Opportunity Cost and Supply of Goods LECTURAOFERTA PDF

Opportunity cost and the supply of goods. 4 The theory of supply in economics is not essentially different from the theory of demand. Both assume that decision makers face alternatives and choose among...

Opportunity cost and the supply of goods. 4 The theory of supply in economics is not essentially different from the theory of demand. Both assume that decision makers face alternatives and choose among them and that their choices reflect a comparison of expected benefits and costs. The logic of economizing process is the same for producers as it is for consumers. We shall discuss how the incentive to produce and supply scarce goods is shaped by opportunity costs and the market prices that reflect and inform us of the costs. Refresher on opportunity costs. First, let’s see if you can further apply the notion of opportunity cost developed in the previous chapters to explain typically puzzling events. Why are poor people more likely to travel between cities by bus and wealthy people more likely to travel by air? Simply answer would be that taking the bus is cheaper. But it isn’t. It’s very costly mode of transportation for people for whom the opportunity cost time is high (think of a lawyer who values her time at $100 an hour); and the opportunity cost time is typically much lower for poor people than for those with a high income from working. Why is it often so much harder to find a teenage baby-sitter in a wealthy residential area than in a low-income area? The frustrated couple unable to find a baby sitter may complain that all the kids in the neighborhood are lazy. But that is a needlessly harsh explanation. Teenage baby- sitter can be found by any couple willing to pay the opportunity cost. That means bidding the baby- sitters away from their most valued alternative opportunity. If the demand for baby sitters in the area is large because wealthy people go out more often, and if the local teenagers receive such generous allowances that they value a date or leisure more than the ordinary income from baby- sitter is high? Why do more college students continue on to graduate school during a recession? Poor job prospects reduce the opportunity cost of staying in college; therefore, more students are inclined to consider spending another year or two to obtain an M.A or M.B.A, rather than accept a job offer as overnight manager of twenty-four-hour gas station. Why are mire young people from low-incomes regions more likely to join military? Do you have the idea? Costs are tied to actions, Not things It is clear from these examples that costs are tied to things. Costs are always tied to actions, decisions, choices. It is for this reason that the economic way of thinking recognizes no objective costs. That offends common sense, which teaches that things do have “real” costs, costs that depend on the laws of physics rather than the vagaries of the human psyche. It’s hard to win a battle against common sense, but we must try. Again, we could profit by thinking A “thing” outside the box of common sense. cannot have a cost, only actions (or decisions) have costs.  Perhaps we can disarm common sense most quickly by pointing out that “things” have no costs at all- Only actions do. If you think that things do indeed have costs and are ready with an example to prove it, you are almost certainly smuggling in an unnoticed action to give your item a cost. For example: What is the cost of baseball? “Ten dollars”, you say. But you mean that the cost of purchasing an official mayor league baseball at the local sporting goods store is 10 dollars. Since purchasing is an action, it can entail sacrificed opportunities and thereby have cost. But note the smuggled-in- action. With other action, the cost of baseball changes. The cost of manufacturing a baseball is quite different. Selling one has yet another cost. And what about the cost of catching one at the ballpark? Just consider what the fan unintentionally did to himself, and the Chicago Cubs, during the 2003 playoffs. Consider college education. What does it cost? The answer is that “it” cannot have a cost. We must first distinguish the cost of obtaining a college education There are from the cost of providing one. As soon as we make that distinction, we should “objective” costs. also notice something that has been implicit in everything; we’ve said do far All costs are about costs, either in this or preceding chapters: Costs are always costs to costs to someone someone. The cost of obtaining an education usually means the cost to the who places value student. But it could mean the cost to the student’s parents. Which is not the on forgone same. Or, if that student’s admission entailed the reaction of some other opportunities applicant, it could even mean the cost to John (who was refused admission) of Marsha ´s obtaining entrance to the first-year class. Those will all be different. A great deal of fruitless argument about the “true cost” of things stems from a failure to recognize that only actions have costs and that actions can entail different costs for different people. What Do I Do now? The irrelevance of “sunk costs” You learned in Chapter 3 that the value of goods is always deter mined at the margin The value of water, for example, is not what people would sacrifice to obtain it if their only alternative was to do without water altogether. The value of water to people is what they would be willing to pay for an additional amount in the actual situation in which they find themselves. The same marginal principles apply to costs. In the case of goods or benefits, most people who go astray do so by confusing the total value of a good or benefit with its marginal value. In the case of costs, the most common error is confusing costs previously incurred with additional or marginal