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The Principle of Opportunity Cost

The Principle of Opportunity Cost. No matter what we do, there are always tradeoffs. Scarcity -- limited resources -- is the reason. The opportunity cost of something is what you sacrifice to get it. Opportunity Costs are Choices ???. How should I spend my money ?

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The Principle of Opportunity Cost

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  1. The Principle of Opportunity Cost • No matter what we do, there are always tradeoffs. • Scarcity -- limited resources -- is the reason. The opportunity cost of something is what you sacrifice to get it.

  2. Opportunity Costs are Choices??? • 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.

  3. Opportunity Costs and Production Possibilities • 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.

  4. Shifting the Production Possibilities Curve The production possibilities curve will shift as a result of: • An increase in the economy’s production factor -- natural resources -- labor -- physical capital -- human capital -- entrepeneurship • Technological innovation that increases output from a given amount of resources.

  5. Y PRODUCTION POSSIBILITY CURVE Thousands of computers per year g 600 h 500 c new original X 2 5 Number of Space Missions Per Year

  6. MARKET An arrangement which allows buyers and sellers to exchange money and goods.

  7. QUESTIONS ADDRESSED ABOUT TRADE • Why do both rich and poor nations benefit from trade ? • What is a firm, and how are firms organized ? • Which of the industrialized nations has the lowest taxes ? • Which nations are most dependent on international trade ? • How do governments restrict international trade? • What are GATT, NAFTA, and the World Trade Organization ?

  8. WHY DO MARKETS EXIST ? • We are not self-sufficient: (We specialize in what we do best.) • 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.

  9. comparative ADVANTAGE & EXCHANGE Productivity of two individuals Brenda Sam Bread Per Hour 6 1 Shirts Per Hour 2 1

  10. ABSOLUTE ADVANTAGE The ability of one individual to produce more of all goods being compared. (Brenda has absolute advantage over Sam).

  11. OPPORTUNITY COST FOR BRENDA AND SAM OPPORTUNITY COSTS LOAVES SHIRTS Brenda 3/shirt 1/3 / loaf Sam 1/shirt 1/loaf • Person should produce good that he/she has comparative advantage (lower opportunity cost) to reduce sacrifice.

  12. HOW DOES SPECIALIZATION HELP ? • If Brenda uses one hour of shirt production for bread production. 2 fewer shirts 6 more bread loaves • If Sam uses three hours of bread production for shirt production 3 more shirts 3 fewer bread loaves • Overall change 1 more shirt 3 more bread loaves

  13. THE GLOBAL ECONOMY(International Trade) • Exports - Goods produced in the U.S. and sold in another country. • Imports - Goods produced in another country and purchased by citizens of the U.S.

  14. 1993 INTERNATIONAL TRADE Product/Service Exports Imports Airplanes & Parts $31 billion Automated Data Processing $27 billion $43 billion Chemicals $45 billion Clothing $34 billion Crude oil & petroleum preparations $49 billion Electrical Machinery $37 billion $46 billion Footwear $11 billion Industrial Machinery $38 billion $31 billion Power Generating Machinery $19 billion $17 billion Scientific Instruments $15 billion Telecommunications Equip. $13 billion $27 billion Toys, games, sporting goods $12 billion Vehicles: cars and trucks $16 billion $61 billion Vehicles: parts $19 billion $18 billion

  15. INTERNATIONAL TRADE • Trade between nations is based on the same principles for trade between individuals: - Specialize in what country does best; - Use comparative advantage; - Lower opportunity cost;

  16. Reliance on Trade Differs With Specific Country • Smaller countries, with fewer opportunities for specialization, rely more heavily on trade; • Larger countries, with greater absolute advantage, rely less on trade.

  17. EXPORT RATIOS(Exports as Percentage of Total Income) COUNTRY EXPORT RATIO Norway 43 Canada 33 Germany 33 South Korea 30 Britain 26 France 23 United States 11 Japan 9 India 9 Brazil 7

  18. THE MARGINAL PRINCIPLE (INCREMENTAL) • Provides a way of fine-tuning decisions. • Will one additional unit of a variable make us better or worse off ?

  19. THE MARGINAL PRINCIPLE • Marginal Benefit The extra benefit resulting from a small increase in the activity. • Marginal Cost The additional cost resulting from a small increase in the activity.

  20. 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.

  21. EDWARD SCISSORHANDS BARBERSHOP Should Edward stay open 3 or 4 hours? • Marginal benefit -- 5 haircuts x $8 = $40 • marginal cost -- electricity @ $4 / hour, plus; $20 / hour opportunity cost trimming hedges and mowing lawns; • marginal benefit exceeds marginal cost $40 - $24 = $16 : stay open the extra hour.

  22. 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) • Marginal cost remains at $24 for each hour.

  23. The Marginal Principle and the Barbershop BENEFIT OR COST ($ / HR) MARGINAL BENEFIT b $40 c $32 d $24 MARGINAL COST 4 5 6 HOURS PER DAY BARBER SHOP IS OPEN

  24. The Principle of Diminishing Returns 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

  25. THE SPILLOVER PRINCIPLE 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.

  26. THE REALITY PRINCIPLE The real value or purchasing power of money or income means more to people than its face value.

  27. THE REALITY PRINCIPLE • Nominal Value -- The face value of a sum of money. • Real Value -- The value of a sum of money in terms of the quantity of goods that can be purchased.

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