An opportunity cost will usually arise whenever an economic agent chooses between alternative ways of allocating scarce resources. The opportunity cost of such a decision is the value of the next best alternative use of scarce resources. Opportunity cost can be illustrated by using production possibility curve (PPC) which provide a simple, yet powerful tool to illustrate the effects of making an economic choice.
A production possibility curve measures the maximum output of two goods using a fixed amount of input. The input is any combination of the four factors of production.
- Point A — all resources are dedicated to the production of leather bags.
- Point B — all resources are dedicated to the production of leather shoes.
- Point C — resources are not being fully utilised and can be increased with minimal opportunity cost.
- Point D — 200 leather bags are produced with 50 leather shoes.
- Point E — 70 leather bags and 150 leather shoes are produced.
- Point F — this is beyond the maximum production curve and is currently unattainable.
Movement along the Curve
A movement along the PPC results in an opportunity cost for the firm. This shows that for more of Shoes to be produced, production of bags needs to be reduced. From the illustration, the number of bags reduced from point A to point B, while the number of Shoes increased from Point C to Point D.
Shift of Curve
An outward shift of the production possibility curve is only possible if the country/firm experiences:
- New inventions i.e. improvement in technology: it increases productivity of other factors of production. This happens when societies forego current consumption to save and invest in capital goods such as roads, etc.
- Population growth and inward immigration: it leads to an increase in the stock of skilled labor.
- Investment in education and other training opportunities: it increases the human capital of a society.
Inward shifts in production possibility curve means that the economy is shrinking i.e. its production potential is decreasing. Factors that can lead to this include:
- Natural disasters such as earth quakes, floods, etc. can have devastating effects on a country. It reduces the production potential by decreasing the quantity of land, destroying infrastructure i.e. capital and decreasing population i.e. labor.
- Wars, terrorism, violent protests and other political disruptions can stall the economic activity and shift the curve inwards.
- Immigration i.e. brain drain causes the skilled people to immigrate to other countries which reduces over production potential.