The KeyPrinciplesof Economics F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S...

The Key Principlesof Economics

FERNANDO QUIJANO, YVONN QUIJANO,

KYLE THIEL & APARNA SUBRAMANIAN

PREPARED BY:

© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez

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THE PRINCIPLE OF OPPORTUNITY COST

The Cost of College

2.1

Opportunity cost of money spent on tuition and books $ 40,000

Opportunity cost of college time (four years working for $20,000 per year) 80,000

Economic cost or total opportunity cost $120,000

• opportunity cost

What you sacrifice to get something

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THE OPPORTUNITY COSTS OF TIME AND INVESTED FUNDS

APPLYING THE CONCEPTS #1: What is the opportunity cost ofrunning a business?

• Inheritance = $10,000

• Expenses = $12,000

• Opportunity cost of funds invested = $800

• Opportunity cost of your time = $30,000

• Bottom line: The cost of doing business is $32,800 per year.

The principle of opportunity cost applies to the cost of running a business. Suppose you inherit $10,000 and decide to use the money to start a lawn-care business.

Based on the following information, what’s your annual cost of doing business?

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Opportunity Cost and the Production Possibilities Curve

2.1

• production possibilities curve

A curve that shows the possiblecombinations of products that aneconomy can produce, given that itsproductive resources are fullyemployed and efficiently used.

FIGURE 2.1Scarcity and the ProductionPossibilities Curve

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Opportunity Cost and the Production Possibilities Curve

2.1

FIGURE 2.2Shifting the ProductionPossibilities Curve

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THE OPPORTUNITY COST OF MILITARY SPENDING

APPLYING THE CONCEPTS #2: What are society’s trade-offs between different goods?

We can use the principle of opportunity cost to explore the cost of military spending. Economists estimate the cost of the Iraq War to be $540 billion.

• Each $100 billion spent on the war could instead support one of the following programs:

•Enroll 13 million preschool children in the Head Start program for oneyear.

•Hire 1.8 million additional teachers for one year.

•Immunize all the children in less-developed countries for the next 33years.

• In terms of domestic security (i.e., securing ports/cargo facilities, more police, airline screening improvement and more), the cost of implementation would be about $31 billion – a fraction of the cost of the war.

Do the benefits from the war exceed its opportunity cost? Would money spent on domestic security be more beneficial than the money spent on war?

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THE MARGINAL PRINCIPLE2.2

• marginal benefitThe additional benefit resulting from a small increase in some activity.

• marginal costThe additional cost resulting from a small increase in some activity.

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THE MARGINAL PRINCIPLE

How Many Movie Sequels?

2.2

Number of Movies

Marginal Benefit

1 $300 million

2 210 million

3 135 million

FIGURE 2.3The Marginal Principleand Movie Sequels

Marginal Cost

$125 million

150 million

175 million

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CONTINENTAL AIRLINES USES THE MARGINAL PRINCIPLE

APPLYING THE CONCEPTS #3: How do firms think at the margin?

• 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?

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:

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THE PRINCIPLE OF VOLUNTARY EXCHANGE

Exchange and Markets

2.3

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.

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TIGER WOODS AND WEEDS

APPLYING THE CONCEPTS #4: What is the rationale for specialization and exchange?

• Average earnings per hour of Tiger Woods = $1000

• Opportunity cost of weed whacking = $1000

• Gardener’s fee (20 hours @ $10.00 per hour) = $200

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?

Use the principle of voluntary exchange to explain why Tiger should hire the less productive gardener.

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THE PRINCIPLE OF DIMINISHING RETURNS

Diminishing Returns from Sharing a Production Facility

2.4

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.

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FERTILIZER AND CROP YIELDS

APPLYING THE CONCEPTS #5: Do farmers 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 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?

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THE REAL-NOMINAL PRINCIPLE2.5

• nominal valueThe face value of an amount of money.

• real valueThe value of an amount of money in terms of what it can buy.

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THE DECLINING REAL MINIMUM WAGE

APPLYING THE CONCEPTS #6: How does inflation affect the real minimum wage?

Table 2.2 | THE REAL VALUE OF THE MINIMUM WAGE, 1974-2005

1974 2005

Minimum wage per hour $2.00 $5.15

Weekly income from minimum wage

80.00 206.00

Cost of a standard basket of goods

49.00 193.00

Number of baskets per week 1.63 1.07

Between 1974 and 2005, the federal minimum wage increased from $2.00 to $5.15. Was the typical minimum-wage worker better or worse off in 2005?

We can apply the real-nominal principle to see what’s happened over time to the real value of the federal minimum wage.

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REPAYING STUDENT LOANS

APPLYING THE CONCEPTS #7: How does inflation affect lenders and borrowers?

Table 2.3 | EFFECT OF INFLATION AND DEFLATION ON LOAN REPAYMENT

Change in Prices and Wages

Annual Salary

Years of Work to Repay $20,000 Loan

Stable $40,000 1/2 year

Inflation: Salary doubles 80,000 1/4 year

Deflation: Salary cut in half 20,000 1 year

Suppose you finish college with student loans that must be repaid in 10 years. Which is better for you, inflation (rising prices) or deflation (falling prices)? As an example, suppose you finish college this year with $20,000 in student loans and start a job that pays a salary of $40,000 in the first year. In 10 years, you will repay your college loans.

Which would you prefer, stable prices, rising prices, or falling prices? We can use the real-nominal principle to compute the real cost of repaying your loans.

The KeyPrinciplesof Economics F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S...

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