1. The Economic Way of Thinking 10e ©Prentice Hall 2003 1 “The Economic Way of Thinking” 10 th Edition by Paul Heyne, Peter Boettke, and David Prychitko “Opportunity Cost and the Supply of Goods” PowerPoint Slides prepared by Assistant Professor Paul Harris Camden County College

2. The Economic Way of Thinking 10e ©Prentice Hall 2003 2 Chapter Outline I.Introduction II.Refresher on Opportunity Cost III.Cost are tied to Actions, Not Things IV.The Irrelevance of “Sunk Cost” V.Producers’ Cost as Opportunity Cost VI.Marginal Cost as Opportunity Cost VII.Marginal Opportunity Cost VIII.Cost and Supply

3. The Economic Way of Thinking 10e ©Prentice Hall 2003 3 IX.Marginal and Average Cost X.The Cost of a Volunteer Military Force XI.Price Elasticity of Supply XII.Cost as Justification XIII.Once over lightly Chapter Outline

4. The Economic Way of Thinking 10e ©Prentice Hall 2003 4 Introduction The theory of supply, like demand theory, assumes that decision makers face alternatives and choices. These choices are based on a comparison of expected benefits and cost. The incentive to produce and supply scarce goods is shaped by opportunity cost, and the market prices that reflect and inform us of those cost.

5. The Economic Way of Thinking 10e ©Prentice Hall 2003 5 Refresher on Opportunity Cost Question…. Why do poor people travel between cities by bus, while wealthy people are more likely to travel by air? Answer……. The higher one’s income, the higher the opportunity cost of time.

6. The Economic Way of Thinking 10e ©Prentice Hall 2003 6 Refresher on Opportunity Cost Question Question …. Why is it so much harder to find a teenage babysitter in a wealthy residential area than a low- income area? Answer……. Wealthier people go out more so they demand more babysitting services, while wealthy teenagers get generous allowances, so they value a date or leisure time more than the extra money they could earn babysitting.

7. The Economic Way of Thinking 10e ©Prentice Hall 2003 7 Costs are Tied to Actions, Not Things Costs are always tied to actions, decisions, and choices. We must first distinguish the cost of obtaining a good or service, from the cost of providing one. The true cost of things stems from a failure to recognize that only actions have cost, and that actions can entail different costs for different people.

8. The Economic Way of Thinking 10e ©Prentice Hall 2003 8 The Irrelevance of “Sunk Cost” With cost, the most common error is to confuse cost previously incurred with marginal cost. The proper stance for making cost calculations is not to look at the past, for the past is filled with sunk cost, irretrievable cost. The proper stance is to look forward to current opportunity cost. Marginal cost always lies in the future. Sunk cost represent no opportunity for future choice.

9. The Economic Way of Thinking 10e ©Prentice Hall 2003 9 Producers’ Cost as Opportunity Cost The concept of opportunity cost asserts that the amount of money a producer must pay for any resource, human or physical, will depend upon what the owner of that resource can obtain from someone else. The resource that more clearly illustrates the opportunity cost concept is probably land. Land can be used for residential, commercial, or industrial purposes. The cost you pay for the land will be determined by the alternative opportunities that people perceive for its use.

10. The Economic Way of Thinking 10e ©Prentice Hall 2003 10 Marginal Opportunity Cost All opportunity cost are marginal cost and all marginal cost are opportunity cost. Opportunity cost calls attention to the value of the opportunity forgone by an action. Marginal cost calls attention to the change in the existing situation that the action entails. The full name for any cost that is relevant to decision making is “marginal opportunity cost”. All such cost are cost of actions, or decisions; all are attached to particular persons; and all lie in the future.

