Chapter 1: Thinking Like An Economist
1. Scarcity Principle and the Scope and Nature of
Economics
2. Main Topics in Microeconomics
3. Pitfalls in Economic Analysis (Cost-benefit
analysis)
A. Measuring costs & benefits as proportions
instead of absolute amounts
B. Ignoring implicit costs
C. Failure to think at the margin
4. Normative economics vs positive economics
5. The Incentive Principle
Economics is the study of how people, individually and collectively, make choices under the condition of scarcity and the
implications of these choices for society (eg, in terms of the price and availability of goods and services and in terms of
economic efficiency and social equality for society).
Scarcity is a fundamental fact of life and the bane of our human existence.
- resources to produce and consume goods and services are limited / finite
- Limited / constrained / restricted by time, space and resources (resources are also known as factors of production and
are broadly categorized as land, labor, capital and entrepreneurship in Economics)
- Our human needs, wants and desires are unlimited / infinite (we are limited by time, resources, energy, health and other
limitations, and we can never fully satisfy all our human needs, wants and desires, individually and collectively, all at the
same time)
- The Scarcity Principle is also informally known as the “no-free-lunch principle” (there is always a price to pay; a cost; a
trade-off; a sacrifice for every choice we make; something has to give; you can’t “have your cake and still eat it”)
Scarcity in Production and Consumption:
- producing more of a good will result in less or even possibly no resources to produce other goods
- consuming more of a good will result in less time, money, energy and other resources to consume other goods
- scarcity affects us at all levels of human existence (individual, family, company, community, country and the world) and
compels us to strive for efficiency (maximize benefits net of costs)
- Cost-benefit principle helps us to make more efficient uses of scarce resources
The choice to buy the keyboard
downtown doesn't imply that you enjoy
making the trip. It simply means that
the trip is less unpleasant than the
prospect of paying $10 extra for the
keyboard (or that the value of the time
and effort to make the trip is less than
$10). You faced a trade-off and had to
make a choice between the competing
interests of a cheaper keyboard versus
the free time gained if you avoided the
trip.
Economics is, in a sense, “the way” (道) of this present world that we are born into, the same “real world” we all will
also depart from one day.
MICROECONOMICS
▪ Microeconomics is the study of:
▪ individual choices (made by individual buyers and sellers of goods, services
and resources);
▪ group behavior (all buyers and sellers of goods, services and resources) in
specific markets; and
▪ the implications of these choices and behavior on:
▪ - the prices and quantities of specific goods and services produced and
consumed in a market economy (with typically imperfect markets and
subject to policy intervention by regulators)
▪ - economic efficiency & the welfare of society
▪ Microeconomic topics include
▪ - scarcity, efficiency; cost-benefit principle and economic welfare (total
economic surplus)
▪ - demand and supply of goods and services in individual markets
▪ - price elasticity of demand and supply
▪ - cross-price and income elasticities of demand
▪ - consumer theory (utility-maximizing behavior of consumers)
▪ - production theory (profit-maximizing behavior of firms)
▪ - market failure: externalities and market power (barriers to entry);
deadweight or efficiency loss
THREE IMPORTANT PITFALLS IN COST-BENEFIT ANALYSIS
PITFALL 1: MEASURING COSTS AND BENEFITS AS PROPORTIONS RATHER THAN ABSOLUTE DOLLAR AMOUNTS
Measuring costs and benefits as proportions instead of
absolute amounts
• A) Would you walk to town to save $10 on a $25 wireless
keyboard?
• B) Would you walk to town to save $10 on a $2,020 laptop?
• Which one of the above-mentioned (A or B) yields higher
marginal benefit to the person walking to town to purchase the
item?
