Comparitive Advantage

We try to keep the balance of trades
Comparative Advantage

Comparative advantage is an economic principle that holds that a country can trade even if it is absolutely more efficient (or more inefficient) than other countries in the production of every good. For example, let's suppose that the United States is 50% more efficient at making computers than any other country, and 10% more efficient at producing steel. In this case, it would benefit the United States to export that good in which is relatively more efficient (computers) and import that good that is relatively less efficient (steel). That is why the Principle of Comparative Advantage tells us that each country will specialize in the production and export of those goods that it can produce at relatively low cost (in which it is relatively more efficient than other countries), conversely, each country will import those goods which it produces at relatively high cost.

Understanding Comparative Advantage

Comparative advantage can be a difficult concept to understand. After all, if your economy can produce both steel and computers, why not make both steel AND computers? The answer to this deals with market specialization. True, in the example provided the economy does have the ability to make steel, but due to scarcity of resources, an economy maximizes its efficiency by producing as much as possible while using as little as possible.

Here is another example. Consider a case in which the best lawyer in town is also the best typist in town. How should the lawyer spend her time? Should she write and type her own legal briefs? Or should she have her secretary do the typing (albeit slower) so that the lawyer can concentrate on legal issues? Clearly the lawyer should concentrate on legal issues where her relative or comparative skills are most effectively used, and output is maximized.

Ricardo's Analysis of Comparative Advantage

English economist David Ricardo came up with a great example of Comparative Advantage in 1817, when comparing the United States to Europe. For this example, we will deal with only two products: food and clothing. Let's say, in America, it takes 1 hour of labor to produce 1 unit of food, while a unit of clothing costs 2 hours of labor. In Europe the cost is 3 hours of labor for food and 4 hours of labor for clothing.
In America (labor hours needed)
In Europe (labor hours needed)
1 unit of food
1 unit of clothing

Looking at the table above, we can see that America has absolute advantage in both goods, for it can produce the with greater absolute efficiency than can Europe. However, America has a comparative advantage in food, while Europe has a comparative advantage in clothing, because food is relatively inexpensive in America while clothing is relatively less expensive in Europe.

From these facts, Ricardo proved that both countries will benefit if they specialize in their areas of comparative advantage - that is, if America specializes in the production of food while Europe specializes in the production of clothing. In this situation, America will export food to pay for clothing, and Europe will export clothing to pay for food.

Comparative Advantage is when the country has the ability to make two products but chooses to make only one product and obtain product two another day.

The Circular Flow Diagram

"What goes around comes around." The circular flow begins with the spending habits of consumers. How much and how fast consumers spend then drives the amount of investments that businesses make in resources to produce goods. These investments in turn affect the number of jobs that are available and the general economic health of a region. As more jobs become available, consumers have more money to spend. Conversely, as employment levels drop, consumers have less money to spend on goods and services. Consumer spending also determines the kinds and quantities of products that businesses produce.[1]

Circular Flow of Economic Activity
Circular Flow of Economic Activity

Picture Citation.[2]

When consumers make purchases, goods and services are transferred from businesses to households in exchange for money payments. That money is used in turn by businesses to pay for productive resources (natural, human, and capital) and to pay taxes.[3]


When people buy things, products and services are traded from businesses to the consumer in exchange for money. That money is then used by businesses to to expand and create more goods and services.

SS.D.2.4. The student understands and is able to explain the circular flow model.
  1. http://www.novelguide.com/a/discover/eueh_01/eueh_01_00163.html
  2. http://images.google.com/imgres?imgurl=http://www.unc.edu/depts/econ/byrns_web/Economicae/Essays/ART/CircFlow.gif&imgrefurl=http://www.unc.edu/depts/econ/byrns_web/Economicae/Essays/Circular_flows.htm&usg=__Y7bmso7vedittf51zWPNZMpuYbI=&h=447&w=626&sz=87&hl=en&start=7&um=1&itbs=1&tbnid=RbgF75k_UiyKRM:&tbnh=97&tbnw=136&prev=/images%3Fq%3DCircular%2Bflow%2Bof%2Beconomic%2Bactivity%2Bpicture%26um%3D1%26hl%3Den%26client%3Dfirefox-a%26sa%3DN%26rls%3Dorg.mozilla:en-US:official%26tbs%3Disch:1
  3. http://www.fte.org/teachers/programs/rightstart/curriculum/topic8/nationaleconomy.php