Chapter 1 — Choice, Opportunity Cost, and Trade

Core question

When resources have alternative uses, what is the relevant cost of one more action?

Learning outcomes

You will be able to:

• identify the best alternative forgone;
• separate sunk, average, and marginal costs;
• interpret a production possibilities frontier;
• calculate comparative advantage and gains from trade.

1. Scarcity creates choice

Scarcity means that a resource—time, money, labour, land, attention, or productive capacity—cannot satisfy every possible use at once. It does not mean absolute poverty.

Every choice therefore has a counterfactual: what would have happened under the best available alternative?

Example: one evening

You have four hours and three feasible options:

If revision is chosen and the paid shift is the best rejected alternative, the opportunity cost includes the £56 wage. It is not the sum of every rejected option.

2. Opportunity cost is not expenditure

economic cost = explicit resource cost + value of the best alternative forgone

University example

Tuition and books are explicit costs. Foregone earnings are an opportunity cost. Ordinary food expenditure is included only to the extent that studying changes it relative to the alternative.

The analysis does not prove university is a bad investment. It identifies what its expected benefits must exceed.

3. Ignore sunk costs; compare future margins

A sunk cost has already been incurred and cannot be recovered. It may explain regret, but it should not change the forward-looking choice.

Choose one more unit when its expected marginal benefit is at least its expected marginal cost:

The rule requires uncertainty, spillovers, and non-monetary effects to be included when relevant.

4. Incentives change behaviour—sometimes indirectly

An incentive changes the payoff or constraint attached to an action. Good analysis traces more than the intended response.

Example: attendance reward

1. A seminar offers marks for attendance.
2. Attendance becomes privately more valuable.
3. Attendance may rise.
4. But physical presence may replace preparation, and students with caring duties may be disadvantaged.

The policy has a direct response, possible substitution, and a distributional effect. “People respond to incentives” is a starting point, not a full evaluation.

5. The production possibilities frontier

A PPF shows maximum feasible combinations of two outputs for given resources and technology.

• on the frontier: technically efficient under the model;
• inside: feasible but resources are idle or misallocated;
• outside: infeasible with current resources and technology;
• outward shift: more resources, better technology, skills, or institutions.

Moving from B to C gains two reports and gives up three tutorials. The opportunity cost is 3/2 = 1.5 tutorials per report.

6. Comparative advantage

Comparative advantage depends on lower opportunity cost, not who is fastest at everything.

Two students can produce coffee or sandwiches in one hour:

Amina has comparative advantage in sandwiches; Ben has comparative advantage in coffee. If they trade one sandwich for three coffees:

• Amina receives 3 coffees for something that costs her 2;
• Ben receives a sandwich for 3 coffees instead of sacrificing 4.

Both can gain even though Amina has absolute advantage in both tasks.

7. When trade gains do not settle the policy question

The basic model assumes voluntary exchange, clear rights, low transaction costs, and no uncompensated third-party effects. Real evaluation must also ask:

• Are gains distributed unevenly?
• Are adjustment costs temporary or persistent?
• Does market power alter the terms of trade?
• Are environmental or social costs omitted?
• Can those harmed adapt or be compensated?

Trade can increase total feasible consumption while still creating losers. Aggregate gain and distribution are different questions.

Worked decision

A café can remain open for one extra hour.

Expected extra revenue                 £90
Ingredients and hourly energy          £28
Extra staff cost                       £42
Expected clean-up/delay cost           £8
Marginal benefit                       £90
Marginal cost                          £78

Opening is worthwhile on these estimates because net marginal benefit is £12. Daily rent is not added: it is unchanged by the extra hour. If late-night noise harms neighbours, that external cost belongs in the social calculation even if the café does not pay it.

Practice

1. Choose one decision you will make this week.
2. State the feasible alternatives.
3. Identify the best rejected alternative.
4. Separate sunk, fixed, and marginal costs.
5. Name one response by another person affected by the choice.
6. State one omitted social or distributional effect.

Quick check

• A resource can be scarce even when abundant.
• Opportunity cost is the best alternative, not all alternatives.
• Sunk costs do not change the future payoff comparison.
• Comparative advantage uses relative opportunity costs.
• Efficiency and distribution must be evaluated separately.

Next: see how interacting plans create market prices and quantities.