costs. The proper stance for making cost calculations is not looking back to the past, for the past is filled with sunk costs, irretrievable costs. The proper stance is looking forward to current opportunities. Mary's parents put up a $5,000 nonrefundable deposit for her wedding reception. Two weeks later, Mary and her parents discover that her fiancé is a cheater and a louse. They cancel the wedding and the reception. Did the family therefore lose $5,000 by canceling the reception? Common sense leads us to say yes. But would they have gotten that deposit back if they had decided to have the reception without the wedding? No. That deposit represented an exchange of property rights. It was no longer the parents' from the moment it was paid. Suppose you pass through the cafeteria line, pick up the tuna lasagna, and pay the cashier $1.90. You are willing to pay that cost because you expect the Tuna Candy satisfaction obtained to be greater than the satisfaction from spending the $1.90 lasagna? Bar? on anything else. Then you take your first bite and realize you have made a serious mistake. The tuna lasagna is awful. What will it cost you to leave the lasagna on your plate? It will not be $1.90. The cash you gave to the cashier is no longer yours; it's the cafeteria's. It's gone, and it won't come back if you continue to eat all your lasagna and claim to "get your money's worth." Instead, once the cash is the cafeteria's and the lasagna is yours, you confront a new set of choices. Do you now wish to dispense with your next class (should eating this meal make Continue Avoid you sick)? Do you wish to dispense with your life (should you fear getting To eat? belly- struck by a lightning bolt if you don't finish your meal)? Or do you wish to Ache? dispense with the lasagna, feel somewhat guilty for not cleaning your plate, but at least reduce your chance of getting ill? The choice is all yours. But that's the point-you now face new choices, and no matter what you do, your $1.90 is gone for good. The price you paid is what economists dismiss as a sunk cost. Sunk costs are irrelevant to economic decisions. Bygones are bygones. The only costs that matter in decision making are marginal costs-additional costs-and marginal costs always lie in the future. Like your $1.90, the $5,000 nonrefundable deposit for Mary's wedding reception is also a sunk cost after it has been. paid. Chalk that up as one of life's important lessons. You now stand at a new fork in the road. Of course, we must be certain that a cost is really sunk, or fully sunk, before we decide to regard it as irrelevant to decision making. The student who paid $100 for the calculus textbook and drops the course after the midterm cannot get his "money's worth" by trying to read the entire book. He might, however, be able to sell it back to the campus bookstore for $20. That's the choice he now faces-continue to own the book versus transferring ownership back to the bookstore. The student hasn't sunk $100; $20 is recoverable. His sunk cost is $80. In the economist's way of thinking, sunk cost is a piece of history, for it represents no opportunity for future choice. It may be cause for bitter regret (at the calculus professor, the bookstore, college life), but it is no longer a cost in any sense relevant to the economics of present decisions. It is a piece of information, a lesson in life. Don't get us wrong-the lesson is certainly not irrelevant, only the cost is. The question is what do you do now? Producers` costs as opportunity costs When we think about prod':1cers' costs-asking ourselves, for example, why it costs more to manufacture a mountain bike than a redwood picnic table-we tend to think first of what goes into the production of each. We think of the raw materials, of the labor time required, perhaps also of the machinery or tools that must be used. We express the value of the inputs in monetary terms and assume that the cost of the bike or the table is the sum of these values. That  isn't wrong, but it leaves two questions unanswered. Why did the producers of the bike or the table choose to use precisely these input s in just this combination? And why did it cost the producers whatever it did cost, in monetary terms, to use these inputs? There are substitutes for everything in production as well as in consumption. Technology creates possibilities and sets limits to what we can do; but it does not decree a single, uniquely correct process for producing anything. In New Delhi, men using short handled hoes dig the foundations for highway overpasses and women haul the dirt away in baskets on their heads. Imagine that. Why do they do it in that way? Contractors choose this technology because they believe it's the least costly way to dig and haul the dirt they want to remove. Human labor moves dirt in India at a lower cost than heavy machinery can do the job because human labor can be hired in India at a very low wage. It is too costly to devote heavy machinery to that particular activity. Why is the wage rate for unskilled labor in India so low? It's low because so many potential workers in that country have no opportunity to employ their labor in any manner that would produce something of substantial value to others. 