Definition of opportunity cost

Contents – Cambridge IGCSE Economics (0455)

• ✅ 1 The Basic Economic Problem
• ✅ 2 Allocation of Resources
• ✅ 3 Micro‑economic Decision‑Makers
• ✅ 4 Government & the Macro‑economy
• ⏳ 5 Economic Development
• ⏳ 6 International Trade & Globalisation

1 The Basic Economic Problem

1.1 Scarcity, Choice & Economic Goods

• Scarcity: Resources (land, labour, capital, entrepreneurship) are limited, while human wants are unlimited.
• Economic goods vs. free goods

  • Economic goods – scarce; must be produced at a cost (e.g., smartphones, wheat).
  • Free goods – abundant; available without cost (e.g., air, sunlight).

1.2 The Three Fundamental Questions

1. What goods and services should be produced?
2. How should they be produced?
3. For whom should they be produced?

1.3 Factors of Production & Their Rewards

1.4 Opportunity Cost

Definition: The value of the next‑best alternative that must be given up when a choice is made.

Conceptual formula:

Opportunity Cost = Benefit of the Next Best Alternative – Benefit of the Chosen Option

Key points

• Measured in terms of the most valuable forgone alternative (often in monetary terms, but can be expressed in units of another good).
• Arises because of scarcity – every decision involves a trade‑off.
• Fundamental to both micro‑ and macro‑economic analysis.

1.5 Production Possibilities Frontier (PPF)

• Shows the maximum possible output of two goods given fixed resources and technology.
• Points on the curve = efficient production; inside = under‑utilisation; outside = unattainable.
• Moving along the curve illustrates opportunity cost – the slope (marginal rate of transformation) tells how many units of one good must be sacrificed to produce an extra unit of the other.
• Shifts:

  • Outward/rightward: Economic growth (more resources or better technology).
  • Inward/leftward: Recession, natural disaster, war.

Diagram suggestion: Draw a PPF for “Cars” (horizontal axis) vs “Computers” (vertical axis). Label points A (on curve), B (inside), C (outside). Show the opportunity cost of moving from A to D (a point further right). Indicate the slope as the opportunity cost of one more car in terms of computers.

2 Allocation of Resources

2.1 Demand and Supply – Definitions & Diagrams

• Demand: Quantity of a good that consumers are willing and able to buy at each price, ceteris paribus. Downward‑sloping demand curve.
• Supply: Quantity that producers are willing and able to sell at each price, ceteris paribus. Upward‑sloping supply curve.
• Market equilibrium: Intersection of demand and supply (price = Pₑ, quantity = Qₑ).

2.2 Movements vs. Shifts

2.3 Price Determination & Price Changes

• At equilibrium, Pₑ = MC = MR for a price‑taking firm; the market price adjusts to equate quantity demanded and quantity supplied.
• Price increase: Movement up the supply curve and down the demand curve – quantity supplied rises, quantity demanded falls.
• Price decrease: Movement down the supply curve and up the demand curve – quantity supplied falls, quantity demanded rises.

2.4 Elasticity

2.4.1 Price Elasticity of Demand (PED)

Formula: PED = %ΔQ_d ÷ %ΔP

• Elastic demand: |PED| > 1 – quantity changes proportionally more than price.
• Unit‑elastic demand: |PED| = 1.
• Inelastic demand: |PED| < 1 – quantity changes proportionally less than price.

Determinants

• Availability of close substitutes.
• Proportion of income spent on the good.
• Nature of the good (necessity vs. luxury).
• Time horizon (short‑run vs. long‑run).

Significance

• Guides firms on how a price change will affect total revenue.
• Helps governments predict the impact of taxes or subsidies.

2.4.2 Price Elasticity of Supply (PES)

Formula: PES = %ΔQ_s ÷ %ΔP

• More elastic when firms can vary output quickly (e.g., services, commodities with spare capacity).
• Less elastic in the short‑run for goods requiring long production periods (e.g., aircraft).

2.5 Market Systems

2.6 Market Failure & Government Intervention

2.6.1 Types of Market Failure

• Public goods – non‑rival and non‑exclusive (e.g., street lighting, national defence). Usually provided by government because the market would under‑provide.
• Merit goods – socially desirable but under‑consumed (e.g., education, vaccinations). Government may subsidise.
• Demerit goods – socially undesirable but over‑consumed (e.g., cigarettes, alcohol). Government may tax or restrict.
• Externalities

  • Negative – pollution, noise. Government response: tax, regulation, tradable permits.
  • Positive – herd immunity, research spill‑overs. Government response: subsidy, grant.

• Monopoly power – single seller can set price above marginal cost → allocative inefficiency.
• Privatisation – transfer of state‑owned enterprise to private sector to improve efficiency.
• Nationalisation – transfer of private enterprise to state ownership, often to protect strategic industries.
• Quotas – limits on the quantity of a good that can be produced or imported, used to protect domestic producers.

2.6.2 Government Tools

3 Micro‑economic Decision‑Makers

3.1 Money & Banking

• Functions of money: medium of exchange, unit of account, store of value, standard of deferred payment.
• Banking role: Accept deposits, provide loans, create money through the multiplier effect (deposit × money multiplier = total money supply).
• Interest rates influence consumer borrowing, business investment and overall aggregate demand.

3.2 Households

• Sources of income: wages, profit, rent, interest, transfers.
• Key decisions: how much to consume, save or borrow.
• Factors affecting consumption: income level, interest rates, consumer confidence, price expectations, taxes.

3.3 Labour Market (Workers)

• Wage determination: Interaction of labour demand (derived from the marginal product of labour) and labour supply.
• Influencing factors: skill levels, education, immigration, minimum‑wage legislation, union activity, geographic mobility.
• Mobility:

  • Geographic – willingness to move for better pay.
  • Occupational – ability to retrain for different jobs.

