Chapter 2

Chapter 2
Key Principles of Economics
1. Chapter Summary
2. Learning Objectives
3. Chapter Outline
4. Examples for Class Discussion and Teaching Tips
Extended Example 1: Saturday Choices
Extended Example 2: Allocation of Societal Resources
5. Using the Tools
6. Problems and Discussion Questions
7. Test Your Understanding
8. Internet Exercise
9. Experiment Instructions

1. Chapter Summary

Chapter 2 introduces the five key principles that are central to all economic theory. The principle
of opportunity cost states that the opportunity cost of something is what you sacrifice to get it.
Opportunity costs in production are generally increasing, and thus, the production possibilities curve is
bowed outward.
The marginal principle states that any activity should be increased as long as the marginal
benefits of the additional activity exceed the marginal costs.
The principle of diminishing returns states that, in the short run, if use of one input is increased
while all others are held constant, production will eventually increase at a decreasing rate.
The spillover principle states that certain activities create spillover costs or benefits that exceed
the costs or benefits to the producers or consumers of that activity.
The reality principle states that what matters to economic agents is the real value or purchasing
power of money or income, not its face or nominal value.

2. Learning Objectives

1. What is the cost of producing military goods such as bombs and warships?
To get a warship, we sacrifice something else, for example, safe drinking water for 2.5
million Malaysians.

2. When is it sensible to tighten the emissions standards on cars, reducing the allowable volume of
pollution per mile driven?
According to the marginal principle, the standard should be made stricter if the marginal
benefit (the savings in health costs form a cleaner environment) exceeds the marginal cost
(the cost of additional equipment and extra fuel).

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3. As a firm hires more and more workers, what happens to the total output of its factory?
According to the principle of diminishing returns, output will eventually increase at a
decreasing rate.

4. If a paper producer dumps chemical waste into a river, what is the true cost of paper?
The true or economic cost of paper equals the firm’s cost (for material, labor, and the
paper mill) and the cost associated with the pollution generated as a byproduct of paper.

5. Suppose your wage doubles and at the same time the price of consumer goods doubles too. Are you
better off, worse off, or equally well off?
Your income will buy the same quantity of goods and services, so you will be equally well
off.

3. Chapter Outline
I. The Principle of Opportunity Cost
A. Definition
1. The opportunity cost of something is what you sacrifice to get it.
2. What you sacrifice is the next best choice.
B. Opportunity Cost and Production Possibilities
1. The PPC is negatively sloped because, if resources are fully employed, producing
more of one good means giving up some of the other. The slope shows the opportunity
cost of producing that good.
2. The PPC is generally bowed outward due to imperfect substitutability of resources,
which causes increasing opportunity costs as more of any good is produced.
C. Using the Principle: Military Spending, Collectibles
1. Malaysia purchased two warships in 1992. For the same amount of money, safe
drinking water could have been provided for 5 million people. Likewise, easing of
international tensions has allowed the United States and Western European countries to
reduce military spending and redistribute those funds, the so-called “peace dividend.”
2. If you buy an antique Barbie doll for $1,000, intending to resell it for more money a
year later, what is the opportunity cost? It is the interest that you could have earned
having the money in a bank account for a year instead.
D. Using the Principle: The Opportunity Cost of a College Degree
The opportunity cost of a college degree is the direct costs, including tuition and books,
plus the opportunity cost of time (the salary you could have earned). Food or housing
would only cost if their costs were different in college than they would be otherwise.
There may also be additional benefits, such as increase in future salary or the thrill of
learning and pleasure of meeting new people.
II. The Marginal Principle
A. Definition
1. Marginal benefit is the extra benefit resulting from a small increase in the activity.
2. Marginal cost is the extra cost resulting from a small increase in the activity.
3. Choose a level of activity such that marginal benefit of the last unit equals the
marginal cost of the last unit.
B. Example: Operating a Barber Shop
A barber is trying to decide whether to keep his store open for one more hour. The price of a
haircut is $8. In an extra hour, he will sell 5 more haircuts. The marginal benefit (revenue
generated from the last hour) is thus 8*5 = $40. The marginal cost, extra costs incurred during
that last hour, including electricity and the value of his time, is $24. Because marginal benefit
exceeds marginal cost, he should remain open for the extra hour.

