Key Principles Of Economics 1 C H A P T E R 2 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin

2 PRINCIPLE of Opportunity Cost  What you sacrifice is the next best choice. To determine opportunity cost we consider only the best of the possible alternatives. PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it.

3 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin PRINCIPLE of Opportunity Cost  As long as resources are scarce, an increase in the production of a good, which necessarily results in a decrease in the production of other goods, means that the production of a good is subject to increasing opportunity cost.  Prices are a measure of opportunity cost because they provide information about the value of one good relative to another.

4 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Opportunity Cost and Production Possibilities  The production possibilities frontier illustrates the concept of opportunity cost for the entire economy.  In order to increase the number of space missions by one, 80 thousand computers will have to be sacrificed.  It explains why the production possibilities frontier curve is negatively sloped.

5 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Marginal PRINCIPLE Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

6 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Marginal Benefit and Marginal Cost  Marginal benefit: the extra benefit resulting from a small increase in some activity.  Marginal cost: the additional cost resulting from a small increase in some activity.

7 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Using the Marginal Principle  Consider this example of how a barbershop applies the marginal principle to decide whether to close or to remain open.

8 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin PRINCIPLE of Diminishing Returns PRINCIPLE of Diminishing Returns Suppose that output is produced with two or more inputs and that we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.

9 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin PRINCIPLE of Diminishing Returns

10 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Spillover PRINCIPLE For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume.

11 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Spillover PRINCIPLE  Another word for spillover is externality. Some goods generate spillover benefits (positive externalities), and others generate spillover costs (negative externalities).  A spillover occurs when the people who are external to a decision are affected by the decision.

12 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Spillover PRINCIPLE  The amount of certain goods produced or consumed by free markets may not be the socially optimal amount.  Externalities are an economic problem because the decisions of consumers and producers tend to be based on their own costs or benefits, not the costs or benefits for society as a whole.

13 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Spillover Benefits  A positive externality occurs when the production or consumption of a good generates benefits that are not confined to the producer or the consumer.

14 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Spillover Benefits Examples of spillover benefits:  A flood control dam that benefits some people who have not paid for it  A contribution to public television benefits some who watch it but have not contributed themselves  A new scientific discovery that treats a common disease  More educated people become better workers and better citizens who benefit those around them

15 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Spillover Costs  A negative externality occurs when the production or consumption of a good generates costs that are not confined to the producer or the consumer. For example: Air pollution Water pollution Noise pollution Ozone depletion

16 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Reality PRINCIPLE  Nominal value: the face value of a sum of money.  Real value: the value of a sum of money in terms of the quantity of goods the money can buy. Reality PRINCIPLE What matters to people is the real value or purchasing power of money or income, not its face value.

17 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Reality PRINCIPLE  The reality principle applies to a variety of important economic measures including: Real wages versus nominal wages Real GDP versus nominal GDP Real interest rates versus nominal interest rates Real money supply versus nominal money supply