In economics, the opportunity cost is defined as the value of the best-foregone alternative that could have been pursued using the available resources (Pindyck & Rubinfeld, 2008). The concept is used in trading activities and it incorporates two other concepts that is the comparative and absolute advantage. The below given scenario can be used to explain the concept more.
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Michelle’s opportunity cost of producing potatoes
From the definition of opportunity cost, Michelle’s opportunity cost of producing 200 pounds of potatoes is 50 chickens. This can be translated into, the opportunity cost of producing one potato or one unit of potatoes is four chickens or four units of chickens.
Michelle’s opportunity cost of producing chickens
Michelle’s opportunity cost of producing 50 chickens is 200 pounds of potatoes. This is the same as saying the opportunity cost of producing one chicken or one unit of chicken is 0.25 pounds of potatoes or units of potatoes.
James’ opportunity cost of producing potatoes
The opportunity cost of James for producing 80 units of potatoes is 40 units of chickens. This can be interpreted to say the opportunity cost of producing a single unit of potatoes is two units of chicken.
James’ opportunity cost of producing chickens
When James decides to devote all his resources to the production of chickens at the expense of potatoes, the opportunity cost of producing 40 units of chickens will be 80 pounds of potatoes. This means the opportunity cost of producing one unit of chicken is two units of potatoes.
The person with absolute advantage
Absolute advantage happens when a given country or individual specializing in the production of two commodities is more efficient in the production of both as compared to another one specializing in the production of the same (Pindyck & Rubinfeld, 2008).
In the above case, Michelle has an absolute advantage in the production of both potatoes and chickens since if all the resources were employed she could produce 200 pounds of potatoes as compared to James who could only produce 80 pounds of potatoes. Similarly, the same resources could yield more chickens as compared to James who could yield only 40 chickens.
The person with comparative advantage in the production of potatoes
Michelle has a comparative advantage in potatoes production because of her lower opportunity cost of production with respect to James.
The person with comparative advantage in chicken production
James has a comparative advantage in the production of chicken due to his lower opportunity cost of production with respect to Micelle.
The benefit of specializing in the areas in which both Michelle and James have comparative advantage
Assuming the above given scenario has been given exchange rate of 2.5 pounds of potatoes for1 chicken both individuals would benefit. This is because if John produced only chickens and traded the same for potatoes, he would get 100 pounds of potatoes a little bit higher than what he would have produced if he were to devote all his resources to the production of potatoes.
Similarly, if Michelle traded her 200 pounds of potatoes for chicken, she would get 80 chickens, which is more than her productive capability. Therefore, it is beneficial for both Michelle and James to specialize in potatoes and chicken production respectively and trade with each other.
Importance of opportunity cost concept, absolute and comparative advantages to the nations, societies and individuals
The above concepts are applicable in people’s everyday lives. This is because nations have varying resource endowment and their production capabilities differ from nation to nation or society to society.
Therefore, each should identify the area in which it can produce goods more effectively compared to other nations and then analyzing the prevailing exchange rates, that particular nation should exchange those goods with other nations (Pindyck & Rubinfeld, 2008). This will benefit all nations of the world and promote international trade.
Pindyck, R. & Rubinfeld, D. (2008). Microeconomics. 7 Ed. New York, NY: Prentice Hall.