The Principle of Opportunity Cost

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The Principle of  Opportunity Cost Powered By Docstoc
					   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 ?
    »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.
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.
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.
Thousands     Y PRODUCTION POSSIBILITY
of
                 CURVE
computers                   g
per year
        600
                                           h
        500
                      c
                                                 new


                                           original




                        2              5
               Number of Space Missions Per Year
                                                       X
        MARKET
An arrangement which
allows buyers and sellers to
exchange money and goods.
        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 ?
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.
    comparative ADVANTAGE &
           EXCHANGE
            Productivity of two individuals
                  Brenda            Sam
Bread Per Hour       6               1
Shirts Per Hour      2                1
ABSOLUTE ADVANTAGE
The ability of one individual to
 produce more of all goods being
 compared.
   (Brenda has absolute advantage
              over Sam).
 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.
        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
 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.
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
                               Major Trading Partners of the U.S.




                                                                     32.20%
                       other
                                  3.6%                                 38.10%
             United Kingdom          5.6%
                                 2.9%
                South Korea
                                 3.0%
                 Netherlands    2.6% 6.7%
Coiuntries




                     Mexico             8.8%
                                                       18.4%
                      Japan
                                            10.1%                               Inports
                   Germany         4.8%
                                  3.9%                                          Exports
                                2.6%
                     France      2.8%
                                    4.3%
              China: Taiwan        3.4%
             China: Mainland         5.3%

                    Canada                                 21.6%

                          0.0% 5.0% 10.0%15.0% 20.0%25.0% 30.0%35.0%40.0%
                                               Percentage of Trade
  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;
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.
                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
THE MARGINAL PRINCIPLE
        (INCREMENTAL)
• Provides a way of fine-tuning
  decisions.
• Will one additional unit of a
  variable make us better or
  worse off ?
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.
 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.
 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.
 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.
  The Marginal Principle and the Barbershop

BENEFIT
OR
                   MARGINAL BENEFIT
COST
($ / HR)                     b
           $40                   c
           $32
                                         d
           $24                               MARGINAL COST



                            4    5   6
                 HOURS PER DAY BARBER SHOP IS OPEN
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
 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.
THE REALITY PRINCIPLE
 The real value or
  purchasing power of
  money or income means
  more to people than its
  face value.
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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