• The economic surplus of an action is
equal to its benefit minus its costs
Total
Costs
Total Benefits
Economic
Surplus
PITFALL 2: IGNORING IMPLICIT COSTS IN COST-BENEFIT ANALYSIS
The opportunity cost of a decision refers to the value of everything (in
relation to the best alternative foregone) one must sacrifice that is related to
that decision. For instance, if seeing a movie requires not only that you buy a
$10 ticket, but also that you give up a $20 job that you could have done or
would have been willing to do for free (meaning you derive value — “utility”
— from this job), then the opportunity cost of watching the film is $30.
Opportunity costs therefore comprise both implicit and explicit costs. Some
more traditional economists and even textbooks use the term opportunity
cost to refer only to the implicit value of opportunities forgone. Thus, in the
example just discussed, these economists or textbooks wouldn't include the
$10 ticket price when calculating the opportunity cost of seeing the film.
Note that the opportunity cost of watching the movie is not the combined
value of all possible activities you could have pursued, but only the value of
your best alternative - the one you would have chosen had you not watched
the movie.
PITFALL 3: FAILING TO THINK AT THE MARGIN
The Importance of Weighing Marginal Benefits Against Marginal Costs
When deciding whether to take an action, the only relevant costs and benefits are those that would occur as a result of taking the action. The
only costs that should influence a decision on whether to take an action are costs we can avoid by not taking the action. Similarly, the only
benefits we should consider are the benefits that would not occur unless the action was taken. However, people are often influenced by sunk
costs, which are costs that are beyond recovery at the moment a decision is made. For example, money spent on a buying a car is a sunk cost
once you’ve paid for it. Sunk costs, such as the $100,000 you’ve paid for a car, cannot be recovered. As such, the price you paid for your car
is irrelevant to a decision on whether it will be more cost-beneficial for you to drive to the city and park in the city to catch-up with friends,
or to leave your car at home and take public transport instead.
Famous College “Dropouts”
PITFALL 3: FAILING TO THINK AT THE MARGIN
The Importance of Weighing Marginal Benefits Against Marginal Costs and of Ignoring Sunk Costs in Decision-making
When deciding whether to take an action, the only relevant costs and benefits are those that would occur as a result of taking the action. The
only costs that should influence a decision on whether to take an action are costs we can avoid by not taking the action. Similarly, the only
benefits we should consider are the benefits that would not occur unless the action was taken. However, people are often influenced by sunk
costs, which are costs that are beyond recovery at the moment a decision is made. For example, money spent on a buying a car is a sunk cost
once you’ve paid for it. Sunk costs, such as the $100,000 you’ve paid for a car, cannot be recovered. As such, the price you paid for your car
is irrelevant to a decision on whether it will be more cost-beneficial for you to drive to the city and park in the city to catch-up with friends,
or to leave your car at home and take public transport instead.
COST-BENEFIT ANALYSIS FOCUSES ON THE MARGINAL COST AND MARGINAL BENEFIT OF CHOICES AND DECISIONS
• Marginal cost is the increase in total cost from one additional unit of an activity (eg: production or consumption activity)
– Average cost is total cost divided by the number of units
• Marginal benefit is the increase in total benefit from one additional unit of an activity
– Average benefit is total benefit divided by the number of units
The Cost Benefit Principle that states that an individual (or a firm or a society) should take an action (to
allocate resources to produce and/or consume an additional unit of a good) if, and only if, the extra
(marginal) benefits from taking the action are at least as great as the extra (marginal) costs.
MC
MB,
MC
($)
MC2
MB1
MB1 > MC1
MB2 < MC2
Equilibrium
MB0 =MC0
MC1
MB2
MB
Q1
Q0
Q2
Quantity of good/service
Why does the MB curve slope downwards while the MC curve slopes upwards?
- MB: Law of diminishing returns
- MC: Law of increasing opportunity costs (“low hanging fruit” principle)
MC
MB,
MC
($)
MC2
MB1
MB1 > MC1
MB2 < MC2
Equilibrium
MB0 =MC0
MC1
MB2
MB
Q1
Q0
Q2
Quantity of good/service