Key Economic Principles

1
Key Economic Principles

• Opportunity Cost

2
Opportunity Cost...

• The value of the next most attractive alternative
  that must be sacrificed when a choice is made.

3
Our first modelProduction Possibilities

• Production possibilities are all combinations of
  goods that can be produced with the resources and
  technology currently available.

4
The Production Possibilities Curve

• A GRAPH showing all possible combinations of two
  goods that can be produced with current resources
  and technology (holding production of everything
  else constant).

E.g., feature films and medical research
5
Production Possibilities Frontier
e
500
Lives Saved (x 1000)
f
300
1000
1800
Feature Films Produced
Opportunity Cost of 800 extra films (e to f) is
200,000 lives. Average 250 lives per film
6
Production Possibilities Frontier
e
500
Lives Saved (x 1000)
f
300
i
100
1000
1800
500
Feature Films Produced
7
Production Possibilities Frontier
unattainable
efficient
Lives Saved (x 1000)
inefficient
Feature Films Produced
8
An Increase in Resources or Improvement in
Technology
Lives Saved
Feature Films Produced
9
Technological Improvement in Only One Good
Lives Saved
Feature Films Produced
10
Key Economic Principles

• Opportunity Cost

• Equate the Margins

11
Reminder Thinking on the margin means using
incremental changes

• Examples
• If I work one more week this year, how much extra
  income will I have?
• If I study one extra hour for my midterm, how
  many extra points will I earn?

12
Marginal Benefit (MB)

• The extra benefit resulting from a small increase
  in some activity.

Example The extra points earned on a midterm
from studying one extra hour.
13
Marginal Cost (MC)

• The extra cost resulting from a small increase in
  some activity.

Example The value of relaxing instead of
studying one extra hour.
14
Equate the Margins(the marginal principle)
If MB gt MC, then increase the activity.

• If MB lt MC, then reduce the activity.
• Best bet choose the activity level where MB MC.

15
Marginal Benefit Example

• Phil estimates he could earn 50 points if he
  studies one hour,
• 70 points if he studies two hours,
• 85 points if he studies three hours,
• 95 points if he studies four hours,
• and 100 points if he studies five hours.

16
Marginal Cost Example

• For each hour of studying, Phil sacrifices one
  hour of relaxation.
• He's willing to give up that hour as long as it
  will increase his score by at least 10 points.
• Marginal cost 10 points per hour

17
Equate the Margins Example

• As long as the benefit outweighs the cost, he
  should keep studying. When the cost outweighs
  the benefit, he should quit. Here, four hours is
  the optimal amount.

18
Equate the Margins Comments

• Ignore fixed costs (i.e., those that do not
  change with the activity).

• Include all variable costs (i.e., those that do
  change with the activity).
• Includes both explicit monetary costs and
  implicit opportunity costs

19
Key Economic Principles

• Opportunity Cost
• Equate the Margins

• Diminishing Returns

20
Diminishing Returns

• After some point, the marginal benefit of an
  activity decreases as the activity is increased.

21
The Principle of Diminishing Returns
22
Diminishing Returns is a Short Run Concept

• The Short Run is a period of time over which one
  or more relevant factors is fixed.
• For consumption of pizza,
• the size of your stomach is fixed.
• For production of goods,
• some important input is fixed (e.g., the size of
  the factory).
• Congestion causes diminishing returns.

23
Diminishing returns is not relevant in the long
run

• The Long Run is a period of time long enough so
  all of the relevant factors can be varied.
• For consumption of pizza,
• your stomach eventually has more room.
• For production of goods,
• the amount of all inputs can be varied.
• We dont run into the congestion problem.