Transcript The Supply of Goods

Chapter 4:
“The Economic
Way of Thinking”
11th Edition
Opportunity
Costs and the
Supply of
Goods
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
Chapter 4 Outline
• Introduction
• Refresher on Opportunity Costs
• Costs are Tied to Actions, Not Things
• The Irrelevance of “Sunk Costs”
• Producers’ Costs as Opportunity Costs
• Marginal Opportunity Costs
• Costs and Supply
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
2 of 27
Chapter 4 Outline
• The Supply Curve
• Supply Itself Can Change
• Marginal and Average Costs
• The Cost of a Volunteer Military Force
• Price Elasticity of Supply
• Cost as Justification
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
3 of 27
Introduction
• The theory of supply, like demand theory,
assumes that decision makers face alternatives
and choices.
– Choices based on comparing expected benefits and
costs
• The incentive to produce and supply scarce
goods is shaped by opportunity cost and the
market prices that reflect and inform us of those
costs.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
4 of 27
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.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
5 of 27
Refresher on Opportunity Cost
• Question
– Why is it so much harder to find a teenage babysitter
in a wealthy residential area than in 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.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
6 of 27
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.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
7 of 27
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 to not 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 represents no opportunity for future choice.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
8 of 27
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.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
9 of 27
Producers’ Cost as Opportunity Cost
• The resource that most clearly illustrates the
opportunity cost concept is probably land.
• Land can be used by residential, commercial, or
industrial purposes.
– The cost you pay for land will be determined by the
alternative opportunities that people perceive for its
use.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
10 of 27
Marginal Opportunity Cost
• All opportunity costs are marginal costs and all marginal
costs are opportunity costs.
• Opportunity cost calls attention to the value of the
opportunity foregone by an action.
• Marginal cost calls attention to the change in the existing
situation that the action entails.
• The full name of any cost that is relevant to decision
making is “marginal opportunity cost.”
• All such costs are costs of actions, or decisions; all are
attached to particular persons; and all lie in the future.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
11 of 27
Costs 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.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
12 of 27
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
10
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
13 of 27
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
13
14
15
Corn output
per harvest
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
14 of 27
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 costs of production when deciding
upon which outputs, and which levels of output
to produce.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
15 of 27
The Supply Curve
• Relative prices further inform 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.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
16 of 27
Supply Itself Can Change
• Anything that changes the marginal cost of
production will tend to change (or shift) the
overall supply curve.
–
–
–
–
Technology changes
Prices of substitutes
Change in expected price
Change in overall number of suppliers
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
17 of 27
Marginal and Average Costs
• 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.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
18 of 27
Marginal and Average Cost
Units of
Corn
Produced
Total Cost of
Producing
Corn
Marginal
Cost
Average
Cost
0
0
0
0
1
$1.00
$1.00
$1.00
2
$2.10
$1.10
$1.05
3
$3.30
$1.20
$1.10
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
19 of 27
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.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
20 of 27
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 foregone wages that could be earned in
other occupations.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
21 of 27
Price and 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.
• Regardless of the elasticity, when prices rise,
total revenue rises; when prices fall, total
revenue falls.
• Time is the major determinant of price elasticity
of supply
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
22 of 27
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 change 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 change in price, then supply will
be inelastic.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
23 of 27
Cost as 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 and
has infiltrated our laws.
– Cost is always the product of supply and demand.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
24 of 27
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.
• Past expenditures cannot be affected by present
decisions. These are sunk costs.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
25 of 27
Once Over Lightly
• Opportunity cost is necessarily marginal cost.
• Supply depends on cost.
• The cost of supplying is the value of the
opportunities foregone by the act of supplying.
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
26 of 27
End of Chapter 4
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
27 of 27