Microeconomics

What are the 4 core principles of microeconomics?

• Cost-benefit principle

• Opportunity-cost principle

• Marginal Principle

• Interdependence principle

What is economics?

The study of choices

helps you understand your decisions and the decisions of others and provides a framework for analyzing individual decisions

Net Present Value (NPV)

A way of making a cost-benefit comparison over time: NPV = present value of benefits - present value of costs

Accounts for the fact that benefits and costs often occur at different times

Cost-benefit principle

Costs and benefits are the incentives that shape decisions; following this principle, before making a decision you should:

• evaluate the full set of costs and benefits associated with that choice

• pursue that choice only if benefits are at least as great as the costs

Willingness to pay

In order to convert nonfinancial costs or benefits into their monetary equivalent, ask yourself: what is the most I am willing to pay to get this benefit or avoid this cost?

Marginal benefit

The additional benefit you receive from consuming one more unit of a good or service

• example: the most you’d be willing to pay for that extra unit

Marginal Utility

The additional satisfaction (utility) you get from consuming one more unit of a good or service

• utility is a theoretical measure of happiness or satisfaction, not measured in dollars

Diminishing Marginal Utility

Each additional unit of a good gives you less added satisfaction than the previous one, so as you consume more your marginal benefit falls eventually leading to the MB dropping below the MC and the cost-benefit principle will tell you to stop consuming

Economic Surplus

The total benefits minus the total costs flowing from a decision - measures how much a decision has improved your well-being

• you generate economic surplus every time you make a decision in accordance with the cost-benefit principle

• good decisions come from maximizing your economic surplus

Framing Effect

When a decision is affected by how a choice is described or framed

• can lead you astray by clouding your cost-benefit analysis

• choices should depend on the cost and benefits of the item, not on something irrelevant like how much an item cost in the past

Key point of the Cost-benefit principle

• pursue the choice if the benefits are at least as large as the costs

• Ask How much am I willing to pay to enjoy this benefit or avoid this cost

• Full set - consider both financial and nonfinancial aspects

• Avoid being led astray by framing effects

Opportunity Cost

The true cost of something is the next best alternative you have to give up to get it

• the trade-offs associated with a particular option - what you had to give up to pursue an option

Scarcity

Resources are limited therefore any resources you spend pursuing one activity leaves fewer resources to pursue others

• Makes trade-offs inescapable

Economic Profit

Total Revenue - (explicit costs + implicit costs)

Explicit costs

Any kind of accounting costs including taxes

Implicit costs

Opportunity cost (what you have to give up)

Sunk Cost

A cost that has been incurred and cannot be reversed. Exists in whatever choice you make and therefore it is not an opportunity cost

• irrelevant to the current decision at hand because the costs are associated with every alternative moving forward

• A past cost that is irreversible and should not be incorporated into a current cost-benefit analysis

Production Possibilities Frontier (PPF)

A curve that shows the different sets of output that are attainable with your scarce resources

• illustrates the trade-offs made when deciding how to allocate your scarce resources as well as scarcity and opportunity costs

Key point of Opportunity cost

• Even if the choice has no direct financial cost, there is always a cost because every choice has an opportunity cost associated with it

• Scarcity makes opportunity costs (trade-offs) inescapable

• Good decision makers ignore sunk costs

• The production possibilities frontier (PPF) can be used to visualize the opportunity costs we face

Marginal Principle

Decisions about quantities are best made incrementally

• You should break “how many” questions into a series of smaller or marginal decisions weighing the marginal benefits and marginal costs

Marginal Benefit

The extra benefit from one extra unit

Marginal Cost

The extra cost from one extra unit

When do you act on decisions using the marginal principle?

When the Marginal benefit exceeds the marginal costs

Rational Rule

If something is worth doing, keep doing it until your marginal benefits equal your marginal costs

Economic Surplus

= benefits - costs

• maximized when the marginal benefits equals the marginal costs

How is the Marginal principle and the rational rule connected?

Every additional unit you acquire using the marginal principle will increase your economic surplus, which is maximized when the marginal benefit equals the marginal cost

What are the key points of the Marginal Principle?

• If the Marginal benefit exceeds the marginal cost then buy that additional unit

• continue to buy additional units as long as the marginal benefit is at least as large as the marginal cost (rational rule)

• stop when the marginal benefit equals the marginal cost

• economic surplus is maximized when marginal benefit equals marginal cost

Rational

Using all available information in a consistent manner to make a decision

Interdependence principle

Your best choice depends on:

• your other choices

• the choices others make

• developments in other markets

• expectations about the future

Dependence between each of your individual choices

Component of the interdependence principle that states your own choices are all connected because you have limited resources

Dependence between economic actors

Component of the interdependence principle: the choices made by other economic actors shape the choices available to you

Dependence between markets

Component of the interdependence principle: Changes in prices and opportunities in one market affect the choices you might make in other markets

Dependence through time

Component of the interdependence principle: Decisions made today shape future opportunities and decisions

• is it better to act today or tomorrow?

The two equilibriums in economics

1. Partial equilibrium: looking at one market (supply and demand)

2. General equilibrium: looking at all the markets at the same time