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C. The marginal principle ignores fixed costs, as they do not change with activity. Only
variable costs, which do change with activity, are considered.
D. Costs include both explicit and opportunity (implicit) costs.
E. Using the Principle: Renting College Facilities, Emissions Standards
1. Student Groups and College Facilities:
Should colleges rent out facilities to student groups? For example, suppose that a
student group wishes to rent an auditorium and offers to pay $500. The college should
compute the marginal costs. If the extra electricity costs $20, the cleanup costs $60, and
security costs $100, the marginal cost is $180. Thus, marginal benefit exceeds marginal
cost, and the college should rent out the auditorium. In fact, colleges often overestimate
the costs of renting facilities because they perceive that the cost should include some of
the fixed costs of the college; thus, they miss the opportunity to serve student groups
and make money at the same time, a mutually beneficial trade.
2. Emissions Standards:
The government specifies the amount of pollutants, such as carbon monoxide, a car is
allowed to emit. The standard should be stricter if the marginal benefits (reduced health
costs) exceed the marginal costs (additional equipment and fuel).
III. The Principle of Diminishing Returns
A. Definition:
Suppose that output is produced with two or more inputs, and we increase one input while
holding the others constant. Eventually output will begin to increase at a decreasing rate.
1. The total product curve shows the relationship between the quantity of labor and the
quantity of output.
2. The marginal product of labor is the change in output from adding one more
worker.
3. Numerical example: Diminishing Returns for Pizza
Number of workers 1 2 3 4
Total pizzas produced 12 18 21 22
Marginal product 12 6 3 1
B. Diminishing returns is a short-run concept. (The short run is defined as a period of time in
which at least one factor of production is fixed.)
C. What about the Long Run?
In the long run, all factors of production can be varied, and thus, the principle of diminishing
returns is not relevant. (The long run can be defined as a period of time sufficient to vary all
factors of production.)
IV. The Spillover Principle
A. Definition
1. For some goods, the costs of producing or consuming the good are not confined
to the producer and/or consumer of the good (Negative externality).
2. For some goods, the benefits of producing or consuming the good are not
confined to the producer and/or consumer of the good (Positive externality).
3. Spillover costs and benefits are an economic problem because producers and
consumers base production and consumption decisions on their own costs or benefits,
not total costs or benefits including spillovers. Thus, the amount of certain goods
produced or consumed by society may not be optimal.
B. Examples of Spillover Costs
1. Air pollution
2. Water pollution
3. Freon leaks from an air conditioner. This not only imposes a cost on the owner (who
must pay to replace it) but also on society due to the costs of ozone depletion.
4. Your neighbor has a loud party while you are trying to study.
5. When you drive your car, you release pollutants that contribute to smog.

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C. Examples of Spillover Benefits

1. A flood-control dam benefits everyone in the area regardless of who pays for it.
2. If you contribute to public television, everyone who watches public television
benefits.
3. If scientists discover a new way to treat a common disease, everyone suffering from
the disease will benefit.
4. If you get a college degree, you will become a better worker and a better citizen, so
your fellow workers and citizens will benefit.
V. The Reality Principle
A. Definition
1. What matters to people is the real value or purchasing power of money or
income, not its face value.
2. The nominal value of money is its face value. The real value is measured in terms
of the quantity of goods that the money can buy.
B. Using the Reality Principle: Government Programs and Statistics
When the government publishes statistics about the economy, it takes into account the reality
principle. For example, the value of “real wages” shows what has happened to the purchasing
power of workers over time. The nominal wage shows what has happened to the sum on the
worker’s paycheck, but it cannot show what has happened to purchasing power.

