5 Key Principles of Economics
Principle of Opportunity Cost
n Marginal Principle
n Principle of Diminishing Returns
n Spillover Principle
n Reality Principle
n
ECO 103 Individual and Society
Dr. David Loomis
The Principle of Opportunity
Cost
Opportunity Costs are Choices
???
No matter what we do, there are always
tradeoffs.
n Scarcity -- limited resources -- is the
reason.
n
How should I spend my money ?
How should I spend my time ?
Opportunity cost is always measured by
how much you give up of the next best
alternative to get what you want.
•
•
The opportunity cost of something
is what you sacrifice to get it.
Opportunity Costs and Production
Possibilities
n
Safe
Drinking
Water
Malaysia
The production possibility curve illustrates the
principle of opportunity cost for an entire
economy.
-- shows all possible combinations of goods and
services available to entire economy.
--- principle of opportunity cost explains why
production possibility curve is negatively sloped.
Warships
1
Malaysia
Safe
Drinking
Water
Safe
Drinking
30
Water
25
Malaysia
5
(Millions
of People)
(Millions
of People)
0
1
Warships
Warships
Shifting the Production Possibilities
Curve
Y PRODUCTION POSSIBILITY
Thousands
of
computers
per year
CURVE
The production possibilities curve will shift as a
result of:
n An increase in the economy’s production factor
-- natural resources
-- labor
-- physical capital
-- human capital
-- entrepeneurship
n Technological innovation that increases output
from a given amount of resources.
500
X
2
Number of Space Missions Per Year
Y PRODUCTION POSSIBILITY
Thousands
of
computers
per year
500
Y PRODUCTION POSSIBILITY
CURVE
Thousands
of
computers
per year
500
c
CURVE
c
new
new
original
2
Number of Space Missions Per Year
2
original
X
2
Number of Space Missions Per Year
X
2
Thousands
of
computers
per year
60
0
50
0
Y PRODUCTION POSSIBILITY
CURVE
Thousands
of
computers
per year
g
60
0
50
0
c
new
Y PRODUCTION POSSIBILITY
CURVE
g
c
new
original
2
Number of Space Missions Per Year
original
X
THE MARGINAL PRINCIPLE
(INCREMENTAL)
n Provides a way of fine-tuning
decisions.
n Will one additional unit of a
variable make us better or
worse off ?
THE MARGINAL PRINCIPLE
Increase the level of an activity if
its marginal benefit exceeds its
marginal cost, but reduce the level
if the marginal cost exceeds the
marginal benefit. If possible, pick
the level at which the marginal
benefit equals marginal cost.
2
Number of Space Missions Per Year
X
THE MARGINAL PRINCIPLE
n Marginal Benefit
The extra benefit resulting from
a small increase in the activity.
n Marginal Cost
The additional cost resulting
from a small increase in the
activity.
EDWARD SCISSORHANDS
BARBERSHOP
Should Edward stay open 3 or 4 hours?
n Marginal benefit -- 5 haircuts x $8 = $40
n marginal cost -electricity @ $4 / hour, plus;
$20 / hour opportunity cost trimming
hedges and mowing lawns;
n marginal benefit exceeds marginal cost
$40 - $24 = $16 : stay open the extra
hour.
3
EDWARD SCISSORHANDS
BARBERSHOP
If Edward progressively cuts fewer
heads each hour he is open,
marginal benefit decreases:
4th hour -- 5 haircuts ($40 marginal benefit)
5th hour -- 4 haircuts ($32 marginal benefit)
6th hour -- 3 haircuts ($24 marginal benefit)
n Marginal cost remains at $24 for each
hour.
