The KeyPrinciplesof Economics F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY: © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 2 of 20 1 What is the opportunity cost of running a business? The Opportunity Costs of Time and Invested Funds 2 What are society’s trade-offs between different goods? The Opportunity Cost of Military Spending 3 How do firms think at the margin? Continental Airlines Uses the Marginal Principle 4 What is the rationale for specialization and exchange? Tiger Woods and Weeds 5 Do farmers experience diminishing returns? Fertilizer and Crop Yields 6 How does inflation affect the real minimum wage? The Declining Real Minimum Wage 7 How does inflation affect lenders and borrowers? Repaying Student Loans

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 3 of 20 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

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 4 of 20 THE OPPORTUNITY COSTS OF TIME AND INVESTED FUNDS APPLYING THE CONCEPTS #1: What is the opportunity cost of running 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?

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 5 of 20 THE PRINCIPLE OF OPPORTUNITY COST Opportunity Cost and the Production Possibilities Curve 2.1 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.  FIGURE 2.1 Scarcity and the Production Possibilities Curve

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 6 of 20 THE PRINCIPLE OF OPPORTUNITY COST Opportunity Cost and the Production Possibilities Curve 2.1  FIGURE 2.2 Shifting the Production Possibilities Curve

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 7 of 20 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 one year. Hire 1.8 million additional teachers for one year. Immunize all the children in less-developed countries for the next 33 years. 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?

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 8 of 20 JUST SAY COCA Bolivia is attempting to paint the coca leaf in a new light in an appeal to the United Nations to remove a 45-year old ban on the coca trade. President Morales believes the plant can fuel an economic revival if the country is allowed to develop the trade in non-narcotic coca products. Morales maintains the plant itself is not harmful and argues that legal alternative uses for the plant might actually reduce the illegal cultivation used to make cocaine. Bolivia has struggled with eradicating the coca plant for decades. However, switching the focus from eradication to alternative uses might present a real opportunity for expanding the economy and creating jobs. Coca makes sense economically. In fact, one of Bolivia’s largest companies currently buys over 14 tons of coca leaf for use in teas. The company pays about 15% more for coca leaves than growers receive from cocaine traffickers. Innovation and new technologies developed from the coca plant might push the curve outward. Extra Application 8

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 9 of 20 THE MARGINAL PRINCIPLE 2.2 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.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 10 of 20 THE MARGINAL PRINCIPLE How Many Movie Sequels? 2.2 Number of Movies Marginal Benefit 1$300 million million million  FIGURE 2.3 The Marginal Principle and Movie Sequels Marginal Cost $125 million 150 million 175 million Renting College Facilities Automobile Emissions Standards

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 11 of 20 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:

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 12 of 20 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. Online Games and Market Exchange

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 13 of 20 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 $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.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 14 of 20 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.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 15 of 20 FERTILIZER AND CROP YIELDS APPLYING THE CONCEPTS #5: Do farmers experience diminishing returns? Table 2.1 | FERTILIZER AND CORN YIELD Bags of Nitrogen FertilizerBushels of Corn Per Acre 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?

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 16 of 20 SO LONG SEAFOOD? EXPERTS WARN OF DISASTER The National Fisheries Institute issued a statement that said “Fish stocks naturally fluctuate in population,” and “By developing new technologies that capture target species more efficiently and result in less impact on other species or the environment, we are helping to ensure our industry does not adversely affect surrounding ecosystems or damage native species.” Seafood consumption is up in the U.S. with the average American eating 16.6 pounds of seafood in 2004 versus 15.2 pounds in Fishing accounts for over $80 billion in revenue worldwide. According to some experts over fishing and pollution will virtually wipe out all the world’s fisheries by the year A team of economists and ecologists arrived at that conclusion by extrapolating current trends. The team warned that unless fisheries management practices radically changed we were in the “last century of wild seafood.” Could it be that the increasing global demand for seafood has pushed fishing to the point of diminishing returns? Extra Application 9

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 17 of 20 THE REAL-NOMINAL PRINCIPLE 2.5 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.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 18 of 20 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, Minimum wage per hour$2.00 $5.15 Weekly income from minimum wage Cost of a standard basket of goods Number of baskets per week 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.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 19 of 20 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$40,0001/2 year Inflation: Salary doubles80,0001/4 year Deflation: Salary cut in half20,0001 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.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 20 of 20 marginal benefit marginal cost nominal value opportunity cost production possibilities curve real value