CHAPTER
2
Key Principles
Of Economics
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
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PRINCIPLE of Opportunity Cost
PRINCIPLE of Opportunity Cost
The opportunity cost of something is what you
sacrifice to get it.

What you sacrifice is the next best
choice. To determine opportunity cost
we consider only the best of the
possible alternatives.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
PRINCIPLE of Opportunity Cost

As long as resources are scarce, an
increase in the production of a good, which
necessarily results in a decrease in the
production of other goods, means that the
production of a good is subject to increasing
opportunity cost.

Prices are a measure of opportunity cost
because they provide information about the
value of one good relative to another.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Opportunity Cost and
Production Possibilities



© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
The production possibilities
frontier illustrates the
concept of opportunity cost
for the entire economy.
It explains why the
production possibilities
frontier curve is negatively
sloped.
In order to increase the
number of space missions
by one, 80 thousand
computers will have to be
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sacrificed.
O’Sullivan & Sheffrin
Marginal PRINCIPLE
Marginal PRINCIPLE
Increase the level of an activity if its marginal benefit
exceeds its marginal cost, but reduce the level if the
marginal cost exceeds the marginal benefit. If
possible, pick the level at which the marginal benefit
equals the marginal cost.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Marginal Benefit and Marginal Cost

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.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Using the Marginal Principle

Consider this example of how a barbershop applies
the marginal principle to decide whether to close or
to remain open.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
PRINCIPLE of Diminishing
Returns
PRINCIPLE of Diminishing Returns
Suppose that output is produced with two or more
inputs and that we increase one input while holding
the other inputs fixed. Beyond some point—called
the point of diminishing returns—output will increase
at a decreasing rate.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
PRINCIPLE of Diminishing
Returns
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spillover PRINCIPLE
Spillover PRINCIPLE
For some goods, the costs or benefits associated with
the good are not confined to the person or organization
that decides how much of the good to produce or
consume.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spillover PRINCIPLE

A spillover occurs when the people who are
external to a decision are affected by the
decision.

Another word for spillover is externality.
Some goods generate spillover benefits
(positive externalities), and others generate
spillover costs (negative externalities).
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spillover PRINCIPLE


Externalities are an economic problem
because the decisions of consumers and
producers tend to be based on their own costs
or benefits, not the costs or benefits for society
as a whole.
The amount of certain goods produced or
consumed by free markets may not be the
socially optimal amount.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spillover Benefits

A positive externality occurs when the
production or consumption of a good
generates benefits that are not
confined to the producer or the
consumer.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spillover Benefits
Examples of spillover benefits:

A flood control dam that benefits some people who
have not paid for it

A contribution to public television benefits some who
watch it but have not contributed themselves

A new scientific discovery that treats a common
disease

More educated people become better workers and
better citizens who benefit those around them
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spillover Costs

A negative externality occurs when the
production or consumption of a good
generates costs that are not confined to the
producer or the consumer. For example:
• Air pollution
• Water pollution
• Noise pollution
• Ozone depletion
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Reality PRINCIPLE
Reality PRINCIPLE
What matters to people is the real value or
purchasing power of money or income, not its face
value.

Nominal value: the face value of a sum of money.

Real value: the value of a sum of money in terms
of the quantity of goods the money can buy.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Reality PRINCIPLE

The reality principle applies to a variety of
important economic measures including:
• Real wages versus nominal wages
• Real GDP versus nominal GDP
• Real interest rates versus nominal interest rates
• Real money supply versus nominal money
supply
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin