Download Chapter 2

2
THE KEY PRINCIPLES
OF ECONOMICS
THE PRINCIPLE OF
OPPORTUNITY COST
• opportunity cost
What you sacrifice to get something

The Cost of College
Opportunity cost of money spent on tuition and books
Opportunity cost of college time (four years working for $20,000 per year)
Economic cost or total opportunity cost
$ 40,000
80,000
$120,000
THE PRINCIPLE OF
OPPORTUNITY COST

Opportunity Cost and the Production Possibilities Curve
 Scarcity and the Production
Possibilities Curve
• production possibilities curve
A curve that shows the possible
combinations of products that an
economy can produce, given that its
productive resources are fully
employed and efficiently used.
THE PRINCIPLE OF
OPPORTUNITY COST
 Opportunity Cost and the Production Possibilities Curve
 Shifting the Production
Possibilities Curve
THE MARGINAL PRINCIPLE
• marginal benefit
The additional benefit resulting from
a small increase in some activity.
• marginal cost
The additional cost resulting from
a small increase in some activity.
CONTINENTAL AIRLINES USES THE MARGINAL PRINCIPLE
How do firms think at the margin?
In the 1960s, Continental Airlines puzzled observers of the airline
industry and dismayed its stockholders by running flights with up to half
the seats empty. Why did the airline run such flights? Were the
managers of the airline irrational? Apply the marginal principle to the
following:
•
Average cost of running a flight = $4000
• Fixed costs = $2000
• Variable costs = $2000
•
Revenue of a half-full flight = $3000
In applying the marginal principle, determine:
• The marginal cost of running an additional flight
• The marginal benefit of running an additional flight
• Should the next half-full flight run?
THE PRINCIPLE OF VOLUNTARY
EXCHANGE

Exchange and Markets
A market is an institution or arrangement that enables people to
exchange goods and services. If participation in a market is
voluntary and people are well informed, both people in a
transaction—buyer and seller—will be better off.
TIGER WOODS AND WEEDS
What is the rationale for specialization and exchange?
The swinging skills that make Tiger Woods one of the world’s best
golfers also make him a skillful weed whacker. His large estate has
a lot of weeds, and it would take the best gardener 20 hours to take
care of all of them. Tiger could whack down all the weeds in just
one hour. Since Tiger is 20 times more productive than the best
gardener, should he take care of his own weeds?
•
Average earnings per hour of Tiger Woods = $10,000
•
Opportunity cost of weed whacking = $10,000
•
Gardener’s fee (20 hours @ $10.00 per hour) = $200
We use the principle of voluntary exchange to explain
why Tiger should hire the less productive gardener.
THE PRINCIPLE OF DIMINISHING
RETURNS

Diminishing Returns from Sharing a Production Facility
When we add a worker to the facility, each worker becomes less productive
because he or she works with a smaller piece of the facility: More workers
share the same machinery, equipment, and factory space. As we pack more
and more workers into the factory, total output increases, but at a
decreasing rate.
FERTILIZER AND CROP YIELDS
Do farmers experience diminishing returns?
The notion of diminishing returns applies to all inputs to the production process. For
example, one of the inputs in the production of corn is nitrogen fertilizer. Suppose a
farmer has a fixed amount of land (an acre) and must decide how much fertilizer to
apply.
Table 2.1 shows the relationship between the amount of fertilizer and the corn output.
Why does the farmer experience diminishing returns?
Table 2.1 | FERTILIZER AND CORN YIELD
Bags of Nitrogen Fertilizer
Bushels of Corn Per Acre
0
85
1
120
2
135
3
144
4
147
THE REAL-NOMINAL PRINCIPLE
The real-nominal principle states that what matters to people is the
real value of money or income, not the nominal value.
• nominal value
The face value of an amount of
money.
• real value
The value of an amount of money
in terms of what it can buy.