Transcript The Economic Way of Thinking 10e ©Prentice Hall 2003

“The Economic Way of Thinking”
10th Edition
by Paul Heyne, Peter Boettke,
and David Prychitko
“Opportunity Cost and the
Supply of Goods”
PowerPoint Slides prepared by
Assistant Professor
Paul Harris
Camden County College
The Economic Way of Thinking 10e
©Prentice Hall 2003
1
Chapter Outline
I. Introduction
II. Refresher on Opportunity Cost
III. Cost are tied to Actions, Not Things
IV. The Irrelevance of “Sunk Cost”
V. Producers’ Cost as Opportunity Cost
VI. Marginal Cost as Opportunity Cost
VII. Marginal Opportunity Cost
VIII.Cost and Supply
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The Economic Way of Thinking 10e
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Chapter Outline
IX. Marginal and Average Cost
X. The Cost of a Volunteer Military
Force
XI. Price Elasticity of Supply
XII. Cost as Justification
XIII.Once over lightly
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Introduction
The theory of supply, like demand
theory, assumes that decision makers
face alternatives and choices.
These choices are based on a comparison of
expected benefits and cost.
The incentive to produce and supply
scarce goods is shaped by opportunity
cost, and the market prices that reflect
and inform us of those cost.
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Refresher on
Opportunity Cost
Question….
Why do poor people travel between cities by
bus, while wealthy people are more likely to
travel by air?
Answer…….
The higher one’s income, the higher the
opportunity cost of time.
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Refresher on
Opportunity Cost
Question….
Why is it so much harder to find a teenage
babysitter in a wealthy residential area than a
low- income area?
Answer…….
Wealthier people go out more so they demand
more babysitting services, while wealthy
teenagers get generous allowances, so they
value a date or leisure time more than the
extra money they could earn babysitting.
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Costs are Tied to Actions,
Not Things
Costs are always tied to actions, decisions, and
choices.
We must first distinguish the cost of obtaining a
good or service, from the cost of providing one.
The true cost of things stems from a failure to
recognize that only actions have cost, and that
actions can entail different costs for different
people.
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The Irrelevance of
“Sunk Cost”
With cost, the most common error is to
confuse cost previously incurred with
marginal cost.
The proper stance for making cost calculations
is not to look at the past, for the past is filled
with sunk cost, irretrievable cost.
The proper stance is to look forward to
current opportunity cost.
Marginal cost always lies in the future.
Sunk cost represent no opportunity for future
choice.
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Producers’ Cost as
Opportunity Cost
The concept of opportunity cost asserts that the
amount of money a producer must pay for any
resource, human or physical, will depend upon
what the owner of that resource can obtain from
someone else.
The resource that more clearly illustrates the
opportunity cost concept is probably land.
Land can be used for residential, commercial, or
industrial purposes.
The cost you pay for the land will be determined by
the alternative opportunities that people perceive for
its use.
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Marginal Opportunity Cost
All opportunity cost are marginal cost and all
marginal cost are opportunity cost.
Opportunity cost calls attention to the value of
the opportunity forgone by an action.
Marginal cost calls attention to the change in
the existing situation that the action entails.
The full name for any cost that is relevant to
decision making is “marginal opportunity cost”.
All such cost are cost of actions, or decisions; all
are attached to particular persons; and all lie in
the future.
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Cost and Supply
• Farmer Smith considers producing
soybeans and corn this season.
• If he devotes all of his acreage to soy
production, he can produce 14.5 units
• If he produces corn instead, he can
produce 10 units.
• The table on the next slide shows his
other production possibilities.
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Cost and Supply
Soybean Output per Harvest
Corn Output per Harvest
14.5
0
13.5
1
12.4
2
11.2
3
9.9
4
8.5
5
7.0
6
5.4
7
3.7
8
1.9
9
0
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Cost and Supply
The marginal cost of a second
unit of corn is 1.1 units of soy.
Soybean output
per harvest
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
Smith’s production possibilities
for corn and soy.
The marginal cost of
Producing a 9th unit
Of corn is 1.8 units of
Soybeans.
`
1
2
3
4
5
6
7
9
10
11
12
Corn output
Per harvest
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Cost and Supply
The data on the preceding slide indicates
increasing opportunity cost of producing each
good.