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 and that this will depend upon the value of what that resource can create for someone else. So manufacturers' costs of producing a bike will be determined by what All costs relevant they must pay to obtain the appropriate resources. And, because these to decisions to resources have other opportunities for employment, the manufacturers must supply lie in the pay a price that matches the "best opportunity" value. The value of forgone future. opportunities thus becomes the opportunity cost of manufacturing a mountain bike. Consider the example of the picnic table. Part of its cost of production is the price of redwood. Assume that the demand for new housing has increased recently and that building contractors have consequently be en purchasing a lot more redwood lumber. If this causes the price of lumber to rise, the cost of manufacturing a picnic table will go up. Nothing has happened to affect the physical inputs that go into the table, but its cost of production has risen. Because houses containing redwood lumber are now more valuable than formerly, table manufacturers must pay a higher opportunity cost for the lumber they want to put into their picnic tables. When Hurricane Andrew devastated southern Florida in 1992, the price of plywood quickly rose across the entire United States. Plywood took on a greatly increased value for people whom Andrew had made homeless, and everyone who wanted to use plywood for other purposes now had to pay this new and higher opportunity cost. Of course, this also gave everyone an incentive to economize on the use of plywood. A skilled worker will be paid more than an unskilled worker because and only insofar as those skills make the skilled worker more valuable somewhere else. Workers who can install wheel spokes while standing on their heads and whistling "Dixie" are marvelously skilled. But our mountain bike manufacturer will not have to pay them additional compensation for that skill unless their unusual talent makes them more valuable somewhere else. That could happen.  A circus might bid for their talents. If the circus offers them more than they can obtain as bike producers, their opportunity cost to the manufacturer rises. In that case, the manufacturer will probably wish them good-bye and good luck and replace them with other workers whose opportunity cost is lower. When the National Basketball Association and the American Basketball Association merged into one league, what happened to the opportunity cost of hiring physically coordinated seven- footers? With two leagues, each player had two teams bidding for his services. What either team was compelled to pay to get him was determined by what the other team was willing to pay, and both were willing to pay a lot if they thought he would make a big difference in ticket sales. When the leagues merged, however, the right to hire a particular player was assigned to a single team, and the opportunity cost of hiring a well- coordinated seven-footer fell. When the players' union subsequently secured the right of players (under certain circumstances) to switch to another team if they chose, the opportunity cost of hiring basketball stars rose again. It's not surprising that owners of professional athletic teams prefer one league to two and vehemently argue that giving players the right to switch teams will destroy balance and hence the quality of the game. Let's take a more ordinary case. If a large firm employing many people (such as a Wal-Mart or Target) moves into a small town, the cost of hiring grocery clerks, bank tellers, secretaries, and gasoline station attendants in the town will tend to go up. Why? Because grocery stores, banks, offices, and gasoline stations must all pay the opportunity cost of the people they employ, and these people might find better opportunities for employment in the new firm. It might be better wages, better conditions, better health care plans. The new firm might attract potential employees in this manner. Owners of gasoline stations, for example, will tend to find it more difficult to retain their workers, or attract new replacements at the same old wage, as workers find more valuable opportunities elsewhere. If a military recruitment office moves into town and cannot attract people away from their current employers,. it might indeed face very real recruitment challenges. The resource that most dearly illustrates the opportunity-cost concept is probably land. Suppose you want to purchase an acre of land to build a house. What will you have to pay for the land? It will depend on the value of that land in alternative uses. Do other people view the acre as a choice residential site? Does it have commercial or industrial potentialities? Would it be used for pasture if you did not purchase it? The cost you pay for the land will be determined by the alternative opportunities that people perceive for its use. Marginal opportunity costs If you are wondering at this point about the relationship between opportunity Mantra on cost and marginal cost, you are wondering about the appropriate question. All costs: only opportunity costs are marginal costs and all marginal costs are opportunity actions have costs. Opportunity cost and marginal costs are the same thing, viewed from costs; all different angles. costs are Opportunity cost cans attention to the value of the opportunity forgone by an costs to action; marginal cost calls attention to the change in the existing situation that someone: all costs lie in the future. the action entails. The fun name for 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. Costs and supply And now we get to the heart of the chapter-using our notion of marginal opportunity cost to explain the decisions to supply goods and services on the market. Just as demand curves indicate the marginal costs or sacrifices that people are willing to incur in order to obtain particular goods, so supply curves show the marginal costs that must be covered to induce potential suppliers to make particular goods available. We can use our familiar production possibilities frontier in Figure 4-1 to illustrate our logic. A small Iowa farmer, let's call him Smith, considers producing soybeans and corn this season. If he devotes all his acreage to soybean production, he can produce 14.5 units. If he produces only corn instead, he can produce 10 units. His production possibilities Smith's production