4. Examples for Class Discussion and Teaching Tips

Opportunity Cost:
Tip: The hardest idea to grasp is often that free things are not free. The best opportunity cost
examples are free things with hidden costs, particularly the cost (and the value) of “free
time.”

The Marginal Principle:

Would you ever purchase something that you valued less than its cost (on the last unit
purchased)? What if you valued it more than its cost?

How do you decide when to stop doing something you like? For example, if you like to run,
why don’t you do it all of the time?

Diminishing Returns:
Tip: Even if you do no other experiments, the fold-its experiment in this chapter is a short
and very valuable illustration of diminishing returns.

Consider a fast-food restaurant at lunch or dinnertime when many people are working. How does
this illustrate the principle of diminishing returns?

What happens when you keep studying for many, many hours in a row? Is this an example of
diminishing returns? Why?

Do all production processes have diminishing returns in the short run? Do any production
processes have diminishing returns in the long run? Is the short run the same amount of time for
every process?

Spillover Benefits and Costs:

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Most of you live in a relatively small area (dormitories) with relatively many people. What kind
of spillover costs do you experience? Are there also spillover benefits? Is this also true about
living at home?

Why is education often considered to be a good with substantial spillover benefits?

Why has concern with spillover costs increased as world population has increased?

The Reality Principle:

If you stuff your savings in your mattress rather than putting them into the bank, what is
happening to the nominal value of your savings? What is happening to the real value?

If you have student loans, they do not accrue interest while you are still in school. What is
happening to the nominal value of the loan? What is happening to the real value?

Extended Example 1: Saturday Choices

On a sunny Saturday, you can choose to go to the nearby state park, work for $5.00 per hour, or study for
an economics exam. There is no entry fee to get into the state park.

1. Some students choose to go to the park. Use the principle of opportunity cost to explain why the park
is not free even though there is no entry fee.

2. Some students choose to study for a few hours and then go to the park. Use the principle of
diminishing returns and the marginal principle to explain to their parents why going to the park is a
rational decision.

3. In recent years, more students are going to the park and fewer are choosing to work. The wage of
$5.00 has remained constant over this time period, but prices have risen every year. Use the reality
principle to explain why fewer students choose to work.

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Chapter 2

Extended Example 2: Allocation of Societal Resources

The countries of Utopia and Nirvana have identical resources, but have decided to produce different
quantities of goods. Both countries can produce only truffles and lobsters.

1. Nirvana is currently producing 1,000 truffles and 2,000 lobsters and can produce no more of one good
without giving up some of the other. Utopia is currently producing 500 truffles and 1,000 lobsters. Draw
a production possibilities curve that shows the positions of Utopia and Nirvana. How do we know that
Utopia could allocate its resources more wisely?

2. Utopia now decides to produce 2,000 truffles and 1,000 lobsters and can produce no more of one good
without giving up some of the other. What is the opportunity cost of the last 1,000 truffles? Is Utopia’s
choice better than Nirvana’s?

3. Nirvana’s population doubles. What will happen to the production possibilities curve?

4. Utopia acquires many more truffle-pigs, which are useful only in truffle production. What will happen
to the production possibilities curve?

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5. Using the Tools

1. ECONOMIC EXPERIMENT: Producing Foldits

Here is a simple economic experiment that takes about 15 minutes to run. The instructor places a stapler
and a stack of paper on a table. Then students produce “foldits” by folding a page of paper in thirds and
stapling both ends of the folded page. There is an inspector who checks each foldit to make sure that it is
produced correctly. The experiment starts with a single worker, who has one minute to produce as many
foldits as possible. After the instructor records the number of foldits produced, the process is repeated
with two students, three students, four students, and so on. The question is, “How does the number of
foldits produced change as the number of workers increases?”
See Experiment Instructions at the end of the chapter.

