The term opportunity cost suggests that:

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Have you been to a frontier lately? Whether you realize it or not, the economy has a frontier—it has an outer limit of economic production. In this episode of the Economic Lowdown Video Series, economic education specialist Scott Wolla explains how the production possibilities frontier (PPF) illustrates some very important economic concepts.

Segment 3 of The Production Possibilities Frontier uses the production possibilities frontier to demonstrate how, in the real world, opportunity cost increases as production increases. This is a difficult concept made simple using the PPF.

Watch other segments of this episode:

More episodes:

• The Economic Lowdown Podcast Series
• The Economic Lowdown Video Series

Transcript:

Below is the full transcript of this video presentation. It has not been edited for readability, and there may be slight differences between the text and the video.

Our final lesson focuses on the shape of the frontier line. Up to this point we've graphed the PPF as a straight line. However, a straight line doesn't best reflect how the real economy uses resources to produce goods. For this reason, the frontier is usually drawn as a curved line that is concave to the origin. This curved line illustrates our fifth and final lesson.

Lesson 5: The law of increasing opportunity cost: As you increase the production of one good, the opportunity cost to produce the additional good will increase.

First, remember that opportunity cost is the value of the next-best alternative when a decision is made; it's what is given up.

So let's compare straight and curved frontier lines to better understand what is more likely to happen when production changes.

Here's the straight frontier line again.

It shows that Econ Isle can produce a maximum of 12 gadgets and 6 widgets or any other combination along the line.

At this point, Econ Isle can produce 12 gadgets and 0 widgets. This point shows widget production increased by 2, and this by 2 more, and this by 2 more, indicating all widgets and no gadgets.

So along the straight line, each time Econ Isle increases widget production by 2, it loses the opportunity to produce 4 gadgets. This straight frontier line indicates a constant opportunity cost.

In reality, however, opportunity cost doesn't remain constant. As the law says, as you increase the production of one good, the opportunity cost to produce the additional good increases.

If Econ Isle transitions from widget production to gadget production, it must give up an increasing number of widgets to produce the same number of gadgets. In other words, the more gadgets Econ Isle decides to produce, the greater its opportunity cost in terms of widgets.

If Econ Isle's production moved in the opposite direction, from all gadgets to all widgets, the law would still hold: As you increase the production of one good, the opportunity cost to produce the additional good increases.

Why does this happen? Well, some resources are better suited for some tasks than others. For example, many Econ Isle workers are likely very productive gadget makers. In the transition to widget production, workers would likely need training and time to develop the skills required to be as productive at making widgets as making gadgets. As the economy transitions from gadgets to widgets, the gadget workers best suited to widget production would transition first, then the workers less suited, and finally the workers not at all well suited to widget production.

Here's where the curved frontier line comes in. It shows that opportunity cost varies along the frontier.

Let's increase widget production in increments of 2 again until only widgets and no gadgets are produced. But this time we'll consider opportunity cost that varies along the frontier.

This point remains the same. At this point, Econ Isle can produce 12 units of gadgets and 0 widgets.

Here's widget production increased by 2. At this point, Econ Isle can produce 10 gadgets and 2 widgets. It loses the opportunity to produce 2 gadgets. In other words, the opportunity cost of producing 2 widgets is 2 gadgets.

Here's widget production increased by another 2. At this point, if Econ Isle produces 6 gadgets, it can produce only 4 widgets, so it loses the opportunity to produce 4 gadgets. In other words, the opportunity cost of producing 2 widgets is now 4 gadgets.

Finally, increasing by another 2, Econ Isle can produce 0 gadgets and 6 widgets. It loses the opportunity to produce 6 gadgets. In other words, the opportunity cost of producing 2 widgets is now 6 gadgets.

Although the production possibilities frontier—the PPF—is a simple economic model, it's a great tool for illustrating some very important economic lessons: The frontier line illustrates scarcity—because it shows the limits of how much can be produced with the given resources. Any time you move from one point to another on the line, opportunity cost is revealed—that is, what you must give up to gain something else. Points within the frontier indicate resources that are underemployed. In turn, movement from a point of underemployment toward the frontier indicates economic expansion. When the frontier line itself moves, economic growth is under way. And finally, the curved line of the frontier illustrates the law of increasing opportunity cost meaning that an increase in the production of one good brings about increasing losses of the other good because resources are not suited for all tasks.

I hope you have enjoyed your journey to the frontier and learned some valuable lessons about economics along the way.

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What do economists think about strawberry smoothies? That depends on how good the kiwi flavor is instead—plus a range of other choices. Which stirs up the idea of opportunity cost.

