Let’s begin our analysis of production by imagining Robinson Crusoe, stranded and alone on an island. The resources at his disposal, while attractive, are limited.
And being a person very much like you, he has unlimited wants. In other words, Crusoe, like all of us, faces the unshakable reality of economic scarcity. What can he do in this situation? Let’s look at his options.
He can spend part of the day in leisure and part at work. He could pick mangoes right off the trees, or he can fish. He can plant and harvest crops. His principal factors of production are his own labor and the virgin land about him.
Let’s suppose he decides to spend his waking hours gathering food for con- sumption. He climbs trees for mangoes and coconuts and spends the better part of the day trying to pickfish out of the lagoon. Let’s suppose he ends each day with six units of consumption. It’s enough to keep him going, but, of course, he wants more.
How does he get it? By making a fishing spear. That requires finding the right materials and fashioning a spear. He sets aside part of the day tofind a young tree that will serve as the shank, a stone that can be sharpened to make a spearhead, and a length of vine to bind the two together.
This takes time. If he takes the time to produce the spear, he can gather only five units of consumption goods. Why then do it? Because with a fishing spear, he expects to catch morefish in the next round of production. It’s a risk, of course.
There’s no guarantee he will catch more fish. Some expectations are never realized.
But let’s suppose he catches more. The spear is Robinson Crusoe’s first unit of capital.
Entrepreneur A person who alone assumes the risks and uncertainties of a business.
Why do people produce capital goods?
30 PART 1 Find more at http://www.downloadslide.comTHE BASICS OF ECONOMIC ANALYSIS
He decides to make a second spear as well to use as an extension tool so that he can reach the bigger, riper fruit at the top of the trees. He discovers thatfinding the right material for the second spear takes even more time than it did for the first. Why? He had already used the most available tree for the fishing spear’s shank, the most available stone for the spearhead, and the most accessible length of vine to tie them together.
While he is producing both the fishing spear and the extension spear, he can manage to gather only three units of consumption goods. Why then do it? Because with both units of capital, he expects to produce considerably more consumption goods in the next round of production.
The Robinson Crusoe story is incredibly simple, yet it contains all the essential elements of our own modern, busy, and highly sophisticated economy. In our economy, as in all others—including Crusoe’s—labor, capital, land, and entrepre- neurship combine to produce two sets of possible goods: consumption goods and capital goods.
The components of the set are variable. For example, these factors of pro- duction can be combined into any of the production possibilities shown in the table in Exhibit 1.
Thefirst possibility, a, allows Robinson Crusoe to devote all his time, energies, and talent to the production of six units of consumption goods. That means he produces zero capital goods. But that’s a production choice he is free to make.
There are other options. He could, if he wishes, shiftsome of the resources he had used to produce the six units of consumption goods into the production of a capital good. We see the result in Exhibit 1, production possibilityb. Crusoe now ends up producing five units of consumption and one unit of capital. Whatever combination he chooses—there are also possibilities c and d—he is smart enough to understand that“there is no such thing as a free lunch.” Crusoe knows a cost is always involved in adding more of one good. As he sees it—and so do we—the first unit of capital cost him one unit of consumption.
Opportunity Cost
What economists mean by cost is opportunity cost—that is, the quantity of other goods that must be given up to obtain a good. That’s a powerful notion of cost.
It applies universally. For example, the opportunity cost of watching the L.A.
EXHIBIT 1 Production Possibilities Frontier
Robinson Crusoe’s economy can produce six consump- tion goods and zero capital goods, shown at pointa.
Alternatively, it can produce five consumption goods and one capital good (pointb), three consumption goods and two capital goods (pointc), zero consumption goods and three capital goods (pointd), or any other combination located on this curve. The law of increasing costs accounts for the balloon-like shape of the production possibilities curve.
5 6
4 3 2 1 0
1 2 3
CAPITAL GOODS a
a b c d
b
c
d
PRODUCTION POSSIBILITIES CURVE
CONSUMPTION GOODS
4 5 6
CONSUMPTION CAPITAL GOODS GOODS
6 0
5 1
3 2
0 3
PRODUCTION POSSIBILITIES IN THE ROBINSON CRUSOE ECONOMY, FIRST PERIOD
Production possibilities The various combinations of goods that can be produced in an economy when it uses its available resources and technology efficiently.
Opportunity cost The quantity of other goods that must be given up to obtain a good.
