Lecture 1, Part 1
Three key economic ideas
Readings: Chapter 1, pp 2-6
Key economic ideas
1.
People are rational
2.
Incentives matter
3.
Optimal decisions are made at the
margin
1. People are rational
◦ In what sense?
◦ People make meaningful and
predictable choices (most of the time)
◦ Behavioural biases do exist
1. People are rational
◦ Its all about the predictive power of
the model
◦ Economic models can explain and
predict aggregate behaviour in markets
1. People are rational
◦ Behavioural Economics
◦ Incorporating biases into economic models
◦ This field has had a significant influence on
◦ Private sector
◦ Government policy making
2. People respond to incentives
◦ Rationality means comparing benefits and
costs
◦ Incentive is the net benefit of a choice or an
action
◦ Example: excise taxes on tobacco and smoking
2. People respond to incentives
Case study 1:
◦ Incentives matter!
◦ Unexpected effects of the baby bonus policy of
2004.
2. People respond to incentives
Case study 2:
◦ Incentives need not be monetary in nature.
◦ Human mobility during the early stages of the
COVID19 pandemic (February-April 2020).
2. People respond to incentives
Case study 2:
Silvia Mendolia, Olena Stavrunova, Oleg Yerokhin,
“Determinants of the community mobility during the COVID19 epidemic: The role of government regulations and
information”,
Journal of Economic Behavior & Organization, 2021.
3. Marginal analysis
◦ Optimal decisions are made at the margin!
3. Marginal analysis
◦ Optimal decisions are made at the margin!
◦ People make choices by comparing benefits and
costs of each option
◦ Some choices are quantitative in nature
◦ How many hour to study?
3. Marginal analysis
◦ “Marginal” refers to an additional unit of activity
(e.g. one additional hour)
◦ Comparing marginal benefit and marginal cost leads
to the optimal choice
3. Marginal analysis
◦ A simple example: how many cups of coffee to drink?
◦ What are the marginal benefits and cost of each unit of
activity (a cup of coffee)?
◦ Marginal cost is $4
3. Marginal analysis
Cups of
coffee
1
2
3
4
5
Marginal
Benefit
Marginal cost
$4
Net Marginal
Benefit
3. Marginal analysis
◦ Marginal cost is $4
◦ Value is a more tricky.
◦ Value exists but it is not readily available as a dollar
number…
3. Marginal analysis
Cups of
coffee
Marginal
Benefit
Marginal cost
1
$6
$4
2
3
4
5
Net Marginal
Benefit
3. Marginal analysis
Cups of
coffee
Marginal
Benefit
Marginal cost
1
$6
$4
2
$4
3
$4
4
$4
5
$4
Net Marginal
Benefit
3. Marginal analysis
◦ Marginal cost is $4
◦ Value is a more tricky.
◦ Value exists but it is not readily available as a dollar
number…
◦ Marginal value gets lower with each additional cup!
3. Marginal analysis
Cups of
coffee
Marginal
Benefit
Marginal cost
1
$6
$4
2
$5
$4
3
$4
$4
4
$3
$4
5
$2
$4
Net Marginal
Benefit
3. Marginal analysis
Cups of
coffee
Marginal
Benefit
Marginal cost
Net Marginal
Benefit
1
$6
$4
$2
2
$5
$4
$1
3
$4
$4
$0
4
$3
$4
-$1
5
$2
$4
-$2
3. Marginal analysis
a
Mc
z
I
z
n
b
y
MB
s
of coffee
3. Marginal analysis
◦ Lets consider a more interesting example
3. Marginal analysis
◦ You lost a $50 note in your living room
◦ You know that it is there, but you need to search to
find it
◦ Assume that the cost of your time is $10 per hour
◦ How long you should search for the $50?
3. Marginal analysis
◦
◦
◦
◦
◦
How long you should search for the $50?
This is a quantitative decision (number of hours)
We can apply marginal analysis
What is the Marginal Cost of one hour of search?
What is the Marginal Benefit?
3. Marginal analysis
◦
◦
◦
◦
Clearly Marginal Cost of each hour is $10
Marginal Benefit is a bit more tricky
Expected MB?
But let’s just say MB=$50, it’s a good approximation
3. Marginal analysis
How long you should search for the $50?
a) I will not search at all as it is a waste of time
b) 5 hours
c) 10 hours
d) I will search until I find it!
3. Marginal analysis
◦ The answer is NOT five hours!
◦ Sunk cost: the cost already incurred that cannot be
recovered
◦ Sunk cost should not affect rational decisions
3. Marginal analysis
Hours of
search
Marginal
Benefit
Marginal cost
Net Marginal
Benefit
1
$50
$10
$40
2
$50
$10
$40
3
$50
$10
$40
4
$50
$10
$40
5
$50
$10
$40
3. Marginal analysis
How long you should search for the $50?
a) I will not search at all as it is a waste of time
b) 5 hours
c) 10 hours
d) I will search until I find it!
3. Marginal analysis
sin
MB
50
Yo
zo
u
lo
i
z
a
a
Arc
b y
s
hours