Economics for Educators

Transcription

1 Economics for Educators Lesson 5 and 5E Model Revised Edition Robert F. Hodgin, Ph.D.

2 ii Economics for Educators, Revised Copyright 2012 All Rights Reserved

3 24 Economics for Educators, Revised Lesson 5: Opportunity Cost and Choice Supply Cost as Value There can be no choice made without a sacrifice a cost. By selecting one purchase option over another or one job opportunity over another, the person making the choice implicitly reveals their preference and their values. This view reflects the fundamental idea that all costs in economics are opportunity costs. Opportunity cost -the value of the next best option foregone when making a choice. The Seller s Dilemma Decisions made and actions taken today always are based on expectations about the future. Sellers assume some risk when producing what they believe buyers will purchase ahead of the actual sales transaction. The sales price, at least by expectation, must be sufficient to cover all the costs of production and selling opportunity costs. So what is it that makes a business proposition sufficiently attractive for a potential seller to undertake? The quick response in a market system is the reward of profit. But that response leaves out too much economic detail. To price a good or service, the producer first assesses the competition (the buyer s options) then figures the sales volume per time to derive the total (opportunity) cost of the required resources. If that cost is equal to or below the price a particular buyer is willing to pay, then production can be fruitful for the seller. If the negotiated price less the estimated opportunity costs for the required economic resources is both positive and greater than the next best use of the seller s time, the proposition should be profitable. Prior to taking action or making a decision, all costs are anticipatory or avoidable, because they have not been incurred. That is the seller s decision point. Once the decision is made to proceed with the one option (and forsaking the next best option) perhaps by taking out a loan, acquiring assets or contracting for labor, the prior estimated costs become real. This fundamental economic logic reduces to the relationship below. Economic Decision Making -Choose the option where the expected additional benefit to additional cost ratio is greater than that same ratio for the next best choice. Additional Revenue Option A <? > Additional Revenue Option B Additional Cost Option A Additional Cost Option B

4 25 Economics for Educators, Revised Profit is the reward for successfully operating a business in an uncertain market environment. The economist s logic to maximize profits suggests that competitive sellers produce up to the point where market price covers all opportunity costs of production, which includes sufficient profit to retain the seller-entrepreneur in that line of work. If market price rises, a supplier operating at less than full capacity would willingly increase production, as long as the increased per unit cost is less than the new market price. Doing so adds to net profit. That is why market supply curves generally rise up and to the right, as the next section reveals. Producer Choices and Supply Demand from buyers elicits supply from producers. And supplying a product is feasible when the buyer s maximum willing purchase price exceeds the seller s minimum willing offer price. Each firm s production cost is a competitive factor so much effort is spent keeping opportunity costs of production low. A seller who offers output below its opportunity cost is not being rational, because the revenue would be insufficient to pay the total opportunity costs of production. Production cost differences exist between sellers, even for a similar product. So goods produced for market get offered at a range of prices, each price covering the respective firm s anticipated opportunity cost.

5 26 Economics for Educators, Revised Supply the quantity of a good sellers are willing and able to offer at a range of prices, all other market forces held constant. Law of Supply Sellers will produce more of a product at a higher expected price than at a lower expected price. Price and quantity supplied move in the same direction along a given supply schedule. An individual supply curve usually slopes upward and to the right in the short run because the opportunity cost of production rises as the output level nears the firm s output capacity. The sum of quantities offered for sale by all sellers at each potential market price comprises the market supply curve. Short run supply curves for the entire market usually slope upward and to the right, reflecting increases in short run opportunity costs of production for all sellers. How is this so? Economists presume that with freely flowing market information, sellers enter the production stream only when market price is expected to at least cover additional production costs. Since not every seller has the same opportunity cost of production they tend to enter the market with their production in the order of their (rising) costs. The chemical industry is a good example of this tendency to produce at market price thresholds. When market prices are low, chemical production is slowed or plants are temporarily idled. As market prices rise, plant managers re-start select facilities to generate new product within desired cost ranges. Seller Responses to Price Changes In a short time period there is no chance to alter the firm s productive capacity. Such decisions require more time and certainty about sustainable future market prices and the expected volume of output to justify undertaking the capital expansion. Yet suppliers in some markets can respond more swiftly to market price changes offer a greater output than can suppliers in other markets. Why? Price elasticity of supply A measure of the relative change in producer output compared to the change in selling price. The prime determinant of supply elasticity is the ability of the firm to re-direct human and physical resources so they produce more or less product during a production run. As an example, it is relatively simple for a local retail pizza producer to add or subtract workers from a work schedule so that the pizza supply can be responsive to changes in price, like a sale price on a Saturday evening. Many other industries, such as petroleum refining and automobile manufacturing have narrow production windows. These highly specialized processes often are capital intensive and their output cannot be cost-effectively altered. A product s supply is said to be elastic when a small change in price brings about a large change in quantity of the good supplied. A product s supply is said to be inelastic when a large change in price brings about a small change in quantity of the product supplied. The most important determinant of supply elasticity is time. As time passes, firms can more easily commit to transforming their workers and machinery to different production rates.