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Chapter 2

2. What’s the Cost?

Consider the following statements about costs. Are they correct? If not, provide a correct statement
about the relevant cost.
• One year ago, I loaned $100 to a friend, and she just paid me back the whole $100. The loan didn’t
cost me anything.
The opportunity cost is the interest that could have been earned if the money was in the
bank instead.
• Our sawmill bought five truckloads of logs a year ago for $20,000. Today we’ll use the logs to make
picnic tables. The cost of using the logs is $20,000.
The opportunity cost is the amount of money that the firm could get from selling the logs
on the log market today.
• Our new football stadium was built on land that a wealthy alum donated to our university. The
university didn’t have enough to buy the land, so the cost of the stadium equals the amount the
university pays to the construction company that builds the stadium.
The opportunity cost is the value of the land in its next-best alternative, for example, a
classroom building, a library, or a student center.

3. How Much RAM?

You are about to buy a personal computer and must decide how much random-access memory (RAM) to
have in the computer. Suppose that each additional unit of RAM costs $40. For example, a 5-megabyte
computer costs $40 more than a 4-megabyte computer. The marginal benefit of RAM is $640 for the
first megabyte, and decreases by half for each additional megabyte, to $320 for the second megabyte,
$160 for the third megabyte, and so on. How much RAM should you get in your computer? Illustrate
your answer with a graph.
The benefit of the 4th megabyte is $80; the benefit of the 5th megabyte is $40; the benefit of
the 6th megabyte is $20. You should buy 5 megabytes; at that point, the marginal benefit
will be equal to the marginal cost.
$

M a r g in a l B e n e fit

40 M a r g in a l C o s t

M e g a b y te s
5

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 Key Principles of Economics

6. Problems and Discussion Questions

1. Suppose another year of college will increase your lifetime earnings by about $30,000. The costs of
tuition and book costs add up to only $8,000 for an additional year. Comment on the following
statement: “Because the benefit of $30,000 exceeds the $8,000 cost, you should complete another year
of college.”
The $30,000 will be received over the course of the rest of your life. It is probable that
prices will continue to rise over that time period, and, thus, the farther off in the future
that you get the money, the less it will be able to buy you. $30,000 received over, say, 40
years probably has less real purchasing power than $8,000 today. Also, you have not
considered the opportunity cost of your time. The true cost of one more year is $8,000 plus
what you could have been earning for that year. The total is likely to exceed the $30,000
gain.

2. To celebrate its 50th anniversary, a gasoline station sells gasoline at the price it charged on its first day
of operation: $0.10 per gallon. As you drive by the gasoline station, you notice that there is a long line
of people waiting to buy gasoline. What types of people would you expect to join the line?
People who place a relatively low value on their time. For others, the opportunity cost of
their time is likely to exceed the gains from buying gasoline at the cheap price.

3. You are the mayor of a large city, and you must decide how many police officers to hire. Explain
how you could use the marginal principle to help make the decision.
You would look at the marginal benefit (reduced crime, increased safety, etc.) of each
additional officer and compare that with the marginal cost (wages, benefits, etc.).

4. Consider a city that must decide how many mobile cardiac units (specially equipped ambulances
designed to treat people immediately after a heart attack) to deploy. Explain how you could use the
marginal principle to help make the decision.
You would look at the marginal benefit (reduced number of deaths, lower medical costs,
etc.) of each additional unit and compare that with the marginal cost (cost of the
ambulance, cost of special training).

5. Explain why the principle of diminishing returns does not occur in the long run.
In the long run, all factors of production can be varied. In the short run, at least one factor
of production is held constant. This causes diminishing returns as each additional variable
input has less of the fixed input to work with. This does not occur in the long run when all
inputs can be changed.

6. You are the manager of firm that makes computers. If you had to decide how much output to produce
in the next week, would you use the principle of diminishing returns? If you had to decide how much
output to produce ten years from now, would you still use this principle?
Yes, in the short run, since your production facility and technology cannot be varied in a
week. In the long run, all things could be changed, and thus, this would not be relevant.

