INTRODUCTION TO ECONOMICS (CONTINUED………):Opportunity Cost

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Introduction to Economics ECO401

Lesson 1.2

INTRODUCTION TO ECONOMICS (CONTINUED.........)

Optimum means producing the best possible results (also optimal).

Equity in economics means a situation in which every thing is treated fairly or equally, i.e.

according to its due share. So if the lives of all individuals are deemed to have equal value,

equity would demand that all of them have equal financial net worth.

Nepotism means doing unfair favors for near ones when in power.

Microeconomics and Macroeconomics:

Microeconomics deals with the behavior of individual elements in the economy.

Macroeconomics deals with the behavior of the economy as whole or on aggregate level.

Rational choice is the choice based on pure reason and without succumbing to one's

emotions or whims.

Barter trade is a non-monetary system of trade in which "goods" not money is exchanged.

This was the system used in the world before the advent of coins and currency.

Opportunity Cost:

The opportunity cost of a particular choice is the satisfaction that would have been derived

from the next best alternative foregone; in other words, it is what must be given up or

sacrificed in making a certain choice or decision.

Marginal Cost and Marginal Benefit:

Marginal cost is the increment to total costs of producing an additional unit of some good or

service. There are other broader definitions as well.

Marginal benefit is the increment to total benefit derived from consuming an additional unit of

good or service. There are other broader definitions as well.

Production Possibility Frontier (PPF):

Production possibility frontier (PPF) is the curve which joins all the points showing the

maximum amount of goods and services which the country can produce in a given time with

limited resources, given a specific state of technology.

Economic growth is an increase in the total output of a country over time.

Introduction to Economics ECO401

END OF UNIT 1 - EXERCISES

Could production and consumption take place without money? If you think they could,

give examples.

Yes. People could produce things for their own consumption. For example, people could grow

vegetables in their garden or allotment; they could do their own painting and decorating.

Alternatively people could engage in barter: they could produce things and then swap them for

goods that other people had produced.

Must goods be at least temporarily unattainable to be scarce?

Goods need not be unattainable to be scarce. Because people's incomes are limited, they can

not have everything they want from shops, even though the shops are stocked full. If all items in

shops were free, the shelves would soon be emptied!

If we would all like more money, why does the government not print a lot more? Could it

not thereby solve the problem of scarcity `at a stroke'?

The problem of scarcity is one of a lack of production. Simply printing more money without

producing more goods and services will merely lead to inflation. To the extent that firms cannot

meet the extra demand (i.e. the extra consumer expenditure) by extra production, they will

respond by putting up their prices. Without extra production, consumers will be unable to buy

any more than previously.

Which of the following are macroeconomic issues, which are microeconomic ones and

which could be either depending on the context?

a) Inflation.

b) Low wages in certain service industries.

c) The rate of exchange between the dollar and the rupee.

d) Why the price of cabbages fluctuates more than that of cars.

e) The rate of economic growth this year compared with last year.

f)The decline of traditional manufacturing industries.

a) Macro. It refers to a general rise in prices across the whole economy.

b) Micro. It refers to specific industries

c) Either. In a world context, it is a micro issue, since it refers to the price of one

currency in terms of one other. In a national context it is more of a macro issue,

since it refers to the exchange rate at which all Pakistanis goods are traded

internationally. (This is certainly a less clearcut division that in (a) and (b) above.)

d) Micro. It refers to specific products.

e) Macro. It refers to the general growth in output of the economy as a whole.

f)Micro (macro in certain contexts). It is micro because it refers to specific industries. It

could, however, also help to explain the macroeconomic phenomena of high

unemployment or balance of payments problems.

Assume that you are looking for a job and are offered two. One is more unpleasant to do,

but pays more. How would you make a rational choice between the two jobs?

You should weigh up whether the extra pay (benefit) from the better paid job is worth the extra

hardship (cost) involved in doing it.

How would the principle of weighing up marginal costs and benefits apply to a worker

deciding how much overtime to work in a given week?

