ECO 230 Principles of Economics I: Microeconomics Chapter I J.F. O’Connor 1/19/05

Introduction Economics is concerned with scarcity. –Wants are unlimited while resources for satisfying them are finite. Scarcity implies the need for choice among alternatives – no free lunch. –Smaller classes require that one give up something else, that is why they cost more. Economics is the study of how individuals and societies make choices under scarcity and the implications of those choices.

Early Definitions Adam Smith ( ), An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 Alfred Marshal ( ), Principles of Economics, 1890 –“A study of mankind in the ordinary business of life”

How to Make Choices? Economists assume that people are rational — they try to fulfill their goals as best they can with available resources and information. A rational approach in deciding on an action is to compare the benefits of the action with the costs of the action.

Implication of Rationality If events or circumstances change the costs or the benefits of an action, people may change their decision. Economists capture this point by saying that: People respond to incentives.

Benefit-Cost Principle Take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs. Measuring the costs and benefits of an action is often difficult –especially for big decisions. –One may have to use assumptions.

Reservation Prices The highest price one would be willing to pay for any good or service. –It is equal to the benefit received from the good or service. The lowest price at which one would be willing to sell a good or service.

Economic Surplus The benefit of taking an action minus its cost: –Economic Surplus = Benefit - Cost –Rational decision makers take all actions that yield a positive economic surplus. –A car is worth $5k to you but you can buy it for $4.5k. Do you buy it? –The minimum I would take for a bicycle that I have for sale is $600. I am offered $700. Should I sell?

Opportunity Cost Opportunity Cost: The value of the next- best alternative that must be forgone in order to undertake an activity. Decisions depend upon opportunity costs. It is not the combined value of all other forgone activities, just the next best one.

Imperfect Decision Makers Rational people will apply the cost-benefit principle using their intuition. However, people can make mistakes when weighing the costs and benefits. People often make inconsistent choices.

Deciding on the Level of Activity Rational decision makers uses the Benefit–Cost principle. Compare added benefits against added costs. Also, called marginal analysis. Marginal Benefit: The increase in total benefit that results from carrying out one additional unit of the activity. Marginal Cost: The increase in total cost that results from carrying out one additional unit of the activity.

Finding the Optimal Level At a given level, if the marginal benefit is greater than marginal cost: Increase level of the activity If the marginal benefit is less than the marginal cost: Decrease the level of the activity. Optimal level of activity is where marginal benefit equals marginal cost MB = MC

Fig. 1.1 The Marginal Cost and Benefit of Additional RAM

Pitfalls in Using B-C Principle 1.Using proportions instead of dollars 2.Ignoring opportunity costs 3.Failing to ignore sunk costs 4. Failing to understand the average-marginal distinction

What are the problems? 1. Not using a proper measure for benefits and cost 2. People often ignore costs that should be counted, mostly implicit costs. 3. People count costs that should be ignored 4. People look at benefits and cost the wrong way

Ignoring Opportunity Costs Making a rational decision requires the recognition of opportunity cost. Opportunity cost of an action –The value of the next-best alternative that must be forgone in order to engage in that action.

Nothing Is Free! Using a good we already own is not free. –It could be sold or used for some other purpose. There is an opportunity cost. Always ask “if I don’t do this, what is my best the alternative”? Should I do this or that? Giving someone the use of money for a period of time.

Opportunity Cost Over Time Having to pay someone a dollar a year from now is not the same as having to pay someone a dollar today. Why? Opportunity costs are different: the opportunity costs of resources used in the future are lower than the opportunity cost of using resources today.

Time Value of Money A given dollar amount today is equal to a larger dollar amount in the future. Money can be invested in an interest- bearing account in the meantime. –Banks paying interest on borrowed money are simply reimbursing the lender for the opportunity costs of not being able to use the money he or she has lent.

Summary of Ignoring Opportunity Costs It is important to account for all relevant opportunity costs. The value of a resource depends upon its best alternative use, even if you got it “free.” Remember to count the time value of money.

Failure to Ignore Sunk Costs Sunk cost: A cost that is beyond recovery at the moment a decision must be made. Pitfall #2: people are influenced by sunk costs when they should be ignored. This pitfall is the reverse of pitfall #1.

Sunk Costs Sunk costs are borne whether or not an action is taken. –It is an expenditure that you cannot recover Therefore, they are irrelevant to a decision on whether to take an action. Rational decision makers weigh the added benefits against only the additional (marginal) costs that must be incurred.

Summary of Not Ignoring Sunk Costs Ignore sunk costs--those that cannot be avoided even if the action is not taken. Note that sunk costs can explain why two persons may make a different decision about some action.

Costs Fixed costs –Costs that do not vary with the level of an activity. –All sunk costs are fixed costs, but not all fixed costs are sunk costs. Some fixed costs may be recoverable. Variable costs –Costs that do vary with the level of an activity.

Average vs. Marginal –Average costs are total costs per unit of activity –Average benefits are total benefits per unit of activity –Marginal costs are the additional costs of adding a unit of activity –Marginal benefits are the additional benefits of adding a unit of activity Average can be greater than, equal to, or less than marginal

Failure to Understand the Average-Marginal Distinction People often compare average costs and average benefits, but the relevant costs and benefits are always marginal. The fact that the average amount per unit that you are taking in exceeds the average cost does not tell you anything about whether you should increase or decrease the activity.

Heather’s Problem

Positive Net Gain Comparing the marginal cost to the marginal benefit of the next unit tells whether or not there is a net gain. –If the net gain is positive, then the next unit should be undertaken. Heather’s optimal level is four units of compost. Yet the average revenue at four is 650 cents versus average cost of 25 cents.

Summary of Ignoring the Average-Marginal Distinction Benefit-cost principle –The level of an activity should be increased if, and only if, the marginal benefit exceeds the marginal cost. Not “if, and only if, the average benefit exceeds the average costs.”

Using Resources in Alternative Activities Marginal analysis applies here too! Allocate each unit of a resource to the production activity that has the highest marginal benefit. Allocate the resources so that the marginal benefit is the same in every activity (or as close as possible).

Example 1.6 Lost Theater Ticket –A theater tickets cost $10 –You have at least $20 and want to see a play Would you buy a theater ticket after losing a $10 bill? Would you buy a second theater ticket after losing the first?

Lost Theater Ticket Many people say that they would purchase the ticket after losing the $10 but would not purchase a second ticket after losing the first. –This is inconsistent behavior since the financial loss is equivalent. The choice of whether to see the play depends upon whether seeing the play is worth spending $10.

Why Study Economics? To understand the world in which we live. Economics is essential in making sensible decisions as a consumer, investor, employee, and employer or manager. Economics is crucial in making decisions as a citizen concerning government policy.