7. Your coffee shop has a single espresso machine. As the firm adds more and more workers, would you
expect output (espressos per hour) to increase at a constant rate? Why or why not?
No, it will increase at a decreasing rate because you are adding more and more variable
inputs (workers) to a fixed input (the machine), and thus, diminishing returns will set in.

8. Use the spillover principle to discuss the following examples. Are there spillover costs or benefits?
• Logging causes soil erosion and stream degradation, harming fish.
This is a spillover cost, as it will harm others, e.g., fishermen.

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• An environmental group buys 50 acres of wetlands to provide a habitat for migrating birds.
This is a spillover benefit, as others who enjoy the birds will also gain.
• Your office mate smokes cigarettes.
This is a spillover cost, as you will be breathing his smoke, which is bad for you.
• A person buys a dilapidated house in your neighborhood and fixes it up.
This is a spillover benefit, as it will increase the value of every house in the neighborhood
by making the area more attractive.

9. Explain this statement: “The salaries of baseball players have increased in both real and nominal
terms.”
If salaries had increased at the same rate as consumer prices increased, they would increase
in nominal but not real terms. If they have increased in both nominal and real terms, the
rate of increase of salaries must have exceeded the rate of increase of prices.

10. Web Exercise: Visit the Web site of the U.S. Environmental Protection Agency, accessing the page
with answers to frequently asked questions (http://www.epa.gov/history/faqs/index.htm ). What is the EPA’s
mission, what are its goals, and how does it try to achieve these goals? Why do we need an organization
like the EPA?

11. The price of a gallon of gasoline was $0.42 in 1973 and had risen to $1.33 by 1999. How does the
change in the price of gasoline compare to the cost of other goods? To answer, go to the Web site of the
Bureau of Labor Statistics (http://www.bls.gov/cpihome.htm) and get information on the consumer price
index. The CPI measures the cost of a standard market basket of goods in different years. The value of
the CPI is 100 in the base year, and as prices increase, the value of the CPI increases. For example, a
value of 123 means that prices have risen to the point where the cost of a standard market basket of goods
is 23 percent higher than it was in the base year. How does the CPI figure for 1973 compare to that of
199? Has the price of gasoline increased or decreased compared to the cost of other consumer goods?

7. Test Your Understanding

1. “The cost of a masters degree in engineering equals the tuition plus the cost of books.” True or false?
Explain.
False. You must also consider the opportunity costs such as the salary that could have
been earned if the person was not in school and the interest that the money could have
earned if it had been invested rather than paid out in tuition.

2. Suppose a nation picks 1,000 young adults at random to serve in the army. What information do you
need to determine the cost of using these people in the army?
What could these 1,000 people have produced if they had not been in the army? (Note: the
answer to this might not be all that straightforward because one of the things that they
could have done was go to school, thus improving their skills and future productivity but
possibly not producing anything during that time period.)

3. Explain the logic behind the economist’s quip that “There is no such thing as a free lunch.”
If resources are fully employed, you can’t have more of one thing without giving up
something else. Thus, your free lunch isn’t really free; its cost might be the hour of time
you have to give up to eat it. Every choice involves a trade-off of some kind even if no
money changes hands.

4. If a bus company adds a third daily bus between two cities, the company’s total costs will increase
from $500 to $600 per day, and its total revenue will increase by $150 per day. Should the company add
the third bus or not?

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The marginal cost is $100, and the marginal benefit is $150. They should add the bus, as
the benefit of the last bus exceeds the cost of that bus.

5. Suppose you can save $50 by purchasing your new car in a different city. If the trip requires only $10
in gasoline, is the trip worthwhile?
It depends on the value of your time. Suppose that the trip takes 1 hour each way. If you
value your time at $5/hr., your total cost is $20, which is less than the $50 you save, and
thus, you should do it. But if you valued your time at $20/hr., your total costs would be
$50, and you would neither gain nor lose. At any higher value of time, you would be worse
off by going to the other city.