The worker would consider whether the extra pay (the marginal benefit) is worth the extra effort

and loss of leisure (the marginal cost).

Introduction to Economics ECO401

Would it ever be desirable to have total equality in an economy?

The objective of total equality may be regarded as desirable in itself by many people. There are

two problems with this objective, however. The first is in defining equality. If there were total

equality of incomes then households with dependants would have a lower income per head than

households where everyone was working. In other words, equality of incomes would not mean

equality in terms of standards of living.

If on the other hand, equality were to be defined in terms of standards of living, then should the

different needs of different people be taken into account? Should people with special health or

other needs have a higher income? Also, if equality were to be defined in terms of standards of

living, many people would regard it as unfair that people should receive different incomes

(according to the nature of their household) for doing the same amount of work.

The second major problem concerns incentives. If all jobs were to be paid the same (or people

were to be paid according to the composition of their household), irrespective of people's efforts

or skills, then what would be the incentive to train or to work harder?

If there are several other things you could have done, is the opportunity cost the sum of

all of them?

No. It is the sacrifice involved in the next best alternative.

What is the opportunity cost of spending an evening revising for an economics exam?

What would you need to know in order to make a sensible decision about what to do that

evening?

The next best alternative might be revising for another exam, or it might be taking time off to

relax or to go out. To make a sensible decision, you need to consider these alternatives and

whether they are better or worse for you than studying for the economics exam. One major

problem here is the lack of information. You do not know just how much the extra study will

improve your performance in the exam, because you do not know in advance just how much you

will learn and you do not know what is going to be on the exam paper. Similarly you do not

know this information for studying for other exams.

Make a list of the benefits of higher education.

The benefits to the individual include: increased future earnings; the direct benefits of being

more educated; the pleasure of the social contacts at university or college.

Is the opportunity cost to the individual of attending higher education different from the

opportunity costs to society as a whole?

Yes. The opportunity cost to society as a whole would include the costs of providing tuition

(staffing costs, materials, capital costs, etc.), which could be greater than any fees the student

may have to pay. On the other hand, the benefits to society would include benefits beyond those

received by the individual. For example, they would include the extra profits employers would

make by employing the individual with those qualifications.

There is a saying in economics, `There is no such thing as a free lunch' (hence the sub-

title for this box). What does this mean?

That there is always (or virtually always) an opportunity cost of anything we consume. Even if

we do not incur the cost ourselves (the `lunch' is free to us), someone will incur the cost (e.g. the

institution providing the lunch).

Are any other (desirable) goods or services truly abundant?

Very few! Possibly various social interactions between people, but even here, the time to enjoy

them is not abundant.

Introduction to Economics ECO401

Under what circumstances would the production possibility curve be (a) a straight line;

(b) bowed in toward the origin? Are these circumstances ever likely?

a) When there are constant opportunity costs. This will occur when resources are equally

suited to producing either good. This might possibly occur in our highly simplified world

of just two goods. In the real world it is unlikely.

b) When there are decreasing opportunity costs. This will occur when increased

specialization in one good allows the country to become more efficient in its production.

It gains `economies of scale' sufficient to offset having to use less suitable resources.

Will economic growth necessarily involve a parallel outward shift of the production

possibility curve?

No. Technical progress, the discovery of raw materials, improved education and training, etc.,

may favour one good rather than the other. In such cases the gap between the old and new

curves would be widest where they meet the axis of the good whose potential output had grown

more.

Do you agree with the positions that the eight countries (including Pakistan) have been

given in the economics systems spectrum diagram? Explain why or why not.

Given that there is no clearly defined scale by which government intervention or free-marketness

is measured, the precise position of the countries along the spectrum is open to question.

Can you think of any examples where prices and wages do not adjust very rapidly to a

shortage or surplus? For what reasons might they not do so?

Many prices set by companies are adjusted relatively infrequently: it would be

administratively too costly to change them every time there was a change in demand.

For example a mail order company, where all the items in its catalogue have a printed

price, would find it costly to adjust prices very frequently, since that would involve printing

a new catalogue, or at least a new price list.

