© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko “The Economic Way of Thinking” 11 th Edition Chapter 4: Opportunity Costs and the Supply of Goods

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 2 of 27 Chapter 4 Outline Introduction Refresher on Opportunity Costs Costs are Tied to Actions, Not Things The Irrelevance of “Sunk Costs” Producers’ Costs as Opportunity Costs Marginal Opportunity Costs Costs and Supply

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 3 of 27 Chapter 4 Outline The Supply Curve Supply Itself Can Change Marginal and Average Costs The Cost of a Volunteer Military Force Price Elasticity of Supply Cost as Justification

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 4 of 27 Introduction The theory of supply, like demand theory, assumes that decision makers face alternatives and choices. –Choices based on comparing expected benefits and costs The incentive to produce and supply scarce goods is shaped by opportunity cost and the market prices that reflect and inform us of those costs.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 5 of 27 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.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 6 of 27 Refresher on Opportunity Cost Question –Why is it so much harder to find a teenage babysitter in a wealthy residential area than in 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.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 7 of 27 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.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 8 of 27 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 to not 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 represents no opportunity for future choice.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 9 of 27 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.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 10 of 27 Producers’ Cost as Opportunity Cost The resource that most clearly illustrates the opportunity cost concept is probably land. Land can be used by residential, commercial, or industrial purposes. –The cost you pay for land will be determined by the alternative opportunities that people perceive for its use.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 11 of 27 Marginal Opportunity Cost All opportunity costs are marginal costs and all marginal costs are opportunity costs. Opportunity cost calls attention to the value of the opportunity foregone by an action. Marginal cost calls attention to the change in the existing situation that the action entails. The full name of any cost that is relevant to decision making is “marginal opportunity cost.” All such costs are costs of actions, or decisions; all are attached to particular persons; and all lie in the future.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 12 of 27 Costs and Supply Farmer Smith considers producing soybeans and corn this season. If 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. The table on the next slide shows his other production possibilities.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 13 of 27 Cost and Supply Soybean Output per Harvest Corn Output per Harvest

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 14 of 27 Cost and Supply Corn output per harvest Soybean output per harvest Smith’s production possibilities for corn and soy. Smith’s production possibilities for corn and soy. ` The marginal cost of a second 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.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 15 of 27 Cost and Supply 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 costs of production when deciding upon which outputs, and which levels of output to produce.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 16 of 27 The Supply Curve Relative prices further inform 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.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 17 of 27 Supply Itself Can Change Anything that changes the marginal cost of production will tend to change (or shift) the overall supply curve. –Technology changes –Prices of substitutes –Change in expected price –Change in overall number of suppliers

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 18 of 27 Marginal and Average Costs 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. –Economic decisions are always made with an eye towards the future.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 19 of 27 Marginal and Average Cost Units of Corn Produced Total Cost of Producing Corn Marginal Cost Average Cost $1.00 2$2.10$1.10$1.05 3$3.30$1.20$1.10

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 20 of 27 The Cost of a Volunteer Military Force 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.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 21 of 27 The Cost of a Volunteer Military Force 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 foregone wages that could be earned in other occupations.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 22 of 27 Price and 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. Regardless of the elasticity, when prices rise, total revenue rises; when prices fall, total revenue falls. Time is the major determinant of price elasticity of supply

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 23 of 27 Price Elasticity of Supply 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. –If the percentage change 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 change in price, then supply will be inelastic.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 24 of 27 Cost as Justification 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. –This way of thinking is known as justification and has infiltrated our laws. –Cost is always the product of supply and demand.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 25 of 27 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 costs.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 26 of 27 Once Over Lightly Opportunity cost is necessarily marginal cost. Supply depends on cost. The cost of supplying is the value of the opportunities foregone by the act of supplying.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 27 of 27 End of Chapter 4