6. When a table producer hired its 20th worker, the output of its factory increased by 5 tables per month.
If the firm hires 2 more workers, would you expect output to increase by 10 tables per month?
It is likely that production would increase by less than 10 units, due to diminishing returns.

7. “According to the principle of diminishing returns, an additional worker decreases total output.” True
or false? Explain.
False. Diminishing returns just means that the next worker produces less than the
previous worker. He still adds to output as long as he produces anything, and thus, total
output is increasing.

8. For each of the following examples, is there a spillover benefit or a cost?

a. Your roommate plays loud, obnoxious music.
Spillover cost
b. Strip mining causes gas and oil to enter an underground water system, making smoking in the
bathtub hazardous to your health.
Spillover cost
c. A person in a residential neighborhood collects and restores old cars.
Spillover cost if the neighbors don’t like to look at the cars, spillover benefit if they
do
d. A family contributes $5,000 to an organization that provides holiday meals to the poor.
Spillover benefit
e. A landowner preserves a large stand of ancient trees and, thus, provides a habitat for the
spotted owl (an endangered species).
Spillover benefit

9. Average hourly earnings in the United States increased between 1970 and 1993, but real wages fell.
How could this occur?
The percentage increase in prices exceeded the percentage increase in wages.

10. Suppose your wage doubles, and the price of consumer goods doubles too. Are you better off, worse
off, or just as well off?
Just as well off. You can still buy exactly what you could before, so you are neither better
off nor worse off.

11. Suppose your bank pays you 4% per year on your savings account: each $100 in the bank grows to
$104 over a one-year period. If prices increase by 3% per year, how much do you really gain by keeping
$100 in the bank for a year?
$1. What you could buy with $100 in the first year will cost you $103 in the second year, so
that extra $3 just covers the higher price. You still end up with an extra dollar (that you
wouldn’t have had if you hadn’t put the money in a bank).

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8. Internet Exercise

Ask students to use any search engine to look for information on anything in which they are interested, or
perhaps a more specific thing like their favorite sports team, and ask them to report how many “hits”
were found. For anything fairly common, the number of hits will be in the hundreds of thousands. Then
ask how many sites they chose to visit, and how much time they spent on each site. For most people,
only a handful of sites will be checked, and they may spend successively less time at each site, either due
to diminishing returns or because the vast number of choices increases the opportunity cost of spending
time on any one choice. How, in economic terms, did they choose when to stop checking out sites or
when to leave a page?

Related approaches to the idea of opportunity costs, diminishing returns, the marginal principle, and the
Internet include asking if students with faster computers looked at more sites, whether the availability of
the Internet has decreased library time (and why), and whether over time they have spent more or less
time on the World Wide Web, and why.

9. Experiment Instructions

You will need:

About 100 sheets of paper
2 staplers
A watch with a second hand
Work space (desks or table)

Time: 15 minutes or less

How To Do It:
1. Ask for a volunteer to be the timer.
2. Select two students for the first production team. Read the instructions (below). Give them
the specified amount of time. Record the number of completed fold-its on the board.
3. Select three students for the second production team. Repeat the procedure until the addition
of one more student does not increase marginal output. (This will usually take 3-4 rounds)
4. Follow up with questions/other examples, or try the experiment again with the addition of one
more stapler (an additional capital input).

Instructions to Students:
You are a production team producing fold-its. A fold-it is produced by folding a piece of paper
in thirds and stapling it. (Demonstrate.) Your goal is to produce as many as possible in (time
period). Are there any questions?

Tips:
*Don’t reuse the same students in the second production team, etc. They will learn by doing,
and it will take a very long time to get diminishing returns.

*The best time periods seem to be 30 seconds or 1 minute.

*This is a very simple and short experiment with big rewards. You will be able to refer to it to
illustrate diminishing returns, and it makes a somewhat abstract concept very concrete.

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*This works well even in a large class. The nonparticipant students tend to enjoy cheering on the
teams, and it’s short enough that they don’t get bored.

*You may wish to give the teams a minute to discuss organization before starting the clock.

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