possibilities frontier for corn and soybeans. He can produce at most 14.5 units of soybeans (and O units of corn) or 10 units of corn (and O units of soybeans), or any combination of the two on the frontier. Notice the bend to this particular frontier. It illustrates that corn can be produced only at higher and higher marginal cost. Table 4-1 shows the actual combinations on Smith's frontier  (You might notice that the frontier in Figure 4-1 is a curve, not a line. This illustrates that Smith faces increasing opportunity costs of producing each good. Were he to consider expanding his corn production, he sacrifices, of course, the opportunity to produce and harvest soybeans. Moreover, he uses portions of his farm that are successively less suited for corn production. The movement along the frontier represents the trade-offs-the opportunity costs-that Smith faces.) Suppose-keeping our numbers simple-the price of soybeans is $1 per unit Market (we will hold that constant throughout our story). Smith could use more prices help information than just that. What matters to Smith is the relative price of us soybeans compared to corn He uses that information to judge against his economize marginal opportunity costs of production, in order to determine how much of more soybeans and com to produce. Here's an easy example. Suppose corn sells for effectively. $0 per unit. Smith would then dearly produce say, only 14.5 units of soybeans. Why? If he produces 1 unit of com, he can produce only 13.5 units of soybeans (we move downward along the frontier). His marginal cost would be $1 (the sacrificed market value of 1 unit of soybeans). What would he gain? A unit of corn, with a zero market value. What's important is that the marginal cost of producing the first unit of corn is $1. What if, instead, corn were priced at 90 cents per unit? If Smith willingly produced 1 unit of com, he would gain an additional 90 cents, but at an additional cost of $1-the value of his sacrificed unit of soybeans. Smith wouldn't be enticed to produce com at that relative price. Suppose, instead, that the price of com were al so $1 per unit. Then Smith would be inclined to produce up to but no more than 1 unit of corn At most, he would plan to harvest 13.5 units of soybeans and 1 unit of corn He would move downward along the frontier, from point A to B. He would sacrifice $1 worth of soybeans and gain $1 worth of corn What is Smith's marginal cost of producing a second unit of com? He'd have to reduce soybean output from 13.5 to 12.4 units. That's a difference of 1.1 units, with a market value of $1.10 (again, holding the price of soybeans constant at $1.00 per unit). Smith would consider producing a second unit of corn only if the market price of corn were to compensate for his marginal opportunity cost of producing corn-in this case if the price of corn were $1.10 per unit. What is Smith's marginal cost of producing a third unit of corn? He'd sacrifice 1.2 units of soybeans, with a market value of $1.20. Smith would be willing to increase com output to 3 units only if he were compensated for that additional cost. Smith would consider producing a third unit of corn only if the market price of corn were $1.20 per unit. We can summarize all of this in Table 4-2 below: We're now ready to draw three important conclusions. First, producers consider marginal costs of production when deciding upon which outputs, and which levels of output, to produce. Second, relative prices further inform producers of the marginal costs, and marginal benefits, of their alternative production plans. The supply curve Our third conclusion is best represented by the information in Figure 4-2, which simply plots the information from our Table 4-2. The bars in the graph show Smith's marginal opportunity costs of The bars in the graph depict the marginal cost (measured in dollars) of producing each unit of corn Smith will want to ensure that the price he can receive compensates him for his last unit produced. Therefore, if the price is $1.10, he11 produce 2 units. A price of $1.80 will encourage him to produce 9 units. In this way we derive an upward-sloping supply curve for corn. The higher prices increase his quantity supplied, reflecting the law of supply. Producing corn, measured in market values when the price of soybeans is given at $1.00 per unit. (The height of the first bar is $1.00, the second is $1.10, the third is $1.20, and this continues to the tenth, which has a height of $1.90.) We've seen how Smith would supply O units of com if the relative price of corn were under $1.00 per unit; he'd supply 1 unit only if the price rose to $1.00 per unit; he'd supply 2 units if the price were $1.20. The upward-sloping line illustrates Smith's supply curve for corn. Each bar represents the marginal cost of producing corn. The total area underneath the supply curve represents Smith's total costs of production (the adding up of all the marginal costs of production). The supply curve illustrates the alternative amounts of a good supplied at alternative prices. In our story, they represent Smith's planned outputs at different corn prices. Because he faces higher marginal opportunity costs of production, Smith would plan to increase corn production only if he expected to be compensated by higher corn prices. Smith would produce up to 10 units of corn if he expected to receive $1.90 per unit. This story about farming tells in a simplified way what underlies all supply curves. Supply curves are the marginal opportunity cost curves of making various quantities of a good available. As the price people are willing to pay for a good rises, that price persuades people with a marginal opportunity cost of supplying the good that is less than the price to shift the resources they own or control into supplying the good in question. Other things being