Lecture%202 - Econ 208 Lecture 2 page 1 Lecture 2...

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Econ 208 Lecture 2 page 1 Lecture 2: Understanding Demand Principles Opportunity Cost: Review. Definition: The opportunity cost of any decision is the total net sacrifice that results from taking it. Sometimes it is a simple calculation: when you purchase a bus pass the net sacrifice (to you) is the money you lay out, or more deeply, the value of the goods you didn’t purchase with that money. We saw this in the case of the Eric Clapton and Madonna concert choice. Sometimes the calculation is more complicated. Suppose you decide to drive to school instead of taking the bus. The bus pass costs $1.00. You use about a $1.00 worth of gas driving, plus you spend $10.00 parking. Let’s suppose for sake of argument that the insurance and amortization cost is independent of that decision. Later in the course we will call those costs fixed costs , because they are incurred whether or not you decide to do anything. So let’s calculate the opportunity cost according to the method we developed earlier. If you decide to drive you save the $1.00 buss pass. If there were no other costs, this would mean that you actually gained $1.00 by driving. i.e. a negative opportunity cost, or what we would call a ‘free good’, or perhaps more accurately a ‘better than free good.’ But you have $11.00 outlays. So your net opportunity cost is $10.00. But this is only your personal cost. Suppose that your driving to school increases traffic congestion so that 100 other drivers spend one minute extra in traffic, or 100 extra total minutes spent driving that would otherwise be spent doing something else. They have sacrificed something else. It’s true that each person only sacrifices a little bit, but the aggregate still amounts to something significant. That is
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Econ 208 Lecture 2 page 2 also an opportunity cost. The difference is that you don’t pay it (you pay only 1 minute’s worth); someone else does. Suppose that the value of time is 50 cents a minute. The total cost of your decision to others is thus 100 minutes x $.50 or $50.00. So the true opportunity cost of your decision is not $10.00 but $60.000. Even so, you take the car. Why is this? Cost-Benefit Analysis : The reason is that you consider the benefit of driving to work at least $10.00. In other words, you would be willing to pay at least that much to drive rather than take the bus. The cost-benefit principle is the mother of all economic ideas. It says you should take an action only when the extra benefit from taking it is greater than the extra cost. This principle has the same status in economics that the principle of natural selection has in evolutionary biology. It is the key that unlocks many otherwise inexplicable things in economic life. Here’s an example. Why do laptop computers operate on any electrical standard (i.e. 220 volts and 110 volts), whereas other appliances usually do not (hair-dryers are an exception). Answer: it costs something to install the extra circuitry in the transformer. In the case of hair-dryers and laptops, which people take with them when they travel, the benefit is worth the extra cost.
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