3.4 Firms – Production, Costs & Revenue

3.4.1 Production

• Short‑run: At least one factor of production is fixed.
• Long‑run: All factors variable; firms can adjust plant size.
• Law of diminishing marginal returns: Adding more of a variable factor, holding others constant, eventually yields smaller increases in output.

3.4.2 Cost Concepts (Short‑run)

3.4.3 Revenue & Profit

• Total Revenue (TR): TR = Price × Quantity.
• Profit: Profit = TR – TC. Positive = profit, zero = break‑even, negative = loss.
• Profit‑maximising rule: Produce where MR = MC. For a price‑taking firm, MR = P, so P = MC.

3.4.4 Economies & Diseconomies of Scale (Long‑run)

• Economies of scale: ATC falls as output rises (e.g., bulk buying, specialised labour, better utilisation of plant).
• Diseconomies of scale: ATC rises after a certain size due to management difficulties, coordination problems, or morale issues.
• Long‑run ATC curve is typically U‑shaped, showing the range of efficient scale.

3.5 Market Structures

4 Government & the Macro‑economy

4.1 Macro‑economic Aims

• Economic growth (increase in real GDP).
• Low unemployment.
• Price stability (low inflation).
• Equitable distribution of income.
• External balance (stable balance of payments).

4.2 Fiscal Policy

• Components: Government spending (G) and taxation (T) affect aggregate demand (AD = C + I + G + (X‑M)).
• Expansionary fiscal policy: Increase G or cut T → AD shifts right → higher output & price level.
• Contractionary fiscal policy: Decrease G or raise T → AD shifts left.
• Budget balance: Deficit = G – T (when G > T); Surplus = T – G.

4.3 Monetary Policy

• Conducted by the central bank (e.g., Bank of England, Federal Reserve).
• Key tools:

  • Interest rate (base rate).
  • Open market operations (buying/selling government securities).
  • Reserve requirements.
  • Quantitative easing (large‑scale asset purchases).

• Lower interest rates → cheaper borrowing → increase consumption & investment → AD shifts right.
• Higher rates → opposite effect.

4.4 Supply‑Side Policies

• Goal: increase productive capacity and shift the long‑run aggregate supply (LRAS) curve right.
• Examples: improving education & training, deregulation, tax incentives for investment, infrastructure development, promoting research & development.

4.5 Inflation, Unemployment & Economic Growth

4.6 Evaluation – Policy Trade‑offs

• Fiscal expansion can boost growth but may increase inflation and public debt.
• Monetary tightening can curb inflation but may raise unemployment.
• Supply‑side measures improve long‑run growth but often have long lag times and may be costly.
• Policy choice depends on the current macro‑economic situation and the relative importance placed on each aim.

5 Economic Development

5.1 What Is Development?

• Improvement in the standard of living and quality of life of a nation’s people.
• Measured by indicators such as:

  • Real GDP per capita.
  • Human Development Index (HDI) – combines life expectancy, education and income.
  • GNI per capita (adjusted for purchasing power).

5.2 Causes of Development

• Investment in physical capital (machinery, infrastructure).
• Human capital formation – education, health, skills.
• Technological progress and innovation.
• Good institutions – stable government, rule of law, low corruption.
• Access to international markets and foreign direct investment (FDI).

5.3 Barriers to Development

• Low levels of education and health.
• Political instability, corruption, weak institutions.
• Insufficient infrastructure (roads, electricity, water).
• Dependence on a narrow range of exports (commodity dependence).
• High levels of external debt.

5.4 Role of Aid & Investment

• Official Development Assistance (ODA): Grants & concessional loans aimed at building infrastructure, health, education.
• Foreign Direct Investment (FDI): Brings capital, technology and managerial expertise.
• Both can stimulate growth if well‑targeted, but may create dependency if not managed properly.

5.5 Sustainable Development

• Meeting present needs without compromising the ability of future generations to meet theirs.
• Balancing economic growth, social inclusion and environmental protection.
• Policies: renewable energy, sustainable agriculture, pollution control, education on environmental stewardship.

6 International Trade & Globalisation

6.1 Benefits of Trade

• Specialisation according to comparative advantage → higher overall output.
• Access to a larger variety of goods and services.
• Economies of scale for exporters.
• Technology transfer and diffusion.

6.2 Costs & Risks of Trade

• Domestic industries may lose market share (import competition).
• Exposure to external shocks (commodity price swings, exchange‑rate volatility).
• Potential for trade‑related environmental degradation.

6.3 Trade Protection Instruments

6.4 Balance of Payments (BOP)

• Current account: Trade in goods & services, income, transfers.
• Capital & financial account: Investment flows, loans, FDI.
• A surplus means inflows exceed outflows; a deficit the opposite.

6.5 Exchange Rates

• Floating exchange rate: Determined by market forces of supply and demand.
• Fixed (pegged) exchange rate: Government or central bank maintains a set rate, often using reserves.
• Changes affect export competitiveness and import prices.

6.6 International Organisations

• World Trade Organisation (WTO): Sets rules for global trade, resolves disputes.
• International Monetary Fund (IMF): Provides short‑term financial assistance, monitors exchange‑rate policies.
• World Bank: Offers long‑term development loans and technical advice.

6.7 Evaluation of Globalisation

• Promotes economic growth and poverty reduction in many developing countries.
• Can widen income inequalities within and between nations.
• Environmental concerns arise from increased production and transport.
• Policy choices (e.g., trade agreements, regulation) determine whether the benefits outweigh the costs.