constant, a change in price of the output increases quantity supplied, not the overall supply curve. Supply itself can change But the supply curve itself can change. Anything that changes the marginal cost of production will tend to change (or shifi) the overall supply curve, too. A rise (or fall) in the Price of a factor of production would raise (or lower) marginal costs, and thereby lead to a shift of the overall supply curve. Higher marginal costs would shift the supply curve upward and to the right; lower marginal costs would shift it downward and to the left. Technological changes, such as new innovations that reduce marginal costs, would tend to increase overall supply. Technological deterioration, on the other hand, would likely decrease overall supply.. Notice from our tables and graphs that a change in the relative price of an alternative product will tend to genera te a change in the supply curve. It will provide the producer an incentive to reconsider his options. Suppose, for example, that the price of soybeans alone falls from $1.00 (as in our original example) to $0.50 per unit. The lower market value of soybeans reduces the farmers marginal opportunity cost of growing corn, as shown in Table 4-3. It will be cut in half for each unit of corn output. That would shift the supply curve for corn downward and to the right. That's an in crease in overall supply. The corn farmer will now be willing to deliver any given unit of corn at a lower price than before. We can view it in another way as well: The farmer will be willing to supply a larger quantity of corn at any given price. If you would like to practice graphing this increase in the supply of corn, plot the quantities shown onto Figure 4-2. Do you recall from the previous chapter how consumer demand may change if consumers expect higher or lower prices in the future? The same holds true for producers. We all act upon our expectations. A change in the expected price of the producers output will tend to change the overall supply of that output. If producers expect lower prices for their outputs six months from now, they may strive to increase deliveries of their present output to the market, attempting to "supply more while the price is still high." Likewise, if they expect more favorable prices six months from now, they may choose to supply less today, which would shift the supply curve upward and to the left. By postponing their present supply, they are not necessarily reducing their current production. In anticipation of the higher future price, they are reducing the current quantities that they plan to deliver to today's market. And finally, a change in the overall number of suppliers tends to shift the market supply curve. The entry of more competitors would tend t6 increase overall supply, whereas exit would tend to decrease overall supply. Typically, expected profits will encourage entry and thereby increase market supply. Expected losses will encourage exit and reduce market supply, as producers search for more profitable uses of their resources. We shall discuss the role of profit and loss quite extensively in Chapter 7 Marginal and average cost It's important not to get the marginal concept mixed up with the notion of average. If you have no intention of doing that, what follows may only plant in your head the seeds of a bad idea. Let's hope it doesn't. Consider Farmer Smith one more time. Table 4-4 illustrates Smith's total cost of producing com (which is merely the sum of his marginal costs), his marginal cost, and his average cost (which is merely the total cost divided by the level of output) for up to 3 units of output. It is clear that marginal cost can differ substantially from average cost. But average cost didn't guide Smith's choice to produce more com; marginal costs did. Shall he produce more? Or less? Marginal cost is the consequence of action; it should therefore be the guide to action. Are businesspeople then not interested in average costs? Unless they receive sufficient revenue to cover all their costs, they will sustain a loss. They won't willingly commit themselves to any course of action unless they anticipate being able to cover their total costs. They might therefore set up the problem in terms of anticipated production cost per unit against anticipated selling price per unit. But notice that the anticipated costs of any decision are really marginal costs. Marginal cost need not refer to the additional cost of a single unit of output. It could al so refer to the additional cost of a batch of output, or the addition to cost expected from a decision regarding an entire process. Decisions are often made in this "lumpy" way. For example, no one plans to build a soda-bottling factory expecting to bottle only one case of soda. There are important economies of size in most business operations, so that unless businesspeople see their way clear to producing a large number of units, they won't produce any. They won't enter the business. They won't build the bottling factory at all. The entire decision build or don't build, build this size plant or that, build in this way or some other way- is a marginal decision at the time it is made. Remember that additions can be very large as well as very small. The lump of output could even be the sales your favorite hangout would enjoy if it stayed open until 2:00 A.M. instead of closing an hour earlier. Whether or not businesspeople cast their thinking in terms of averages, it is expected marginal costs that guide their decisions. Averages can be looked at after the fact to see how well or poorly things went, and maybe even to learn something about the future if the future can be expected to resemble the past. But this is history-admittedly an instructive study-whereas economic decisions are always made in the present with an eye to the future.