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Scarcity means we cannot have it all, we must make choices. But how do we make those choices? How can we explain the choices people and businesses make? Economists tend to adopt the approach that choices are rational, when making decisions people and businesses weigh the benefits and the costs and choose actions where the benefits exceed the costs. As a result economists tend to focus a considerable amount of attention on the concept of cost, one of the inputs into decisions. They also tend to approach cost from a rather unique perspective, one grounded in the concept of scarcity. If we accept the existence of scarcity, then we realize every choice to do something is also a choice to not do something else. Your choice to study can be looked at as your choice not to party, the choice to attend class can be viewed as a choice not to watch the soaps or catch up on your sleep.

Once you recognize there are two sides to every choice, you can better understand opportunity/economic cost and sunk cost. As a starter let's look at a simple example - let's look at the choices of Rueben and Raye who are going to pay $7.50 a ticket to see the movie A Funny Thing Happened on the Way to School. Rueben has a $5,000 scholarship at RIU where he is studying underwater basket weaving. Raye, meanwhile, is a consultant who is paid $100 per hour for advice on dating. What is the cost of the movie for Rueben and Raye?

We could all agree the accounting cost is $7.50, what each will need to pay for the two hour movie. But how much is it really costing them? For Raye, if she could have used the time for consulting, then she would be giving up $200 for two hours of work. This is what an economist would say you need to add to the ticket price to get the movie's economic cost. The economic cost of using a scarce resource to achieve something is the cost of not using the resource in its best alternative use. If Raye does not go to the movie she earns $200, and if she goes to the movie she spends $7.50. The difference in her 'bank account' at the end of the movie would be $207.50 - what we would call the economic cost of the movie for Raye.

And then there is Rueben, who expected to enjoy a night away from his studies. Unfortunately for Rueben, he is met by a classmate at the candy counter just after he has paid his $7.50 for the movie. The classmate informs Rueben he just received an e-mail which stated that there will be a test the next day. Rueben realizes he should study because a bad grade, the one he is likely to get if he does not study tonight, will cause him to lose his scholarship. At this time we would look at the $7.50 as a sunk cost (a past, non recoverable cost that has little to do with the current choice). For Rueben, once he has paid for the movie and finds out about the exam, the cost of the movie becomes $5,000. If he goes home to study he keeps his scholarship, but if he stays at the movie he will lose his scholarship of $5,000. We can only hope that Rueben realizes the true cost of the movie.

For another example, consider the situation facing Tammy's Tutoring, a for-profit tutoring service. To run her business Tammy must maintain a balance of $1,000 a day in her company checking account. The accountant would not consider this money that sits in a checking account as a cost of doing business and it would therefore not enter the company's books. An economist, meanwhile, would look at the money and ask: what else could be done with the money? If we assume a reasonably safe investment would produce a return of 8 percent, then the economic cost of these funds being tied up would be $80 [.08*$1,000]. By staying in the tutoring business, Tammy is losing the opportunity to earn $80 a year with her $1,000 cash and economists would have this reflected in the 'economic' books. Economic profit would be $80 lower than accounting profit.

For a third example of the differences between the two costs we could look at the books of Gene's Graphics. Gene was a very successful Silicon Valley engineer making $100,000 a year working for a software company. The problem was Gene wanted to try something new, wanted to get on the entrepreneurial bandwagon and form a start-up company. The company was Gene's Graphics and the product was tutorial software for ECN courses. At the end of the first year's operation Gene had an accountant and economist review the year. The accountant's review of the books indicated Gene had drawn a salary of $60,000 and the company's total revenues had exceeded costs by $20,000. The accountant reported the company earned Gene a profit of $20,000.

The economist, however, reported back that Gene had lost $20,000. As the economist saw it, Gene had the ability to earn $100,000 a year and the cost of Gene's labor on the books should be $100,000 rather than the $60,000 salary he was pulling in. If we computed costs on the basis of economic cost, then total costs of operation would rise by $40,000 and the $20,000 profit would become a $20,000 loss.

The difference between economic and accounting cost can also be seen in the situation faced by Stephen Works, the owner of SDI, a rapidly expanding computer services business which he started a few years ago. Stephen has just finished a review of the company's "books" were prepared by his accountant. According to the accountant, the firm's expected 'lifetime' profits should total $250,000 on projected future revenues of $1,500,000 and labor and material costs of $1,250,000. He has also been approached by WBS (World Business Systems) to sell his business. They are willing to pay him $500,000 for the business. Should Stephen take the deal?

You may not be able to offer sound advice on the sale because you do not know much about Stephen, but you could provide a good deal of help by using the concept of economic cost. More specifically, you could provide Stephen with an estimate of the lifetime profit of the business. Once you have done it, you should compare your number to what an economist would estimate as the profit of SDI?