How is opportunity cost defined in everyday life?

“Opportunity cost is the value of the next-best alternative when a decision is made; it's what is given up,” explains Andrea Caceres-Santamaria, senior economic education specialist at the St. Louis Fed, in a recent Page One Economics: Money and Missed Opportunities.

The Scoop on Scarcity

We can’t have everything we want in life. This is where scarcity factors in. Our unlimited wants are confronted by a limited supply of goods, services, time, money and opportunities. This concept is what drives choices—and, by extension, costs and trade-offs, Caceres-Santamaria says.

She uses the example of deciding to buy a $7 smoothie at the mall. She notes that many people would view the choice as a single one based on whether you want the drink.

Instead, she suggests wearing “a unique pair of ‘economist glasses’” to see the decision differently, asking:

1. How much do I value this?
2. What am I giving up now to have this?
3. What am I giving up in the future to have this now?

Costs That Are Seen and Unseen

Our inclination is to focus on immediate financial trade-offs, but trade-offs can involve other areas of personal or professional well-being as well—in the short and long run.

That’s why Caceres-Santamaria challenges us to consider not only explicit alternatives—the choices and costs present at the time of decision-making—but also implicit alternatives, which are “unseen” opportunity costs.

“It's about thinking beyond the present and assessing alternative uses for the money—that is, not being shortsighted,” she writes.

What are some other examples of opportunity cost?

• A student spends three hours and $20 at the movies the night before an exam. The opportunity cost is time spent studying and that money to spend on something else.
• A farmer chooses to plant wheat; the opportunity cost is planting a different crop, or an alternate use of the resources (land and farm equipment). 
• A commuter takes the train to work instead of driving. It takes 70 minutes on the train, while driving takes 40 minutes. The opportunity cost is an hour spent elsewhere each day.

Is Opportunity Cost a Big Deal?

We might not consider lost studying time or $7 spent on a smoothie costly decisions, but what about bigger choices—like the decision to stretch and buy a more expensive home versus a starter home, or to spend $1,500 more on an upgraded trim package for your next car?

Caceres-Santamaria describes how opportunity costs are neglected even more when making higher priced purchases. Using the car-buying example, a consumer might default to thinking of the relative value of the $1,500 upgrade to the base price of the car, say, $18,500.

Rather than comparing the fancier configuration to the vehicle itself, it might be more helpful to ask what else that $1,500 could buy outright.

Why the Rush?

“Most of our decisionmaking that involves money is based on immediate or sooner-than-later consumption,” Caceres-Santamaria notes. “The excitement of consuming today is valued significantly more than the thought of consuming in the future.”

It’s human nature: We grow impatient, tugged by the immediacy of a promised benefit versus a payoff that’s possibly years down the road.

If seeing is believing, it’s worth looking at the future value of money—a concept many of us have read about in retirement plan literature or heard from financial advisors.

The Future Value of Money

Example 1: The one-time windfall

Let’s say you got a surprise $4,000 windfall and want to use it for a getaway trip. Why not? It’s found money, so there’s no loss to you—unless you think about the opportunity cost.

If you nixed the trip and plunked your money into an income-producing product that earned an average annual interest rate of 3%, compounded monthly, you could find yourself with a cool $5,397 in 10 years.

Wait another five years, and your funds could grow to $6,270. (Neither example factors in the effects of inflation and taxes owed.)

That’s the added benefit in money terms. You’ll also want to consider the experiences that an extra $1,400 or more—the future earnings on your $4,000—could make possible.

Example 2: Small, regular savings over time

That’s an example of investing a single lump sum over time. What about the opportunity cost associated with daily purchases, such as the $4.49 caffè mocha you pick up three times a week? How much money could you find yourself with if investing that $54 each month rather than spending it?

If you dropped the coffee (careful!), invested $54 per month and earned the same 3%, compounded monthly, you’d have $7,619 to dunk your doughnut into in 10 years.

Too long to forego that regular mocha? Cutting the time frame in half to five years would still give you $3,554 in savings. (Again, these sums don’t include the impact of inflation and taxes.)

These examples are striking, especially when considering that a $4.49 caffè mocha habit over time can dwarf the seemingly larger decision to splurge on a $4,000 getaway trip.

Want to test some of your own opportunity cost what-ifs? Caceres-Santamaria encourages consumers to avoid “autopilot” mode when it comes to financial decisions. Start small—even with a pack of gum—and brainstorm as many alternative uses for your money as you can. 

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