Lecture 2: Opportunity Cost, Sunk Costs, and Comparative Advantage

Learning Objectives

• Define and calculate opportunity cost
• Contrast accounting cost and economic cost and economic rent
• Understand the concept of sunk costs
• Explain the concept of comparative advantage
• Calculate and compare absolute and comparative advantage

Individuals at the Center of Economics

Every major economic trend starts with individual decisions.

• Enrollment at Vassar
  
• Working more or fewer hours
  
• Moving, trading, innovating
  
• Global GDP growth

Today: what people do
Next: how they decide

Recall last week: Unprecedented Growth

Global GDP growth (Core Unit 2, Slide 5)

Why Economists Use Models

Economics simplifies the world on purpose.

“You can’t have everything — where would you put it?”

If we tried to explain everything:

-weather - mood - politics - culture - luck

…we wouldn’t have a model.
We’d have recreated the universe.

Malthus’ Model

Malthus’ Model from Core Micro, Unit 2, Slide 24

Malthus in graphs

All taken from Core Unit 1.

Ceteris Paribus

Ceteris paribus = holding other things equal

• Strip away noise
• Focus on key relationships
• Make predictions
• Check against reality

“All models are wrong. Some are useful.”

Model of decision-making: Opportunity Cost

• Opportunity cost: The value of the next best alternative you give up.
• Reservation option: The next best alternative you give up.
• Economic cost: Direct/accounting costs + opportunity cost
• Economic rent: Net benefit from option taken – opportunity cost

Coming to class today cost you something:

• sleep
• studying another class
• working
• doing nothing

That forgone option is the real cost.

Incentives and Opportunity Cost

I try to raise the opportunity cost of skipping class by:

• assigning class jobs
• awarding participation points

Creates an incentive to attend class.

Flex passes create incentives to (1) engage deeper and (2) manage time

• What is the opportunity cost of buying a 24-hour extension?

Real-world example: Church attendance

Per Devin Pope’s (2024) analysis, church attendance changes meaningfully with weather (and holidays).

Beliefs didn’t change. Relative opportunity costs did.

Accounting Cost vs Economic Cost

• Accounting cost: what you pay in dollars
  
• Economic cost: accounting cost + opportunity cost

Example: Going to Vassar

Economic cost of attending Vassar:

• Tuition + fees (accounting cost)
• Wages you didn’t earn by working instead (opportunity cost)

This matters for:

• college choice
• career choice
• education policy

Economic Rent

Economic rent = Benefit − opportunity cost

If going to Vassar:

• raises lifetime earnings
• expands networks
• changes how you think

Then the economic rent is positive.

Sunk Costs

A sunk cost is:

• already paid
• unrecoverable
• irrelevant for current decisions

Your tuition this semester? Sunk.

Relative Prices

A relative price tells you: Price of one option relative to another

Opportunity cost = relative price: give up 75 min to attend one class.

Relative prices are critical for identifying incentives that drive:

• individual choices
• firm behavior
• technology
• trade

Relative prices are often a ratio of prices (more later).

Specialization

A key determinant of growth is specialization. Why?

Absolute Advantage

Absolute Advantage: Who is more productive?

Greta and Carlos spend all their time producing apples or wheat.

Who has an absolute advantage in producing apples? Wheat?

Comparative Advantage

Comparative Advantage: Who can produce at a lower opportunity cost?

Who has a comparative advantage? Consider opp. costs as relative prices:

How many apples can Greta produce per ton of wheat?

\[ \text{Opp Cost of 1 Ton of Wheat} = \frac{1,250\ \text{apples}}{50\ \text{tons of wheat}} = 25\ \text{apples/ton of wheat} \]

Fill in the table below to find the relative opportunity costs.

Who has a comparative advantage?

Self-sufficiency vs specialization and trade

Let’s compare self-sufficiency (autarky) with specialization and trade. Say:

• Greta spends 40% of time on apples and 60% of time on wheat.
• Carlos spends 30% of time on apples and 70% of time on wheat.

What prices would each person accept for trade?

If Greta buys 600 apples for 15 tons of wheat, what is the relative price of wheat in terms of apples?

600/15=40 apples per ton of wheat.

Recall: Greta produces 25 apples/ton of wheat and Carlos produces 50 apples/ton of wheat. Would they both agree to this price?

Yes. They both get more of both and the relative price is between their opportunity costs.

What is the range of prices they would agree to?

Between 25 and 50 apples per ton of wheat.

Production Possibilities Frontier

The Production Possibilities Frontier (PPF) shows the maximum possible production of two goods given the available resources and technology.

Production Possibilities Frontiers tend to be curve

Due to the law of diminishing returns¹, PPFs tend to curve: you give up more and more of one good to produce more of the other.

Why This Matters

Comparative advantage:

• creates gains from trade
• encourages specialization
• raises productivity
• drives economic growth

This is the micro-foundation of:

• firms
• trade
• supply, demand, and markets
• long-run growth

From People to Firms

So far:

• Individuals make choices
• Choices respond to opportunity cost and relative prices

Now:

-Firms make choices too - Using the same logic

What Is a Firm?

A firm is an organization that:

• uses inputs (labor, machines, energy)
• to produce outputs
• that can be sold

Key ideas:

• Division of labor: specialization within firms
• Technology: how inputs are turned into outputs

Production Technology

A firm’s production technology describes:

• what inputs it uses
• in what proportions
• to produce output

Key terms:

• Factors of production: labor, capital, energy, materials
• Production function: relationship between inputs and output

Fixed-Proportions Technology

Some technologies require inputs in fixed ratios.

Doubling all inputs doubles output.

Choosing a Technology

Suppose a firm can produce the same output using different combinations of inputs.

Question: > Which technology should the firm choose?

Answer: > The one that minimizes cost.

Costs and Relative Prices

Choosing the Cost-Minimizing Technology

A Change in Relative Prices

Technology, Incentives, and History

Why Firms, Technology, and Prices Matter

Escaping the Malthusian Trap

One Unifying Idea

Individuals: choose actions based on opportunity cost

Firms: choose technologies based on opportunity cost

Markets: coordinate these choices through relative prices

Next: Choosing optimally under constraints.

Wrap-Up

Key takeaways:

1. Economics starts with individual decisions
   
2. Models simplify to clarify
   
3. Opportunity cost is central
   
4. Economic cost ≠ accounting cost
   
5. Sunk costs should be ignored
   
6. Comparative advantage explains trade

Next:
How people choose optimally under constraints.