11. The Economic Way of Thinking 10e ©Prentice Hall 2003 11 Farmer Smith considers producing soybeans and corn this season.Farmer Smith considers producing soybeans and corn this season. If he devotes all of his acreage to soy production, he can produce 14.5 unitsIf he devotes all of his acreage to soy production, he can produce 14.5 units If he produces corn instead, he can produce 10 units.If he produces corn instead, he can produce 10 units. The table on the next slide shows his other production possibilities.The table on the next slide shows his other production possibilities. Farmer Smith considers producing soybeans and corn this season.Farmer Smith considers producing soybeans and corn this season. If he devotes all of his acreage to soy production, he can produce 14.5 unitsIf he devotes all of his acreage to soy production, he can produce 14.5 units If he produces corn instead, he can produce 10 units.If he produces corn instead, he can produce 10 units. The table on the next slide shows his other production possibilities.The table on the next slide shows his other production possibilities. Cost and Supply

12. The Economic Way of Thinking 10e ©Prentice Hall 2003 12 Cost and Supply Soybean Output per Harvest Corn Output per Harvest 14.50 13.51 12.42 11.23 9.94 8.55 7.06 5.47 3.78 1.99 010

13. The Economic Way of Thinking 10e ©Prentice Hall 2003 13 Cost and Supply Corn output Per harvest Soybean output per harvest Smith’s production possibilities for corn and soy. for corn and soy. Smith’s production possibilities for corn and soy. for corn and soy. ` The marginal cost of a second unit of corn is 1.1 units of soy. unit of corn is 1.1 units of soy. The marginal cost of Producing a 9 th unit Of corn is 1.8 units of Soybeans.

14. The Economic Way of Thinking 10e ©Prentice Hall 2003 14 The data on the preceding slide indicates increasing opportunity cost of producing each good. Smith has to be concerned with the relative prices of both soy and corn to make his production decisions. Based on the relative prices, producers consider marginal cost of production when deciding upon which outputs, and which levels of output to produce. Cost and Supply

15. The Economic Way of Thinking 10e ©Prentice Hall 2003 15 Relative prices further informs producers of the marginal cost, and the marginal benefits, of their alternative production plans. The supply curve for corn is an upward sloping curve which reflects the marginal cost of producing corn. The area under the curve reflects the total cost of production. The supply curve illustrates the alternative amounts of a good supplied at alternative prices. Cost and Supply

16. The Economic Way of Thinking 10e ©Prentice Hall 2003 16 Cost and Supply Supply Schedule for Corn. Supply Schedule for Corn.

17. The Economic Way of Thinking 10e ©Prentice Hall 2003 17 Cost and Supply Supply Curve for Corn

18. The Economic Way of Thinking 10e ©Prentice Hall 2003 18 Marginal cost is not the same as average cost.Marginal cost is not the same as average cost. –Marginal cost reflects the change in total cost from producing one more unit. –Average Cost is total cost divided by the number of units produced. Marginal cost is the consequence of action; therefore it should be the guide to action.Marginal cost is the consequence of action; therefore it should be the guide to action. –Economic decisions are always made with an eye towards the future. Marginal cost is not the same as average cost.Marginal cost is not the same as average cost. –Marginal cost reflects the change in total cost from producing one more unit. –Average Cost is total cost divided by the number of units produced. Marginal cost is the consequence of action; therefore it should be the guide to action.Marginal cost is the consequence of action; therefore it should be the guide to action. –Economic decisions are always made with an eye towards the future. Marginal and Average Cost

19. The Economic Way of Thinking 10e ©Prentice Hall 2003 19 Marginal and Average Cost Units of Corn produced Total Cost of Producing corn Marginal Cost Average Cost 0000 1$1 2$2.10$1.10$1.05 3$3.30$1.20$1.05

20. The Economic Way of Thinking 10e ©Prentice Hall 2003 20 The Cost of a Volunteer Military Force Since 1999 there has been a concern about enlistment and recruitment shortages in the military.Since 1999 there has been a concern about enlistment and recruitment shortages in the military. –As a result there have been arguments for initiating a draft. –But is a draft the less costly way to organize a military force? The “cost” we are referring to is the cost to the taxpayer.The “cost” we are referring to is the cost to the taxpayer. Since 1999 there has been a concern about enlistment and recruitment shortages in the military.Since 1999 there has been a concern about enlistment and recruitment shortages in the military. –As a result there have been arguments for initiating a draft. –But is a draft the less costly way to organize a military force? The “cost” we are referring to is the cost to the taxpayer.The “cost” we are referring to is the cost to the taxpayer.

