CHAPTER 1
ECONOMICS: THE STUDY OF OPPORTUNITY COST
DEFINITION OF ECONOMICS
According to Guell:
• Economics: the study of the allocation and use of
scarce resources to satisfy unlimited human wants
• Opportunity Cost
• The forgone alternative of the choice made
Or
• What you would have done had you not done what you
did.
OPPORTUNITY COSTS
• Point of both of these is that if you want to get more
of one thing you typically have to give up something
of another
We see these things all the time:
1. In order to buy food I need to give up money
2. In order to get money I have to give up some free
time and work more
3. If I want to eat more potato chips I have to spend
less on bananas
4. I spend time in school today to make money in the
future
The opportunity cost can be different over time
When you study you give up time when you could be
doing something else.
The opportunity cost of your time probably is
different:
• On a Monday Evening
• On a Saturday Night
• During the Super Bowl
• On thanksgiving
• On the day you get married
PRODUCTION POSSIBILITIES FRONTIER
• We are going to start with a simple model to learn
how economists formalize these things
• This is called a production possibilities frontier
• Just a fancy way of describing the the way in which
we are limited in what we can get
PRODUCTION POSSIBILITIES FRONTIER
Imagine you are in charge of a small tribe on an
island.
You have 2 workers and you want to allocate them
between two different tasks: Hunting or Fishing
You know how good the workers are at each skill:
WORKERS
Workers
Fish
Deer
Bill
40
2
Sally
20
4
How do you assign them?
There are 4 different possibilities that would lead to the
following outcomes:
Fisherman
Fish
Deer
None
0
6
Bill
40
4
Sally
20
2
Both
60
0
FISH AND DEER
7
Deer
6
5
4
3
2
Inefficient
1
0
0
20
40
Fish
60
80
NOW SUPPOSE WE ADD A FEW MORE
PEOPLE
Name
Fish
Deer
Donna
50
1
Bill
40
2
Jane
30
3
Sally
20
4
Carl
10
5
This gives us quite a few more options
POSSIBILITIES NOW
16
14
12
10
Deer
8
6
4
2
0
0
20
40
60
80
Fish
100
120
140
160
WITH A LOT OF PEOPLE
Now it is going to look something like this:
We are going to end up somewhere
on the red line
Attainable (and efficient)
Not Attainable
Deer
Attainable (but not efficient)
Fish
WHAT WILL I CHOOSE?
I know that I will be somewhere on the red line
But where?
It depends how much I like venison as opposed to
seafood
There is a tradeoff between fish and deer:
The more deer I get the fewer fish I can get
Economics is fundamentally about making these
kinds of tradeoffs
INCREASING OPPORTUNITY COSTS
When things are bowed out like this there are
increasing opportunity costs
Suppose the PPF looks like what is on the next slide
Think about the opportunity cost of a Deer when
• I have no Deer
• I already have 4 Deer
Increasing Opportunity Cost
6
5
4
If I already have 4 Deer,
the opportunity cost of another is
3
Deer
2
5 fish
If I have no Deer, the
opportunity cost of a deer is
1 fish
1
0
0
5
10
Fish
15
20
HOMOGENEOUS WORKERS
Now suppose all workers are the same
Worker
Fish
Deer
Henry
20
2
Phil
20
2
Anne
20
2
Rachel
20
2
Barney
20
2
PPF WITH WORKERS SAME
12
Here the opportunity cost is constant
10
The opportunity cost of 2 more deer is
8
20 fish regardless of how many deer
I already have
6
Deer 4
2
0
0
20
40
60
Fish
80
100
120
BUDGET CONSTRAINT
This is also very similar to another really important
concept: the budget constraint
• Suppose you have $100 to spend on Deer and Fish
• The price of a fish is $1.00
• The price of a deer is $10.00
• This will look exactly the same
THE BIG PICTURE
Circular Flow Model: A model that shows the
interactions of all economic actors
• Markets are where the interactions take place
(rectangles)
• Actors are the entities interacting (ovals)
MARKETS IN A CIRCULAR
FLOW DIAGRAM
• Market: Any mechanism by which
buyers and sellers negotiate an
exchange
• Factor Market: A mechanism by
which buyers and sellers of labor and
financial capital negotiate an
exchange.
• Goods and Services Market: A
mechanism by which buyers and
sellers of goods and services
negotiate an exchange.
• Foreign Exchange Market: A
mechanism by which buyers and
sellers of the currencies of various
countries negotiate an exchange.
ACTORS IN A CIRCULAR FLOW
DIAGRAM
• Households
• Firms
• Government
THINKING ECONOMICALLY:
MARGINAL ANALYSIS
• Optimization Assumption: an
assumption that suggests that the
person in question is trying to
maximize some objective
• We usually assume people are
maximizing utility or happiness
• Firms maximize profits
MARGINAL COSTS AND BENEFITS
• Marginal Benefit: the increase in the benefit that
results from an action
• Marginal Cost: the increase in the cost that results
from an action
Generally we do things until the marginal
cost=marginal benefit
• If the marginal cost of fish I give up is greater than
the marginal benefit I get from more deer, then I
have too many deer
• If the marginal cost of fish is less than the marginal
benefit then I want more deer
POSITIVE AND NORMATIVE
ANALYSIS
• Positive Analysis: a form of analysis that seeks to
understand the way things are and why they
are that way
• Normative Analysis: a form of analysis that seeks
to understand the ways things should be
ECONOMIC INCENTIVES
• Incentive: something that influences the decisions
we make
Examples:
1. Hourly wage influences how many hours you work
2. My grade scale influences how hard you study
3. Price of gas influences how much gas you buy
4. Taxes on pineapples influence how many
pineapples you eat
5. Paying teachers based on students test scores
influences how they teach
UNINTENDED CONSEQUENCES
Thinking about policy the most important thing
economics has to offer is that policies often affect
incentives and these incentives can have unintended
consequences
Examples:
• Taxes
• Teacher Cheating
• Welfare(and other social programs)
• Insurance
• Safety Regulations
CORRELATION AND CAUSATION
If I was still teaching econometrics I would make a
really big deal of this
Often what we learn in economics depends on data
and how we think about data is important
Causation just means that one thing causes another
Correlation means that they are related in the data
(tend to move together)
Things that are positively correlated:
• Height/Weight
• Wife’s Education/Husband’s education
• GDP/Food Consumption
Things that are negatively correlated:
• Unemployment/GDP Growth
• Family Income/Family Size
Things that are not correlated have no relationship
• Temperature here/weight of Vice President
• Result of first die/result of second die
• Just because two things are correlated does not
mean that one causes the other
• Possibilities:
• A causes B
• A causes B and B causes A at the same time
• Z causes both A and B
• These are not mutually exclusive
• This is not a minor problem-it makes empirical work
in economics very difficult
• As we will see in this course theory is not enough-we
need to combine models with evidence to really
say anything strong about policy