Download Practical # 5 Help Sheet

Practical #5 Help Sheet
Definitions:
When you choose one alternative over others, you give up benefits from the alternatives that are
not chosen. Opportunity cost is defined as the value of the benefits from the most profitable
alternative that is sacrificed.
A production possibilities curve shows the trade off in the production of goods or services. It
shows that to obtain more of one good that you have to give up an increasing amount of another
good. The law of increasing opportunity costs states that to increase the production of one
good, a greater amount of another good must be sacrificed. .
Marginal Analysis is making decisions based on per unit changes in profit or some other measure
of net benefit. The rule to follow in decision making is to follow a course of action if the benefits
from a unit change in that action are greater than or equal to the costs of a unit change in that
action.
Opportunity Cost example:
Consider the following production possibilities schedule:
Consumer Goods
0
5
8
Units
10
11
Capital Goods
8
6
4
2
0
Draw the production possibilities curve. Put capital goods on the vertical axis and consumer
goods on the horizontal axis and plot the points in the table. For example, plot the point
(consumer goods, capital goods) = (0,8).
Consumer Goods
Production Possibilities Curve
12
11
10
9
8
7
6
5
4
3
2
1
0
0
2
4
Capital Goods
6
8
Note that the law of increasing
opportunity cost holds:
Sacrificing the first 2 units of
capital goods gives 5 units of
consumer goods but the next 2
units of capital goods gives only 3
units of consumer goods. In
other words, the relative costs of
consumer goods in terms of
capital goods increases ( i.e. You
pay the same price for consumer
goods, two units of capital, but get
less for your money as you buy
more consumer goods).
2
What is the opportunity cost of moving from 5 units of consumer goods to 8 units? Going from 5
units to 8 units of consumer goods requires that 2 units of capital goods be sacrificed. This means
that the opportunity cost is 2 units of capital goods.
In making the move from 5 units of consumer goods to 8 units of consumer goods, 3 units of
consumer goods are obtained at a cost of 2 units of capital goods: 3 consumer goods = 2 capital
goods. This means that the unit cost of consumer goods is 2/3 the number of capital goods:
consumer good = 2/3 X capital goods (i.e. Divide both sides by 3 to get the cost of consumer
goods in terms of capital goods).
If a unit of capital goods costs $10, what is the opportunity cost in dollars of one unit of consumer
goods?
Opportunity cost = 2/3 X $10 = $6.67
i.e. One unit of consumer goods is equivalent to 2/3 units of capital goods and a unit of capital
goods is worth $10.
Marginal Analysis example:
Consider the following benefits and costs:
Number of Machines
Total Revenue
Total Costs
3
4
5
$10 M
$15 M
$17M
$5M
$8M
$11 M
(M = millions)
Should 3 or 4 machines be used? The benefit of a 4th machine is $5 M ($15 M - $10 M) and the
cost is $3 M ($8 M - $5 M). Since the benefits of a 4th machine are greater than the costs of a 4th
machine, four machines should be used.
Should 4 or 5 machines be used? The benefit of a 5th machine is $2 M ($17 M - $15 M) and the
cost is $3 M ($11 M - $8 M). Since the benefits of a 5th machine are less than the costs of a 5th
machine, five machines should not be used.