Chapter%202 - Econ 160, Vardanyan Chapter 2 Key Principles...

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Econ 160, Vardanyan 1 Chapter 2 Key Principles of Economics In this chapter we introduce five key principles that underlie the economic analysis. The Principle of Opportunity Cost Opportunity cost is what you give up to get something. For instance, the opportunity cost of education is the wage income that a student foregoes when s/he attends classes. Similarly, the opportunity cost of one CD that costs $15 is 15 one-dollar online songs. The principle of opportunity cost incorporates the notion of scarcity. The idea of scarcity of resources can be illustrated with the production possibilities curve (or production possibilities frontier, Fig. 2.1). It shows all of the possible combinations of goods and services that can be produced in an economy provided all factors of production are used fully and efficiently. For instance, point b is always preferred to point e because b is associated with the same number of farm goods (20) but a greater number of factory goods (650) than e . Similarly, the points outside the curve are not feasible given the economy’s resource base. The production possibilities curve tells us that an increase in the production of one good is possible only if we produce less of another good, i.e. as we move from point a to point b, we reallocate the resources from the production of steel towards the production of wheat. We must do that simply because the resources are scarce. Thus, the opportunity cost of 10 (20-10) tons of wheat is 50 (700-650) tons of steel. Note that the opportunity cost is increasing with increases in production of wheat. (The opportunity cost of the same 10 tons of wheat is 180 tons of steel as the production of wheat is increased from 60 to 70 tons, i.e. as we move from point c to point d .) This is because as more and more wheat is produced, the farmers are forced to start using
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Chapter%202 - Econ 160, Vardanyan Chapter 2 Key Principles...

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