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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