1. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 2 Key Principles of Economics

2. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin What Is a Principle? A principle is a simple truth that most people understand and accept.A principle is a simple truth that most people understand and accept. The following five principles provide the underlying logic behind economic analysis:The following five principles provide the underlying logic behind economic analysis: Principle of Opportunity CostPrinciple of Opportunity Cost Marginal PrincipleMarginal Principle Principle of Diminishing ReturnsPrinciple of Diminishing Returns Spillover PrincipleSpillover Principle Reality PrincipleReality Principle

3. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin PRINCIPLE of Opportunity Cost PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it. Opportunity cost: What you sacrifice to get something.Opportunity cost: What you sacrifice to get something.

4. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Opportunity Cost and Production Possibilities A drought decreases the amount of electric power available for aluminum smelting and irrigation, shifting the production possibilities curve inward.A drought decreases the amount of electric power available for aluminum smelting and irrigation, shifting the production possibilities curve inward. The region’s economy moved from point i to point f, with aluminum production dropping to zero.The region’s economy moved from point i to point f, with aluminum production dropping to zero.

5. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Using the Principle: The Opportunity Cost of a College Degree Tuition and books (4 years at $10,000 per year) $40,000 Opportunity cost of college time (4 years at $20,000 per year $80,000 Total opportunity cost $120,000

6. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Marginal PRINCIPLE Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost; reduce the level of an activity if its marginal cost exceeds its marginal benefit. If possible, pick the level at which the activity’s marginal benefit equals its marginal cost.

7. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Marginal Benefit and Marginal Cost Marginal benefit: The extra benefit resulting from a small increase in some activity.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.Marginal cost: The additional cost resulting from a small increase in some activity.

8. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Marginal Principle and TV Time If the opportunity cost of TV time is $0.35 per hour and pedaling is not required for TV time, the marginal principle is satisfied at point n, and the child will watch 20 hours of TV per week.If the opportunity cost of TV time is $0.35 per hour and pedaling is not required for TV time, the marginal principle is satisfied at point n, and the child will watch 20 hours of TV per week.

9. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Marginal Principle and TV Time If pedaling is required and the discomfort of pedaling is $0.85 per hour, the marginal cost of TV time is $1.20 (equal to $0.35 + $0.85), and the marginal principle is satisfied at point m, with only 3 hours of TV time per week.If pedaling is required and the discomfort of pedaling is $0.85 per hour, the marginal cost of TV time is $1.20 (equal to $0.35 + $0.85), and the marginal principle is satisfied at point m, with only 3 hours of TV time per week.

10. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin PRINCIPLE of Diminishing Returns PRINCIPLE of Diminishing Returns Suppose output is produced with two or more inputs and we increase one input while holding the other input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.

11. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Total Product Curve: A curve showing the relationship between the quantity of labor and the quantity of output.Total Product Curve: A curve showing the relationship between the quantity of labor and the quantity of output. Total Product Curve and Diminishing Returns Diminishing Returns for Pizza Number of Workers Total Pizza Produced 112 218 321 4 22 22

12. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Marginal Product of Labor: The change in output from one additional worker.Marginal Product of Labor: The change in output from one additional worker. Marginal Product of Labor and Diminishing Returns Diminishing Returns for Pizza Number of Workers Total Pizza Produced Marginal Product 12121 6182 3213 1224

13. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Diminishing Returns in the Short Run and the Long Run Short Run:Short Run: A period of time over which one or more factors of production is fixed; in most cases, a period of time over which a firm cannot modify an existing facility or build a new one. Long Run: A period of time long enough that a firm can change all the factors of production, meaning that a firm can modify its existing production facility or build a new one.Long Run: A period of time long enough that a firm can change all the factors of production, meaning that a firm can modify its existing production facility or build a new one.

14. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Spillover PRINCIPLE Spillover PRINCIPLE For some goods the costs or benefits associated with producing or consuming those goods are not confined to the person or organization producing or consuming them. Spillover: A cost or benefit experienced by people who are external to the decision about how much of a good to produce or consume.Spillover: A cost or benefit experienced by people who are external to the decision about how much of a good to produce or consume.

15. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Reality PRINCIPLE Reality PRINCIPLE What matters to people is the real value of money or income–its purchasing power–not the face value of money or income. Nominal value: The face value of an amount of money.Nominal value: The face value of an amount of money. Real value: The value of an amount of money in terms of the quantity of goods the money can buy.Real value: The value of an amount of money in terms of the quantity of goods the money can buy.