21. The Economic Way of Thinking 10e ©Prentice Hall 2003 21 The best way to determine the cost of a soldier is to offer a bribe and keep raising it until it is accepted.The best way to determine the cost of a soldier is to offer a bribe and keep raising it until it is accepted. –Or you could simply pay low wages and force everyone to join with a draft. The opportunity cost of serving in the military is the forgone wages that could be earned in other occupations.The opportunity cost of serving in the military is the forgone wages that could be earned in other occupations. The best way to determine the cost of a soldier is to offer a bribe and keep raising it until it is accepted.The best way to determine the cost of a soldier is to offer a bribe and keep raising it until it is accepted. –Or you could simply pay low wages and force everyone to join with a draft. The opportunity cost of serving in the military is the forgone wages that could be earned in other occupations.The opportunity cost of serving in the military is the forgone wages that could be earned in other occupations. The Cost of a Volunteer Military Force

22. The Economic Way of Thinking 10e ©Prentice Hall 2003 22 When the government bids for military personnel it should raise its offer price until it can get the exact number of enlistments it needs. Studies show that the wage offer should be at least $16,000 per year. Will the taxpayers go for it? The Cost of a Volunteer Military Force

23. The Economic Way of Thinking 10e ©Prentice Hall 2003 23 Price Elasticity of Supply Price Elasticity of Supply is calculated by taking the % change in quantity supplied in the numerator, divided by the % change in price in the denominator. Price and quantity supplied are directly related, so regardless of the elasticity, when prices rise, total revenue rises, and when prices fall total revenue falls. Time is the major determinant of Price Elasticity of Supply.

24. The Economic Way of Thinking 10e ©Prentice Hall 2003 24 If producers do not have the time to secure additional resources when prices change, supply will be perfectly inelastic.If producers do not have the time to secure additional resources when prices change, supply will be perfectly inelastic. With time to react to price changes supply becomes more elastic.With time to react to price changes supply becomes more elastic. –If the percentage in quantity supplied is greater than the percentage change in price, then supply will be elastic. –If the percentage change in quantity supplied is less than the percentage in change in price, then supply will be inelastic. Price Elasticity of Supply

25. The Economic Way of Thinking 10e ©Prentice Hall 2003 25 Cost Justification Many people think that prices should be related closely to cost.Many people think that prices should be related closely to cost. They think that if prices are significantly above cost then producers are pursuing some unfair advantage.They think that if prices are significantly above cost then producers are pursuing some unfair advantage. –This way of thinking is known as justification. –Cost is always the product of supply and demand.

26. The Economic Way of Thinking 10e ©Prentice Hall 2003 26 Once Over Lightly Supply curves reflect people’s estimates of the value of alternative opportunities. Quantity supplied and demanded depends on the economizing choices based on the opportunity costs of people. Cost is the value of opportunities that people sacrifice. Past expenditures cannot be affected by present decisions. These are sunk cost. Opportunity cost is necessarily marginal cost. Supply depends on cost. The cost of supplying is the value of the opportunities forgone by the act of supplying.

27. The Economic Way of Thinking 10e ©Prentice Hall 2003 27 There is a direct relationship between price and quantity supplied. The supply curve slopes upward and to the right. Price Elasticity of Supply is the% change in quantity supplied divided by the % change in price. Only actions have cost. Ask yourself “cost to whom”, “cost of doing what?” Once Over Lightly

28. The Economic Way of Thinking 10e ©Prentice Hall 2003 28 End of Chapter 4 Next Chapter 5 Supply and Demand: A Process of Cooperation