6 27 Economics for Educators, Revised Supply Responses to Non-price Changes Supply analysis for an individual producer and supply analysis for an entire market of producers are similar. This is true because a market s supply is the sum of units supplied, at each and every price, by the sellers in the market. While the behavior or response of a particular seller in a market may occasionally vary from that of all sellers as a group, the total market supply curve commonly slopes upward and to the right. Recall that the last phrase in the definition of supply is all other market forces held constant. What is the meaning and importance of this phrase? You have seen when time is artificially held still, that price changes bring about a change in the quantity supplied, noted by reading along a fixed-in-place supply curve for the short run. Just as you suspected in the lesson on demand, forces other than price also are at work in the supplier market. Inspect the chart above. Choose a price on the vertical axis, say $40. Then read the quantity supplied at the left edge of the yellow supply line. It is about 50 units. If supply increased, by shifting to the right, to become the blue supply line, the number of units supplied at the same price of $40 would be about 55 units. That s an increase in supply, at the same price. Had we begun with the blue supply line at the price of $40, a movement back to the yellow supply line would have represented a decrease in supply. Forces that increase supply shift the curve to the right. Forces that decrease supply shift the curve to the left. Economists categorize the forces that move or shift market supply. As non-price market forces influence sellers, the actual supply curve position changes through time. Non-price forces on supply are factors that cause a change in supply a shift of the supply curve without a change in

7 28 Economics for Educators, Revised the current price for the product. A change in supply means that, at any and all prices, a different quantity greater or lesser than before of the good will be supplied. The reason for the emphasis on the difference between changes in quantity supplied brought about by changes in the current price of the good versus shifts in supply caused by other market forces is the same as for the demand discussion and bears repeating. This distinction, the time-based separation of price from other market forces, lets the careful thinker correctly understand how the supply side of the market works. The supply determinants and the logic for how to determine the direction of their influence on the supply schedule appear below. Supply determinants: factors that shift the supply curve (with no change in price) Number of sellers as the count of sellers rises, the supply increases (and the opposite is true) Technology as technology is adopted, the supply increases (and does not decrease) Future price expectations if future market price is expected to rise, current supply falls (and the opposite is true) Input costs if the costs of material and labor rise, the supply decreases (and the opposite is true) How to Analyze the Effect of Determinants on Supply Step 1: From the facts provided, determine which supply force is affected Step 2: Determine the direction of the force itself: increase or decrease Step 3: From the direction of the force and knowledge of economic incentives, determine the direction of change for the supply curve: increase (rightward shift) or decrease (leftward shift)

8 29 Economics for Educators, Revised In Sum Cost means the opportunity costs of resources in use, reflected by the owner-made choices of each economic resource. Opportunity cost is the value of the next best option foregone. A seller-entrepreneur decides if an opportunity is a good business proposition by: o Assessing expected net profits from a venture o Comparing the first option s net benefits to the next best alternative Business owners sellers must pay a resource opportunity cost to attract them into a particular use. Revenue left after paying resources their opportunity costs becomes profit for the entrepreneur-seller. Supply the quantity of a good that sellers are willing and able to offer at a range of current prices other market forces constant Law of Supply sellers will produce more of a product for sale at a higher current price than at a lower current price. Price elasticity of supply A measure of proportionate producer output response to a relative change in current price. o The main determinant of supply elasticity is time and the ability to direct resources to different uses Non-price market forces shift the supply curve, as time passes, to reflect changes in the quantity supplied at all prices. o Increase in supply is a rightward shift of the curve; o Decrease in supply is a leftward shift of the curve; Number of sellers as the count of sellers rises/falls, the supply increases/decreases Technology as technology is integrated, the supply increases Future price expectations if future market price is expected to rise/fall, current supply falls/rises Input costs if the costs of material and labor rise/fall, the supply decreases/increases

9 Engage Lesson 5: Opportunity Cost and Choice Supply, page 24 Ask if everyone in the marketplace always pays the market equilibrium price for water bottles prevailing at a given time. [Tally the Yes and No votes.] Ask why they think they do or do not. Page 17 The answer is No. Then ask why they think this is so. Correct answer is: any price below the buyer s highest willing price and above the seller s offer price is possible, even in a competitive market. Explore Project the chart below, which is from page 24 in Economics for Educators, Revised Edition. Identify the area where ALL transactions MUST occur! Why is this so? To emphasize, a buy/sell transaction can occur anywhere in the brown crinkly space! 1801 Allen Parkway * Houston, TX * (713) * Fax: (713) tcee@economicstexas.org *

10 Explain Ask the students to explain what is happening in the market to drive supply and demand to the crinkle area on the graph. Page 18 Note two things: 1. Consumer demand is the MAXIMUM the customers will pay, but they will gladly pay less. This is called Consumer Surplus. 2. Then repeat that the supply curve is the MINIMUM cost for which a company can willingly supply some of its product. So the seller needs that price or MORE to induce him/her to bring the good to market. This is called Producer s Surplus. Extend Now notice the P,Q space where all transactions occur (the brown crinkle paper texture). Then ask how you might be able to find/negotiate a price below the maximum supply price and list them on the board. [Some examples are given below.] 1. Visit another store with the same product 2. Ask if there is discount for quantity purchases. 3. If the purchase is large/expensive, see if the clerk will negotiate (esp. 100 cases of water bottles Allen Parkway * Houston, TX * (713) * Fax: (713) tcee@economicstexas.org *

11 Evaluate Do you ever think about situations in this way? Would it be worth it? Finally, have the class think about a situation where they have the motivation to negotiate e.g. buying a car or a house! Choose one product and have the students determine the characteristics they would like to see in that product. What are the opportunity costs of their choices? Page 19 Many may not have thought about this. Discuss why or why not? Then suggest that in other countries, negotiating (with or without currency!) is the norm in market transactions. Discuss their reasons for if this would be worth it reasons will vary. The answers will vary Allen Parkway * Houston, TX * (713) * Fax: (713) tcee@economicstexas.org *

12 The (TCEE) thanks the Council for Economic Education and the Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices Program grant that allowed Economics for Educators, Revised Edition to be written and published. The also thanks six of its major partners whose support allows TCEE to provide the staff development that utilizes content and skills provided in Economics for Educators.

13 Helping young people learn to think & make better economic & financial choices in a global economy. economicstexas.org 1801 Allen Parkway Houston, Texas Telephone Fax info@economicstexas.org