Smith has to be concerned with the relative
prices of both soy and corn to make his
production decisions.
Based on the relative prices, producers
consider marginal cost of production when
deciding upon which outputs, and which levels
of output to produce.
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Cost and Supply
Relative prices further informs producers of
the marginal cost, and the marginal benefits,
of their alternative production plans.
The supply curve for corn is an upward
sloping curve which reflects the marginal cost
of producing corn.
The area under the curve reflects the total cost
of production.
The supply curve illustrates the alternative
amounts of a good supplied at alternative
prices.
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Cost and Supply
Price
$0.20
$0.40
$0.60
$0.80
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
Units of Corn
1
2
3
4
5
6
7
8
9
10
Supply Schedule
for Corn.
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Cost and Supply
Supply Curve for Corn
Units of Corn
12
Price
10
8
Units of Corn
6
4
2
0
1
2
3
4
5
6
7
8
9
10
Quantity
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Marginal and Average Cost
• Marginal cost is not the same as average cost.
– Marginal cost reflects the change in total
cost from producing one more unit.
– Average Cost is total cost divided by the
number of units produced.
• Marginal cost is the consequence of action;
therefore it should be the guide to action.
– Economic decisions are always made with
an eye towards the future.
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Marginal and Average Cost
Units of
Corn
produced
0
Total Cost of
Producing
corn
0
Marginal
Cost
Average
Cost
0
0
1
$1
$1
$1
2
$2.10
$1.10
$1.05
3
$3.30
$1.20
$1.05
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The Cost of a Volunteer
Military Force
• Since 1999 there has been a concern
about enlistment and recruitment
shortages in the military.
– As a result there have been arguments for
initiating a draft.
– But is a draft the less costly way to organize
a military force?
• The “cost” we are referring to is the cost
to the taxpayer.
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The Cost of a Volunteer
Military Force
• The best way to determine the cost of a
soldier is to offer a bribe and keep raising
it until it is accepted.
– Or you could simply pay low wages and
force everyone to join with a draft.
• The opportunity cost of serving in the
military is the forgone wages that could
be earned in other occupations.
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The Cost of a Volunteer
Military Force
When the government bids for military
personnel it should raise its offer price
until it can get the exact number of
enlistments it needs.
Studies show that the wage offer should be
at least $16,000 per year. Will the taxpayers
go for it?
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Price Elasticity of Supply
• Price Elasticity of Supply is calculated by taking
the % change in quantity supplied in the
numerator, divided by the % change in price in
the denominator.
• Price and quantity supplied are directly related,
so regardless of the elasticity, when prices rise,
total revenue rises, and when prices fall total
revenue falls.
• Time is the major determinant of Price Elasticity
of Supply.
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Price Elasticity of Supply
• If producers do not have the time to secure
additional resources when prices change,
supply will be perfectly inelastic.
• With time to react to price changes supply
becomes more elastic.
– If the percentage in quantity supplied is greater
than the percentage change in price, then supply
will be elastic.
– If the percentage change in quantity supplied is less
than the percentage in change in price, then supply
will be inelastic.
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Cost Justification
• Many people think that prices should be
related closely to cost.
• They think that if prices are significantly
above cost then producers are pursuing
some unfair advantage.
– This way of thinking is known as
justification.
– Cost is always the product of supply and
demand.
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Once Over Lightly
Supply curves reflect
people’s estimates of the
value of alternative
opportunities.
Quantity supplied and
demanded depends on
the economizing choices
based on the
opportunity costs of
people.
Cost is the value of
opportunities that
people sacrifice.
The Economic Way of Thinking 10e
Past expenditures
cannot be affected by
present decisions. These
are sunk cost.
Opportunity cost is
necessarily marginal
cost.
Supply depends on cost.
The cost of supplying is
the value of the
opportunities forgone
by the act of supplying.
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Once Over Lightly
There is a direct relationship between price
and quantity supplied.
The supply curve slopes upward and to the right.
Price Elasticity of Supply is the% change in
quantity supplied divided by the % change in
price.
Only actions have cost.
Ask yourself “cost to whom”, “cost of doing
what?”
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Next Chapter 5
Supply and
Demand: A
Process of
Cooperation
End of Chapter 4
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The Economic Way of Thinking 10e
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