KEY
Lakers play the Boston Celtics the night before an exam is the five points that could have earned an A. The opportunity cost of renovating the high school auditorium is the new biology lab that the school had been thinking about.
Opportunity cost applies even where you may least suspect. For example, for a married couple, the opportunity cost of marriage to each partner is the opportunities each gives up that would have been possible had they remained single.
You see the connection, don’t you? The thought that goes through Crusoe’s mind when contemplating production is the same kind of thinking that you do before studying for an exam. You both think about the opportunities given up. But you make choices. When Crusoe gives up a unit of consumption goods to produce that first unit of capital goods, it’s probably because he values that first unit of capital goods more than the consumption good given up. If you spend the evening studying for the exam, it’s probably because you value the expected higher grade more than you do the Celtics game.
You may have erred. The game was the season’s best and the studying didn’t make a difference in your exam score. In hindsight, youfind that the studying wasn’t worth the cost. But what could you have done otherwise? Opportunity costs are typically subjective. How could you possibly know with certainty what opportunity costs are? Even Robinson Crusoe, making simple choices on the island, must rely on calculatingexpected gains and opportunity costs of choices made.
The Law of Increasing Costs
If Robinson Crusoe decides to produce two units of capital, he ends up with only three units of consumption. Measured in terms of its opportunity cost, that second unit of capital costs Crusoe two units of consumption. That is more than he had to give up for thefirst unit of capital.
What happens if he decides to produce three units of capital? Look again at the table in Exhibit 1. Their production absorbs all the resources available. He ends up with nothing at all to consume! The opportunity cost of that third unit of capital is the remaining three units of consumption.
Do you notice what’s happening? The opportunity cost of producing each additional unit of capital increases as more of the units are produced. Economists refer to this fact of economic life as the law of increasing costs. It applies no matter what goods are considered. For example, if Robinson Crusoe had started with three units of capital and began adding consumption, the amount of capital goods he would have to give up to produce each additional unit of consumption would also increase. The graph in Exhibit 1 illustrates the production possibilities of the table in graphic form.
Look at pointsa, b, c, and d in the graph in Exhibit 1. These are precisely the production possibilities shown in the table. Point a, for example, represents the choice of devoting all resources to the production of six units of consumption.
The curve has a negative slope because any increase in capital goods production comes only at the cost of consumption goods production.
The bowed-out shape to the curve illustrates the law of increasing costs. When Crusoe decides to increase capital goods production from one unit to two, he is forced to use resources less suited to the production of capital goods than the resources employed in producing thefirst unit. After all, resources are not always of equal quality, and he obviously would use the best first. The result is a movement along the curve from pointb to point c that, when plotted in Exhibit 1, traces out the bowing character of the curve. Suppose Crusoe decides on three units of consumption and two units of capital. He works busily, finishes pro- duction, eats the three consumption goods, and has available now what he had not had before—two new units of capital.
Law of increasing costs The opportunity cost of producing a good increases as more of the good is produced. The law is based on the fact that not all resources are suited to the production of all goods and that the order of use of a resource in producing a good goes from the most productive resource unit to the least.
32 PART 1 Find more at http://www.downloadslide.comTHE BASICS OF ECONOMIC ANALYSIS
In the next period of production, Crusoe has available the same quantity of resources he used in the earlier periodplus the two new units of capital that had been produced earlier. With more resources available, Crusoe can produce more goods, which is what we see in the table in Exhibit 2.
Compare this table to the one in Exhibit 1. Working now with two units of capital, Robinson Crusoe can produce more. For example, ten units of consump- tion can now be produced when Crusoe, using the fishing spear and extension tool, devotes all his labor to consumption. Of course, he may again decide to produce more units of capital goods in order to be able to produce even more units of consumption in the following period. This can go on forever and does in most economies.
Suppose after deliberating over the production possibilities of the table in Exhibit 2, he selects seven units of consumption and two units of capital. This combination means that he not only adds two more units of capital to his resource base but also is still able to produce more consumption goods—seven—than he could have produced in the first period, even had he devoted all the resources exclusively to consumption goods production.
The graph in Exhibit 2 illustrates the change in the Crusoe economy over the two periods.
The production possibilities curve shifts outward to the right. The shift reflects the changing resource base available to Crusoe. In the second period, capital is added to the land and labor resource base of thefirst. The dashed curves represent later period production possibilities as long as Crusoe continues the strategy of adding units of capital to his resource base.
applied perspective