Key Economic Concepts
1. Opportunity Cost
• Economic cost of a decision or action =
direct cost + opportunity cost
• Opportunity cost = what else would you
have done if you did not take that action or
make that decision?
Opportunity Cost of being in this
classroom
Example: LIUC Degree
With degree
• - € 6,000
• - € 6,000
• - € 6,000
• € 25,000
• € 27,000
• € 28,000
• € 30,000
• € 32,000
Direct cost
€ 18,000
Without degree
• € 15,000
Opportunity cost
• € 16,000
€ 48,000
• € 17,000
• € 18,000
• € 19,000
• € 20,000
• € 21,000
• € 22,000
Economic Cost = € 66,000 !
Economic Cost of LIUC Degree
(with discounting)
Direct Cost:
6000 + 6000/(1.05) + 6000/(1.05)2 = € 17,156
Opportunity Cost:
15,000 + 16,000/1.05 + 17,000/(1.05)2 = € 45,658
Economic Cost:
€ 62,814
Economic Decision- Making
• A decision or action is worth pursuing if:
economic benefit from it > economic
cost (direct cost + opportunity cost) of
undertaking it.
Whether to Pursue LIUC Degree 10 year analysis
Year
1
2
3
4
5
6
7
8
9
10
NPV
€
With
Degree
(6,000)
(6,000)
(6,000)
25,000
27,000
29,000
31,000
33,000
35,000
37,000
Without
Degree
15,000
16,000
17,000
18,000
19,000
20,000
21,000
22,000
23,000
24,000
136,666
€ 147,478
Discount Rate 5%
Whether to Pursue LIUC Degree 20 year analysis
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
NPV
With
Degree
(6,000)
(6,000)
(6,000)
25,000
27,000
29,000
31,000
33,000
35,000
37,000
39,000
41,000
43,000
45,000
47,000
49,000
51,000
53,000
55,000
57,000
€ 360,408
Without
Degree
15,000
16,000
17,000
18,000
19,000
20,000
21,000
22,000
23,000
24,000
25,000
26,000
27,000
28,000
29,000
30,000
31,000
32,000
33,000
34,000
€ 285,422
Discount Rate
5%
2. Incentives
• Economic agents respond to incentives
Penalties
Rewards
Example: Incentives to reduce pollution
• Gasoline tax
• Investment tax credit
• Emissions limits
• Tax exemptions
• Driving regulations
• Tradable permits
• Fuel mileage standards
• Funding for research
and development
Example: Incentives to improve
worker efficiency
• Pay for performance
• Promotions/demotions
• Benefits
• Equity in the firm
Example: Incentives to improve firm efficiency
• In market economies:
Firm efficiency  firm profits  stock price 
managers’ salaries 
• In regulated markets:
Price = cost of production insufficient incentives for
efficiency.
Solutions:
(1) Regulatory oversight, private/public partnership
(2) Price-caps
(3) Industry standards
3. Marginal Analysis
• Economic decisions are made at the margin,
by comparing:
The additional
value from the
decision
The additional
cost of the
decision
Employment
• P = price of good
• MPL = marginal product of labor
= additional output (in units) from an
additional worker/day
• WL = wage (in $) of additional worker/day
• Then, firm should hire an additional worker if:
(MPL * P) > WL
Marginal product of labor (in $) > wage
Example: How many workers do
you hire?
Number
of
Workers
Number of
Skateboards
Produced
1
12
MPL
12
2
21
9
$270
3
29
8
$240
4
36
7
$210
5
42
6
$180
Price/skateboard = $30
Wage/worker/day = $200
MPL * P
$360
Production
• Let P = price
• Q = quantity
• C(Q) = cost of producing Q
• R(Q) = revenue from Q = P*Q
• Then, a firm should produce an additional unit if:
Marginal revenue MR(Q) > marginal cost MC(Q)
Example: Do you produce an
additional kilo of pastries?
Cost: C(Q) = 500 + 10Q
Where:
500 = fixed cost
10Q = variable cost
Q measured in kilos
C(Q) measured in $
Market price: P = $20/kilo
MC(1 Kilo of pastries) = $10
MR(1 Kilo of pastries) = $20
Answer: Yes
Consumption
• U(x) = utility from consuming x units
• P = price of good
• Then a consumer should consume an
additional unit x if:
Marginal utility MU(x) > price
Example: Do you eat another slice of
pizza?
Price = $2/slice
Marginal utility (slice) = ?
Eat additional slice if:
MU (add. slice) > $2
Economists Tyler Cowen and Alex Taborrok
video clip on Incentives.
http://mruniversity.com/courses/principles-economicsmicroeconomics?utm_source=Email&utm_medium=MRUannouncement&utm_cam
paign=MRUNewsletter