Let's start by setting out the appropriate framework. In this situation we need to compare the two possibilities - staying in business (column 1) and selling the company (column 2). If Stephen keeps the business and does not sell, then the difference between the revenues ($1,500,000) and costs ($1,250,000) would be the accounting profit of $250,000. If Stephen sold the business, however, revenues from the sale would be $500,000 and costs will be $0 because it was no longer his business. In this situation accounting profits will be $500,000.

So what is the profit earned from running the business? If he runs the business his lifetime profit will be $250,000 and if he sells he gets $500,000. Given this information we can see that Stephen loses $250,000 by staying in business.

Stay	Sell	Difference
$1,500,000	$500,000	$1,000,000	Revenue
$1,250,000	$0	$1,250,000	Costs
$250,000	$500,000	-$250,000	Profit

The 'Bottom Line' is that Stephen will lose $250,000 by staying in business. We could also arrive at this point by looking at the final column.

To make sure that you have mastered the concept of opportunity cost, try your hand at the following two examples.

If you believe there is any truth to the above phrase, then you should not be surprised to find economists have attempted to present their analysis of choice in visual form. The visual form is the possibility curve that describes graphically the options open to a decision maker. This diagram could be used to describe the choice situations facing an individual, a firm, or an entire society. What you will see is the possibilities open to a decision maker depend upon two very important concepts - the level of available resources and the productivity / efficiency with which those resources can be employed to produce an output.

I suggest you make the investment needed to understand these graphs since you are likely to see them again. The practice at interpreting and creating graphs will prove valuable as we go further into the course and these diagrams are quite useful in highlighting the similarities in a wide array of choice situations. We will also use the model to look at issues as diverse as war, international trade, the cost of an MBA program, and the cost of a good grade in ECN.

As a warm-up exercise to see what we are talking about with this possibility curve model, let's return to RIU where we will now look at students' study choices and the administration's choice of the mix of class sizes. We can begin by examining the situation facing Fred as he begins the semester. To make life easy, let's assume Fred is taking this ECN course and a HIS course and he must decide how to allocate his time. Time is the scarce resource he will need to allocate in an effort to produce grades, the output. You also know that his grade in each course depends upon the time he puts into study for the course and on the productivity / efficiency of his study time. What we would like to know are the choices open to Fred who is allocating the time.

To demonstrate the choices graphically, we will construct a 'grade' possibility curve for Fred. On the two axes we will measure the outputs, in this case they will be grades in the two courses. On the vertical axis we will measure the grade Fred gets in economics and on the horizontal axis we will measure the grade Fred gets in history.

As for the available resources, we will assume that Fred has 10 hours to study for ECN and HIS (we must be talking about only one day). You have reason to believe each hour spent studying HIS brings improves his HIS grade in the course by 6 points, and each hour spent on ECN improves his ECN grade by 5 points. Given these resources and productivities, we can fill in Fred's grade-possibility diagram that appears below.

The blue grade possibility line presents visually the choices open to Fred. Any point inside the line is achievable, but all of the resources would not be used. Fred would not be using the ten hours for studying if we found Fred getting grades that were inside of the possibility curve. An example would be if Fred received a grade of 20 in both courses.

Any point outside of the line would be impossible to attain given the existing resources. Given the current situation, Fred could not get a grade of 50 in both courses. The points on the line represent all of the possibilities open to Fred. By choosing a specific allocation of the ten hours between HIS and ECN Fred would be on one of the point on the possibility curve. For example, Fred could use all 10 hours studying ECN and get a 0 in HIS and a 50 in ECN (horizontal intercept), or he could use all of the time studying HIS and get a 0 in ECN and a 60 in HIS (vertical intercept). If Fred split the ten hours evenly between the two, the HIS grade would be 30 and the ECN grade would be 25.

So what advice do we give Fred who wants to do better? How can Fred improve his grades? If you return to the making of the graph, you may see the options open to Fred. He can either increase the resources (time) devoted to study or increase the productivity of that study time. Let's look at what happens if Fred decides to devote 12 hours to studying. If Fred spends all 12 hours studying ECN then he can get a grade of 60, while 12 hours spent studying HIS would give him a grade of 72. As you can see from the outward shift in the grade possibility diagram below, Fred can now attain what was unattainable before.

But there are other ways to extend the possibilities. Fred could work to improve study habits, maybe no TV while studying or forming a study group to work with someone from the class. Let's look at the situation where Fred increases his productivity in ECN so each hour in ECN now translates into 6 points. The new grade possibility curve appears below and once again Fred can attain what was once unattainable.

As you work through other examples, keep in mind the four features of the graph mentioned below are important and you should keep the list in mind as you create or interpret a possibility diagram. These features determine the nature of the story being conveyed by the graph. The four important features of a possibility graph are:

Now you are ready to look at a few examples of where this analysis can be used. If you are interested in some additional warm-up, you might want to look at the situation of an individual entering an MBA program who must make choices regarding the allocation of time. You could also look into the choice between consumption and investment - a choice that individuals, firms, and nation's must deal with. With these warm-ups you will be ready for our discussion of the end of war.

