OPPORTUNITY COST
Practice Problems

1. Consider a simple economy producing two goods: cars and milk. The following table gives several points on this economy's production possibility frontier.

Cars (1000's/year)
Milk (1000's of gallons/ year)
0
60
1
50
2
30

3

0

a. Graph this economy's production possibility frontier.

b. Why is the production possibility frontier downward sloping? Be sure to explain economic intuition behind that fact.

The negative slope of the PPF illustrates the fact that larger quantities of cars correspond to a smaller amount of milk, and vice versa. This happens because all the economy's resources are already in use, and therefore obtaining more cars would always require sacrificing some milk. In economic terms, the negative slope is due to the presence of opportunity cost.

c. Why is the production possibility frontier concave? Be sure to explain economic intuition behind that fact.

The slope of a particular segment of the PPF shows how much good on the vertical axis (milk) has to be sacrificed in order to obtain an additional car (the good on the horizontal axis). The steeper the slope the larger the aforementioned sacrifice has to be. This happens as we move from left to right and therefore towards larger quantities of cars, which represents the principle of increasing costs discussed in class - as we produce more and more cars, each additional car costs us more in terms of milk we have to forgo.

d. Suppose the economy is currently producing 2000 cars and 30,000 gallons of milk. What is the opportunity cost of producing additional 20,000 gallons of milk?

We can see from either the table or the graph that if 30,000+20,000=50,000 gallons of milk were produced, the economy could at the same time produce no more than 1000 cars. This represents a decrease by 1000 cars relative to the current production. (2000 - 1000 = 1000). The opportunity cost of additional 20,000 gallons of milk is 1,000 cars.

e. The synthetic production of Bovine Growth Hormone (BGH) allows dairy farmers to get twice as much milk from each cow. In terms of this production possibility frontier, this means that this economy can now produce twice as much milk at each level of car output. With the economy currently producing 2000 cars, Jerry claims that the development of BGH allows the economy to produce more milk and more cars.
Do you agree? Explain carefully, using an appropriate diagram to illustrate your answer.

Yes, Jerry is right. As a result of the BGH introduction, each point on the PPF will be located twice as high as it was originally. See graph. It is easy to see that, being at point A (corresponding to 2000 cars and 30,000 gallons of milk), the economy can move up to point B (more milk), to the right to point C (more cars), or have more milk and more cars at the same time (point D).

2. A team consisting of three people is working on a big project, which involves manual entry of data in a computer, with subsequent processing of these data and making a poster presentation.
Naturally, each member of the team has different abilities in performing either task. Adam can make 1 poster or 400 data entries in a day. Hard-working Becci can make 2 posters or 1200 data entries in a day. Artistic Cliff can make 3 posters or 900 entries in a day.
a. Originally, the entire team (each of them having their own personal computer) starts with entering data. How many entries will be made in a day?

400 + 1200 + 900 = 2500

b. As the time comes to start making posters, you decide to assign one member of the team to this task. Whom would you choose? Explain why.

Since along with making posters you will still need to enter data, you may want to look for the scenario in which each poster produced costs you the least in terms of data entries forgone. If you ask Adam to make posters, the opportunity cost of each poster is 400 entries. In the case of Becci, each poster costs 1200:2 = 600 entries. If Cliff switches to making posters, then each poster costs your team 900:3 = 300 entries. The last option is the most attractive, so Cliff should be the first who is assigned to do the posters.

c. As you make this decision, what is the opportunity cost of each poster made?

The answer is given above: Each poster costs 300 data entries.

d. As there is less and less data remaining to be entered, another person can shift to making posters as well. Which of the remaining two members of the team will you choose this time? Explain your choice. As a result, what is the opportunity cost of each additional poster you will get?

Our calculations in part b indicate that Adam should be next, since between him and Becci he has the lowest opportunity cost of each poster - 400 data entries.

e. Draw a sketch of your team's production possibility frontier, placing the number of numerical entries on the vertical axis and the number of posters on the horizontal axis.


f. What does the order in which you reassign your team members from data entry to making posters imply about the shape of your PPF? Which important economic principle does this fact illustrate?

The PPF came out concave. This happened because, as successive team members are assigned to making posters, the opportunity cost of each additional poster increases. This is an illustration of the principle of increasing costs discussed in class.


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