Opportunity Cost, Cost-Benefit Analysis, and the Production Possibilities Frontier
Due to the basic economic problem (unlimited wants, limited resources), people are forced to make decisions. These decisions come with trade-offs: if Jimmy buys concert tickets to go see One Direction, he won't have enough money left over to buy a new iPhone. If not for that problem of limited resources, we wouldn't have the study of economics.
Because people are making these trade-offs, we can analyze the decisions they are making and what they are giving up for what they are getting. This is known as opportunity cost: the next-best choice that is forgone in order to something else. In the previous example, the opportunity cost of Jimmy buying concert tickets is a new iPhone.
Because people are making these trade-offs, we can analyze the decisions they are making and what they are giving up for what they are getting. This is known as opportunity cost: the next-best choice that is forgone in order to something else. In the previous example, the opportunity cost of Jimmy buying concert tickets is a new iPhone.
Economists use opportunity cost to preform cost-benefit analyses, where they analyze the opportunity costs of making various decisions and then assess what would be the most efficient decision. Say, for example, that the town of Awesomeville has to build a road. There are two different ways to build the road, either straight through the heart of downtown Awesomeville, or a bypass on the town's south side. Whichever decision the town decides to make, they'll have to way the opportunity costs. If Awesomeville builds the road right through the heart of town, it will increase traffic in the town, which will necessitate increased road repairs, as well as additional stoplights, traffic cops, and, potentially, hospital services to treat pedestrians who are run over by long-haul truckers.
On the flip side, if Awesomeville elects to build the bypass, the entire downtown could wither for lack of customers, and all the cute little Mom'n'Pop shops will close, which will have an even bigger effect on the town's tourism industry. If that happens, people may start to move out of Awesomeville, which will reduce the tax income, which will then cause the schools to fail, and Awesomeville might as well rename themselves "Stupidtown." As you can see, a cost-benefit analysis is a really important examination of the facts surrounding a situation.
On the flip side, if Awesomeville elects to build the bypass, the entire downtown could wither for lack of customers, and all the cute little Mom'n'Pop shops will close, which will have an even bigger effect on the town's tourism industry. If that happens, people may start to move out of Awesomeville, which will reduce the tax income, which will then cause the schools to fail, and Awesomeville might as well rename themselves "Stupidtown." As you can see, a cost-benefit analysis is a really important examination of the facts surrounding a situation.
The video at the right is a quick and accurate description of the function of the Production Possibility Curve (sometimes referenced as the Production Possibility Frontier). This is a tool that is used by economists (and businesses, and others) to determine the opportunity costs associated with a particular decision.
After watching the video, think of it like this: if you have a given quantity of metal, you could turn it into one of two things: luxury cars or automatic rifles. But, thanks to scarcity (limited resources, unlimited wants), you can't produce a maximum output of both products. For every rifle you produce, you'll produce fewer luxury cars. For each additional car you produce, you produce fewer rifles. This is a cost-benefit analysis. |
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