n
The Marginal Principle and the Barbershop
BENEFIT
OR
COST
($ / HR)
The Marginal Principle and the Barbershop
BENEFIT
OR
COST
($ / HR)
HOURS PER DAY BARBER SHOP IS OPEN
The Marginal Principle and the Barbershop
BENEFIT
OR
COST
($ / HR)
MARGINAL BENEFIT
$40
$24
MARGINAL COST
$24
MARGINAL COST
4
HOURS PER DAY BARBER SHOP IS OPEN
The Marginal Principle and the Barbershop
BENEFIT
OR
COST
($ / HR)
HOURS PER DAY BARBER SHOP IS OPEN
The Marginal Principle and the Barbershop
BENEFIT
OR
COST
($ / HR)
MARGINAL BENEFIT
MARGINAL BENEFIT
b
$40
$40
$32
$32
$24
MARGINAL COST
4
5
HOURS PER DAY BARBER SHOP IS OPEN
c
d
$24
MARGINAL COST
4
5
6
HOURS PER DAY BARBER SHOP IS OPEN
4
To Fly or not to Fly ?
Is it reasonable to fly a
plane with only 30
passengers if the plane
has a 120-seat capacity
?
Flight costs:
3-person crew = $1,000;
jet fuel
= $1,200
TOTAL
= $2,200
n Flight Revenue:
30 tickets @ $100/ticket
TOTAL
= $3,000
n Daily Profit
= $ 800
n
FLY !
Should a College Rent Its
Facilities to Students ?
The Principle of Diminishing
Returns
Marginal Cost:
electricity & heating = $20
cleanup = $60
security = $100
TOTAL
= $180
n Marginal Benefit:
student club will pay = $500
If an output produced from two or
more inputs has one input
increasing, while the other remains
constant, a point will be reached
where the output will increase at a
decreasing rate.
THE POINT OF DIMINISHING RETURNS
n
Since $320 greater benefit, RENT!
The Principle of Diminishing
Returns
The Principle of Diminishing
Returns
5
The Principle of Diminishing
Returns
The Principle of Diminishing
Returns
SHORT RUN VERSUS LONG
RUN
THE SPILLOVER PRINCIPLE
Short Run -A period of time over which one or
more production factors is fixed.
n Long Run -A period of time long enough so a
firm can change all of the factors of
production.
n
THE REALITY PRINCIPLE
The real value or
purchasing power of
money or income means
more to people than its
face value.
For some goods, the costs or
benefits associated with the good
are not confined to the individual
or organization that decides how
much of the good to produce or
consume.
THE REALITY PRINCIPLE
nNominal
Value --
The face value of a sum of money.
nReal
Value --
The value of a sum of money in
terms of the quantity of goods that
can be purchased.
6
5 Key Principles of Economics
WHY DO MARKETS EXIST ?
Principle of Opportunity Cost
Marginal Principle
n Principle of Diminishing Returns
n Spillover Principle
n Reality Principle
n
n
n
We are not self-sufficient:
(We specialize in what we do best.)
n We trade what we make for goods or
services we need, or for money to buy
goods and services we need.
Markets facilitate specialization and
exchange.
comparative ADVANTAGE
& EXCHANGE
Productivity of two individuals
Brenda
Sam
Bread Per Hour
6
1
Shirts Per Hour
2
1
HOW DOES
SPECIALIZATION HELP ?
If Brenda uses one hour of shirt production
for bread production.
2 fewer shirts
6 more bread loaves
n If Sam uses three hours of bread production
for shirt production
3 more shirts
3 fewer bread loaves
n Overall change
1 more shirt
3 more bread loaves
n
ABSOLUTE ADVANTAGE
The ability of one individual to
produce more of all goods being
compared.
(Brenda has absolute advantage
over Sam).
PRINCIPLE OF
OPPORTUNITY COST
The opportunity cost of
something is what you
sacrifice to get it.
7
OPPORTUNITY COST FOR
BRENDA AND SAM
Brenda
Sam
n
OPPORTUNITY COSTS
LOAVES
SHIRTS
3/shirt
1/3 / loaf
1/shirt
1/loaf
Person should produce good that he/she has
comparative advantage (lower opportunity cost)
to reduce sacrifice.
8