Many wages are set annually by a process of collective bargaining. They are not adjusted

in the interim.

Why do the prices of fresh vegetables fall when they are in season? Could an individual

farmer prevent the price falling?

Because supply is at a high level. The increased supply creates a surplus which pushes down

the price. Individual farmers could not prevent the price falling. If they continued to charge the

higher price, consumers would simply buy from those farmers charging the lower price.

If you were the owner of a clothes shop, how would you set about deciding what prices to

charge for each garment at the end of season sale?

You would try to reduce the price of each item as little as was necessary to get rid of the

remaining stock. The problem for shop owners is that they do not have enough information

about consumer demand to make precise calculations here. Many shops try a fairly cautious

approach first, and then, if that is not enough to sell all the stock, they make further `end of sale'

reductions later.

The number of owners of CD players has grown rapidly and hence the demand for CDs

has also grown rapidly. Yet the prices of CDs have fallen. How could this come about?

· The costs of manufacturing CDs may have fallen with improvements in technology and

mass-production economies.

· Competition from increased numbers of manufacturers may have increased supply of CDs

and driven prices down.

Introduction to Economics ECO401

· The advent of copying tracks from the internet reduces the demand for CDs. This change

in demand has further compounded the fall in price.

Which of the following are positive statements, which are normative statements and

which could be either depending on the context?

a) Cutting the higher rates of income tax will redistribute incomes from the

poor to the rich.

b) It is wrong that inflation should be reduced if this means that there will be

higher unemployment.

c) It is wrong to state that putting up interest rates will reduce inflation.

d) The government should raise interest rates in order to prevent the

exchange rate falling.

e) Current government policies should reduce unemployment.

a) Positive. This is merely a statement about what would happen.

b) Normative. The statement is making the value judgment that reducing inflation is a less

desirable goal than the avoidance of higher unemployment.

c) Positive. Here the word `wrong' means `incorrect' not `morally wrong'. The statement is

making a claim that can be tested by looking at the facts. Do higher interest rates reduce

inflation, or don't they?

d) Both. The positive element is the claim that higher interest rates prevent the exchange

rate falling. This can be tested by an appeal to the facts. The normative element is the

value judgment that the government ought to prevent the exchange rate falling.

e) Either. It depends what is meant. If the statement means that current government

policies are likely to reduce unemployment, the statement is positive. If, however, it

means that the government ought to direct its policies towards reducing unemployment,

the statement is normative.

Explain in words what is happening in the following diagram.

T h e p r ic e m e c h a n is m : th e e f fe c t o f th e d is c o v e r y o f r a w m a te r ia ls

F a c to r M a rk e t

Si ↓

Si ↑

Pi ↓

s u rp lu s

u n t il D i = S i

( S i > D i)

Di ↑

G o o d s M a rk e t

Sg ↓

Pi ↓

Sg ↑

Pg ↓

s u rp lu s

u n t il D g = S g

(S g > D g)

Dg ↑

The new discovery of raw material i means an increase in the supply i. This causes a surplus

(excess supply) in the market for i, causing the price of i to fall until the same is removed (lower

Pi causes demand to increase and supply to fall). The reduction in Pi also reduces the cost of

producing good g (we can assume good g uses the factor i intensively), causing the supply of

good g to increase beyond demand. The surplus in the market for good g drives the price of g

down until the excess is cleared. The diagram illustrates interdependence between goods and

factor markets.

Can different factor markets be interdependent also? Give examples.

Yes. A rise in the price of one factor (e.g. oil) will encourage producers to switch to alternatives

(e.g. coal). This will create a shortage of coal and drive up its price. This will encourage

Introduction to Economics ECO401

increased production of coal. Similarly an increase in the population (and consequently size of

the labour force) of a country will depress the price of labour (wages). This will cause producers

to shift to more labour intensive production and reduce production methods which are capital (or

machine) intensive. As a result the demand for capital will fall reducing its rental price.

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