Let's look at another example. In the 1990s there was considerable growth in Executive MBA programs where students are professionals who keep their jobs while taking courses on weekends. It sounds good, but we know there are no free lunches, so let's look a little closer at the plight of students who enroll in the Executive MBA programs as they attempt to manage their personal and professional lives. Let's assume the students had complete lives before taking on the program and they allocated time between their personal and professional lives. Now, however, they have additional demands on their time, the scarce resource that must now be allocated. These students will be trading off peace at home, related to the time spent at home, for good grades, related to the hours spent studying. Please use the following graph to describe conceptually the tradeoff between Peace at home and Grades in the program that now faces them.

Once you have constructed the graph, you should test your mastery by answering the following questions.

The 'possibilities open to the EMBA student can be demonstrated by the curve below. The red line represents the options if the student utilizes all of the available time to produce either 'peace' or 'grades'. Point B is simply one possible efficient choice for allocating time. Point C, which is inside of the curve, indicates not all of the time has been utilized. Point A, meanwhile, is unattainable given the current resources (time) and productivities in producing grades and peace. Now let's look at what happens when we change the nature of the choice by altering the resources or altering the "productivities."

One of the ways of 'expanding the possibilities' open to the student would be an expansion of resources - in this case more time to devote to 'producing' grades and peace. With more time, the student could produce more, a situation we could capture graphically with an outward shift in the possibility curve. Now it would be possible for the student to move beyond the initial possibilities-to simultaneously increase both grades and peace.

A second way of 'expanding the possibilities' open to the student would be an increase in productivity/efficiency - in this case time devoted to 'producing' peace would produce more peace (maybe the student discovered that often mentioned concept of 'quality' time). With greater efficiency in producing peace, the maximum potential peace would increase - a situation we would demonstrate with an increase in the vertical intercept. Once again it would be possible for the student to move beyond the initial possibilities and simultaneously increase both grades and peace.

A third example would be the situation where each country (firm, individual) must decide how much of their income to allocate between consumption, spending that gives immediate benefits, and investment (machines...), spending that increases future possibilities. In the diagram below, consumption spending in Country B is lower than the spending in C and if one assumes that it is consumption spending that provides the standard of living, then the people in country C are experiencing a higher standard of living at the present time. But what about 5 years from now?

Now you should have it, so you are ready for one last example of the possibility curve. Once you have mastered this example, you will be ready to move on to a discussion of trade.

What is the basis for trade? Why is free trade viewed as such a key piece of the economic puzzle? The answer lies in the concept of specialization / division of labor, but before we get there, let's look at the situation facing an ancient empire, one of the many that have risen and fallen over the years. To make life easy, let's assume this empire supplies its people with luxuries (L) and necessities (N). We can capture the situation facing the empire's ruler with the aid of a possibility line.

Now what is a ruler to do? An obvious possibility would be to 'take' some resources which would expand the possibility curve outward. There are, however, potential limitations to this strategy. The empire may have to devote an increasingly large amount of resources to provision of security which will drain it of its ability to produce both L and N. The end result would be the eventual collapse of the empire. A second possibility would be to promote productivity growth - to get more out of existing resources which could be accomplished by a division of labor and specialization.

A third possibility is trade for more stuff, to enter into a mutually beneficial exchange. To get a "picture" of the situation, you can look at the situation below where we have two empires with their respective possibility lines. Left on its own, Empire A could produce anywhere along the blue possibility line. If it settled on the midpoint, it could supply 10 units of L and 2.5 units on N. If it produced only luxury items (L), it could produce 20 units. In Empire B, meanwhile, the possibilities are different and here a possible mix would be 5 units of L and 7.5 units on N. If all of Empire B's resources were devoted to production of Necessities (N), then they could produce 15 unit.

Can you devise a scheme to expand the consumption possibilities open to the two Empires? [You will note the introduction of a new term - the consumption possibility curve. Once we introduce trade there is a wedge between what we produce and what we consume]. If you can, then you have the makings of a deal that will result in trade. After you have tried for a while to find the deal, try checking out one solution.

The solution is based on the concept of comparative advantage which is closely related to the concept of opportunity cost. If you look at country A, you can see the cost of one unit of necessities costs 4 units of luxuries. In Empire B, meanwhile, the cost of one unit of necessities is 2/3 of a unit of luxuries. If there was no trading you would expect the prices of the goods would be different - luxuries would be more expensive in Empire B and necessities in Empire A. In this simple example we would say Empire A has the comparative advantage in luxuries and Empire B has the comparative advantage in necessities. This is the basis for the deal.