chapter 2: opportunity costs. scarcity economics is the study of how individuals and economies deal...

Chapter 2: Opportunity costs

Scarcity

• Economics is the study of how individuals and economies deal with the fundamental problem of scarcity.

• As a result of scarcity, individuals and societies must make choices among competing alternatives.

Opportunity Cost

• Is a benefit, profit, or value of something that must be given up to acquire or achieve something else.

• The opportunity Cost is the value of the next best choice that one gives up when making a decision...

• “opportunity cost” of a resource, means the value of the next-highest-valued alternative use of that resource.

Example I

• The opportunity cost of college attendance includes:– the cost of tuition, books, and supplies,– foregone income (this is usually the largest cost

associated with college attendance), and– spiritual costs.

Example II:

• Opportunity cost of attending a movie includes:– cost of tickets– cost of time

Net benefit• Net Benefits = Total Benefits - Total Costs

• Individuals are not expected to maximize benefit; nor are they expected to minimize costs.

• Individuals are assumed to attempt to maximize the level of net benefits from any activity in which they are engaged.

• In any situation, people want to maximize net benefits.

Marginal analysis

• Marginal analysis is used to assist people in allocating their scarce resources to maximize the benefit of the output produced.

• Simply getting the most value for the resources used.

Marginal analysis

• Marginal benefit = additional benefit resulting from a one-unit increase in the level of an activity

• Marginal cost = additional cost associated with one-unit increase in the level of an activity

Other Costs

• Fixed Costs (FC)--Cost that do not vary with changes in output.

• Variable Costs (VC)--Cost which increase with the level of output.

• Total Costs (TC)--Cost that is the sum of fixed and variable costs at each level of output.

Revenues Versus Costs

• Total, Average, and Marginal Revenue– Total Revenue = P Q– Average Revenue = TR/Q = (P Q)/Q = P– Marginal Revenue = total revenue from one

more unit of output.

• Total, Average, and Marginal Revenue– Total Revenue = P Q– Average Revenue = TR/Q = (P Q)/Q = P– Marginal Revenue = total revenue from one

more unit of output.

Key Procedures for Using Marginal Analysis

Determine what the increase in total benefits would be if one more unit of the output were added. This is the marginal benefit

Determine what the increase in total cost would be if one more unit of the output were added. This is the marginal cost

If the unit's marginal benefit exceeds (or equals) its marginal cost, it should be added.

Why Does This Work?Because:

Marginal Benefit = Increase in Total Benefits per unit of product. TR / Qo = MR

Marginal Cost = Increase in Total Costs per unit of product. TC / Qo = MC

In short run. TVC / Qo= MC

So: Change in Net Benefits = Marginal Benefit - Marginal Cost

Why Does This Work?• If the (expected) marginal benefit of doing something

is greater than or equal to the (expected) marginal cost,-----> do it, because net benefits go up.

• If the (expected) marginal cost of doing something is greater than the (expected) marginal benefit,----> don’t do it, because if you did, net benefits go down.– If MR > MC, production profits

– If MR < MC, production profits

• optimal level of activity: MB = MC (Net benefit is maximized at this point)

Problem:

International rugs is producing forty rugs at a total cost of $80000 and is selling them for $3000 each for a total revenue of $120000.

If it produces a forty-first rug, its total revenue will be $123000 and its total cost will be $84000.

•Should the firm produce the forty one rug?

Answer:

Q Qrugs TR TR TC TC

40 120,000 80,000

1 3,000 4,000

41 123,000 84,000

MR = TR / Q = $3,000 / 1 = $3,000

MC = TC / Q = $4,000 / 1 = $4,000

A Question:

What is the minimum price consumers would have to pay to get a 41st rug produced?

• Consumers would have to pay at least $4,000 for the extra rug to get the producer to increase production.

Marginal benefit• MB generally declines as the level of an activity rises,

with other things the same," or "all other things being equal or held constant.

• Consider the MB of time spent studying:

Marginal cost• U-shaped, meaning it has a negative slope for small

quantities of output, reaches a minimum value, then has a positive slope for larger quantities.

• For two reasons.

• First, marginal cost is relatively high for the first unit produced, then declines. However, it reaches a low, and then rises with the production of additional unit.

• Second, marginal cost remains positive; it never reaches a zero value let alone negative. The only way for negative marginal cost is for a decrease in total cost, which just does not happen in a real world filled with scarcity, limited resources, unlimited wants and needs, and opportunity cost.

Marginal opportunity cost

• Marginal opportunity cost = the amount of another good that must be given up to produce one more unit of a good.

Production possibilities Frontier/Curve

• Reflects the maximum production that the Factory can produced.

Assumptions:– A fixed quantity and quality of available resources– A fixed level of technology– Efficient production (i.e., no unemployment and

no underemployment)

Production possibilities Frontier• A graph represent the alternative combinations of

the quantity of two goods or services that an economy can produce by transferring resources from one good or service to the other.

• This curve helps in determining what quantity of a nonessential good or a service an economy can afford to produce without jeopardizing the required production of an essential good or service. Also called transformation curve.

points A, B, C and D represent the points at which production of Apples and Wheat is most efficient. Point X demonstrates the point at which resources are not being used efficiently in the production of both goods; point Y demonstrates an output that is not attainable with the given inputs.

Wheat

Applesunattainable

inefficient

just attainable

just attainable Y

X

C

B

D

A

A Typical Production possibilities Frontier PPF

PPF and Calculating marginal opportunity cost

The marginal opportunity cost of wheat in terms of Apples is increasing as we move down the PPF!The PPF is typically bowed-out or linear.

The slope of the Production Possibility Frontier measures the marginal opportunity cost of producing one good in terms of the amount of the other good foregone.In the space between points B and C, the marginal opportunity cost of one KG of Wheat equals 1/2 of a KG of Apples.

wheat

Applesunattainable

inefficient

just attainable

just attainable

70

60

80

45 65 100

C

B

Law of diminishing returns

• Law of diminishing returns: "If an increasing amounts of a variable factor are applied to a fixed quantity of other factors per unit of time, the increments in total output will first increase but beyond some point, it begins to decline .

• Diminishing Returns occurs in the short run when one factor is fixed (e.g. Capital).

• This law only applies in the short run because in the long run all factors are variable

A good example of Diminishing Returns

• The use of Farmers leads to a big increase in output. However, increasing use of farmers further lead crowding in this limited area, thus lead to declining Marginal Product (MP) as the efficacy of the farmer declines.

Need to farmers - Free spaces

adequate farmers Crowded area

Stage 1 Stage 3Stage 2

Fixed Input (land, machines, and equipments)

Inputs of Variable

Resources

Total Produce TP (in tons)

Marginal product MP   (in

tons)

12 Acres 12 Acres12 Acers12 Acres12 Acers12 Acres

1 Labor2 Labor 3 Labor4 Labor5 Labor6 Labor

50 120180200200195

50 7060200-5

Unemployed or underemployed resources

Points outside of the PPC

Economic growth

Commodity-specific technological change