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 (1723-1790), An Inquiry into
the Nature and Causes of the Wealth of
Nations, 1776
• Alfred Marshal ( 1842-1924), 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 nextbest 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.
2.
3.
4.
Using proportions instead of dollars
Ignoring opportunity costs
Failing to ignore sunk costs
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 interestbearing 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
Compost
Tomatoes
0
1
2
3
4
5
6
7
100
120
125
128
130
131
131.5
131
Sales
Average Average
Revenue$ Revenue$variablecost
2000
2400
2400
25
2500
1250
25
2560
853
25
2600
650
25
2620
524
25
2630
438
25
2620
374
25
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.