Lesson 1-2 Opportunity Cost

Objectives Describe why every decision involves trade-offs. Explain the concept of opportunity cost. Explain how people make decisions by thinking at the margin.

Reviewing Scarcity Scarcity means that we live in a world with unlimited wants, but limited resources. Because we can’t have everything, we have to make choices. In making our choices, we seek to maximize the satisfaction of our needs and wants. Presented with the same choices, people will make different choices.

Every Decision involves Trade-offs Because of scarcity, we can’t have everything, so we pick and choose the things we want most. Whenever we make a choice, we leave behind all the other choices we could have made. All of the things we give up when we make a choice are called trade-offs.

Examples of Trade-offs Luigi goes to the Olive Garden and orders lasagna, salad and a Coke. He could have had spaghetti, rigatoni, fettuccini or a number of other entrees on the menu. Instead of salad, he could have had 2 different kinds of soup and instead of Coke, he could have had Sprite, Diet Coke, tea, coffee, or water. Every choice Luigi made meant many other choices were forgone. In a way, everything Luigi did not choose is traded for what he chose. Thus every possible choice that was not made is a trade-off.

Taking Luigi’s Trade-off a Little Farther In the example, Luigi went to Olive Garden, but he could have gone to dozens of other restaurants. Or, instead of using the money he spent on food, he could have gone to a baseball game, bought a new shirt, had the oil changed in his car, or given the money away. These and every other possible option were forgone and thus, are trade-offs.

Guns or Butter Decisions Looking at the national economy, a country has to decide how of its resources it will devote to military goods and how much to consumer goods. As an economy devotes more of its resources to producing more military goods (guns) it must reduce its production of consumer goods like butter, and vice versa. 

Thinking About Trade-Offs in Students’ Lives Trade-offs are all the alternatives that we give up whenever we choose one course of action over others. Thinking About Trade-Offs in Students’ Lives Students that work AP Students High School Dropouts

The Real Cost of Things is Not Money People automatically think of cost in terms of dollars and cents. Dominos Pizza $12 Dell Notebook Computer $499 New Toyota Corolla $16,250 KB Home in League City $142,495 To an economist, these are just prices and NOT the real cost. So what is the real cost of something?

The Real Cost of Things OR Simply stated, the real cost of anything is the most desirable alternative given up as a result of a decision. Money is never the most desirable alternative. People really don’t want money. They want what money can buy. To an economist, the real cost of something is known as the opportunity cost. When we talk about costs in class, we are referring to the opportunity cost. OR

Reviewing Trade-Offs & Opportunity Cost Trade-offs are all the alternatives that we give up whenever we choose one course of action over others. The most desirable alternative given up as a result of a decision is known as the opportunity cost.

An Example of Trade-Offs & Opportunity Cost Tom wants to buy several pieces of electronics, but can afford only one of the choices on his list. For simplicity’s sake, assume all of these items have the same price. HDTV XBOX One HD Camera Notebook Computer Playstation 4 Smart Phone Desktop Computer Stereo System Tablet

How We Make Economic Decisions Tom has many different choices to consider. He could sit down and write out the choices and the benefits of each, but he would also have to consider what he would be giving up with each choice. For example, when thinking about buying an Xbox One, Tom would consider all the games he could play and the enjoyment he would get from them, but he would also have to consider that the Xbox’s high resolution graphics would look poor on his old television. Most people don’t make up a decision making grid like you’ll find in the book, but they go through the same process (sometimes in just a few seconds) for all kinds of decisions. The bigger the decision the more time spent considering the costs and benefits.

Tom’s Decision: Trade-Offs & Opportunity Cost Tom wants everything on the list, but after thinking about it, he narrowed his final decision down to either the HDTV or the notebook computer. After thinking about it for a while and discussing it with his wife, Tom bought the HDTV. Tom bought HDTV Opportunity Cost Notebook Computer Trade-Offs HD Camera, Smartphone, Tablet, XBOX One, PS4, Stereo, Desktop Computer, Notebook Computer Note that the opportunity cost is listed as a trade-off too. It is by definition the most valuable of the trade-offs.

Jack bought Notebook Computer Opportunity Cost Desk Computer Jack and Sam are friends of Tom’s with similar interests. Here are their decisions. Jack bought Notebook Computer Opportunity Cost Desk Computer Trade-Offs HD Camera, Smartphone, Tablet, XBOX One, PS4, Stereo, Desktop Computer, HDTV Sam bought XBOX One Opportunity Cost HDTV Trade-Offs HD Camera, Smartphone, Tablet, Notebook Computer, PS4, Stereo, Desktop Computer, HDTV

Tom, Jack and Sam have similar interests, but made different choices. Remember the concept of Rational Maximizers? Different people faced with the same choices may make very different decisions. To the people making these choices, their decisions make perfect sense and are expected to give the buyer the maximum possible satisfaction of their wants. Beyond making different choices, the costs and trade-offs will vary depending on the person making the choice.

Different Choices, Different Costs Imagine a group of friends going out to dinner together. Even though they are sitting at the same table and may even order the same foods, it is likely they will have different costs and trade-offs for going to the dinner.

All or Nothing Decision Making The decision as to whether to jump out of an airplane or not is an all or nothing decision. You either jump (hopefully with a parachute) or you don’t. Most decisions in life are not all or nothing decisions.

Marginal Decision Making Most decisions involve marginal thinking. When you decide how much more or less of to do (or buy), you are thinking at the margin.

Marginal Decision Making When you decide how much more or less of to do (or buy), you are thinking at the margin. For example, let’s consider the decision to fix your hair in the morning before school.

Example: Marginal Hair Styling Minutes Spent Which is greater? Keep Styling? Cost Benefit 5 x yes 10 15 20 25 maybe 30 no

Marginal Decisions Made Simple Minutes Spent Which is greater? Keep Styling? Cost Benefit 5 x yes 10 15 20 25 maybe 30 no IF THE BENEFIT > THE COST , THEN KEEP GOING IF THE COST > THE BENEFIT, THEN STOP IF THE BENEFIT = THE COST, THEN STOP OR GO

Common Marginal Decisions IF THE BENEFIT > THE COST , THEN KEEP GOING IF THE COST > THE BENEFIT, THEN STOP IF THE BENEFIT = THE COST, THEN STOP OR GO Will you have another bowl of ice cream? Should I exercise for another 30 minutes? Do you want a small, medium, or large fries with your Big Mac? Will you study for another hour? Should you much gas should I buy at $1.99 a gallon?

Marginal Basketball If you make the first basket you get 2 points on your next test. If you miss, then you sit down without penalty. If you make the next basket, you will get an additional 3 points on your next test. If you miss, then you lose the 2 points you got from the first basket and sit down. If you make the 3rd basket, you will get an additional 5 points on your next test. If you miss, then you lose your 10 points and you stand in front of the class for the rest of the period.

Review Questions Describe why every decision involves trade-offs. Explain the concept of opportunity cost. Explain how people make decisions by thinking at the margin.

Terms to Know Define these terms and use them in a sentence that shows its meaning. trade-off guns or butter opportunity cost thinking at the margin benefit forgone all or nothing