Tools of Economic Analysis
Opportunity Cost:
  • opportunity cost = the value of the best alternative that is forgone when an item or activity is chosen
    • opportunity cost is subjective
    • calculation requires time and information
    • sunk costs need to be considered
Comparative Advantage:
  • absolute advantage versus comparative advantage
  • results in specialization
    • creates a division of labor
    • leads to exchange (barter)
Production Possibilities:
  • The Production Possibilities Curve
    • the alternative combinations of final goods and services that could be produced in a given time        period with all available resources and technology.
    • each point on the production possibilities curve depicts an alternative mix of output.
    • the production possibilities curve illustrates two essential principles:
      • Scarce resources – there is a limit to the amount we can produce in a given time period with available resources and technology.
      • Opportunity costs – We can obtain additional quantities of any desired good only by reducing the potential production of another good.
  • Increasing Opportunity Costs 
    • the shape of the production possibilities curve reflects another limitation on our choices.
    • why do opportunity costs increase?  because it is difficult to move resources from one industry to another.
    • the “law” of increasing opportunity cost says that we must give up ever-increasing quantities of other goods and services in order to get more of a particular good.
  • Efficiency 
    • increasing opportunity costs aren’t a sign of inefficiency.
    • efficiency means “getting the most from what you’ve got” – that is, using factors of production in the most productive way.
    • maximum output of a good from the resources used in production.
    • there’s no guarantee, of course, that we’ll always use resources efficiently.
    • a production possibilities curve shows potential output, not necessarily actual output.
    • if we are inefficient, actual output will be less than the potential output
  • Economic Growth
    • an increase in output (real GDP); an expansion of production possibilities.
    • all output combinations that lie outside the production possibilities curve are unattainable with available resources and technology.
    • over time, population increases and we get more labor.  Also, if we continue building factories and machinery, the stock of available capital will also increase.
    • the quality of labor and capital can also increase if we train workers and pursue new technologies.


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this page is maintained by Reed Fisher
last updated January 15, 2011