ECON CH1-3

A Principled Approach to Economics

Economics as a lens through which to examine and understand your decisions and the decisions of others

The Cost-Benefit Principle

• Defining and practicing the cost-benefit principle

• Willingness to pay

• Economic surplus

• Understanding and avoiding framing effects

Cost-benefit principle:

Costs and benefits are the incentives that shape decisions.

Before you make a decision …

• 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: (cost-benefit)

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 that cost)?”

Do not confuse “want to pay” with “willing to pay” when doing this conversion.

Evaluating the FULL set of costs and benefits

Using money as the measuring stick allows you to take into account the financial and nonfinancial costs and benefits of a decision.

In cost-benefit analysis, money is the measuring stick, not the objective.

 Cost-benefit analysis still allows for unselfish decisions.

Economic Surplus:

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

Making good decisions is all about maximizing your economic surplus!

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

Framing effect:

when a decision is affected by how a choice is described or framed.

The Opportunity Cost Principle

Understanding opportunity cost as the next best alternative.

Always consider the opportunity cost rather than just the out-of-pocket financial costs.

Opportunity cost:

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

Costs are not always obvious

 you often have to give up more than just money to get something.

Focus on the trade-offs associated with a particular option. What did you give up to pursue this option?

Scarcity:

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

Every choice involves a trade-off. Every choice has a cost.

Why? Because everyone deals with issues of scarcity!

Sunk cost:

a cost that has been incurred and cannot be reversed. A sunk cost exists in whatever choice you make, and hence it is not an opportunity cost.

 Good decision makers ignore sunk costs.

Do not incorporate past, irreversible costs into your current cost-benefit analysis.

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

Production Possibilities Frontier (PPF):

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

The Marginal Principle

Define and practice the marginal principle.

Use the marginal principle to break “how many” decisions down into a series of smaller, or marginal, decisions.

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 (of goods purchased, hours studied, etc.).

Marginal Cost:

the extra cost from one extra unit.

Rational Rule:

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

Connecting Concepts:

Every additional unit you acquire using the marginal principle will increase your economic surplus (recall: economic surplus = benefits – costs)

Economic surplus is maximized when the marginal benefit equals the marginal cost

The Interdependence Principle

Defining and understanding the interdependence principle.

How does your decision interact with everything and everyone else around you?

Interdependence principle:

Your best choice depends on …

1. your other choices,

2. the choices others make,

3. developments in other markets,

4. and expectations about the future.

When any of these factors change, your best choice might change.

You are not making decisions in isolation.

 You are part of a larger network.

Key take-aways: Cost-benefit principle

Evaluate the full set of benefits and costs for any given choice:

 Pursue the choice if the benefits are at least a large as the costs.

 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

Key take-aways: Opportunity cost

The opportunity cost is the most valuable alternative you

had to give up to pursue your choice.

 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.

Key take-aways: The marginal principle

The marginal principle tells you to break “how many”

decisions into a series of smaller, marginal decisions.

 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 marginal cost.

 Economic surplus is maximized when marginal benefit

equals marginal cost

Individual Demand: What You Want, at Each Price

Defining, drawing, and understanding an individual’s demand curve

 Ceteris Paribus

 The Law of Demand

Individual demand curve:

A graph that plots the quantity of an item that an individual plans to purchase at each price

In other words, your demand curve visually summarizes your buying plans, and how your plans vary with price.

ceteris paribus

Every time you draw an individual’s demand curve, you are drawing this person’s

buying plans given current economic conditions. If something important changed the individual demand curve would change.

The Law of Demand

The tendency for the quantity demanded to be higher when the price is lower.

This law implies that demand curves slope down.

Key take-aways: Individual demand

The individual demand curve plots the quantity a person plans to buy at each price, holding all other factors constant (ceteris paribus).

 Other factors that impact a person’s buying plans will be assessed later.

The Law of Demand: As the price falls, the quantity demanded rises.

 Or, equivalently, as the price rises, the quantity demanded falls.

Your Decisions and Your Demand Curve

Apply the core principles of economics to make good demand decisions.

The Rational Rule for Buyers

Demand and marginal benefit are one and the same.

The Rational Rule for Buyers:

Buy more of an item if the marginal benefit of one more is greater than (or equal to) the price.

Diminishing marginal benefit:

Each additional item yields a smaller marginal benefit than the previous item

Key take-aways: Your decisions and your demand curve

The Rational Rule for Buyers: Buy more of an item if the marginal benefit of one more is greater than (or equal to) the price

 Keep buying until Price = Marginal Benefit

Your demand curve and your marginal benefit curve are one and the same.

Diminishing marginal benefit: Each additional item yields a smaller marginal benefit than the previous item

 The next slice of pizza, while still yummy, tastes a little less delicious than the previous slice.

Market Demand: What the Market Wants

Building the market demand curve from individual demand curves

Tracing out movements along the demand curve

Market demand curve:

A graph plotting the total quantity of an item demanded by the entire market, at

each price.

Individual demand curves are the building blocks of market demand:

Characteristics of the Market Demand Curve

The market demand curve is downward-sloping:

 Law of demand: The total quantity demanded is higher when the price is lower.

Prices change the quantity demanded for both old and new customers:

 Lower prices mean current customers buy more units.

 Lower prices bring new customers into the market

Movements Along the Demand Curve

The market demand summarizes the entire relationship between price and quantity demand.

To assess how consumers will react to a change in the price of the good, simply compare different points on the same demand curve:

• Move from one point on the existing demand curve to another point.

A change in price causes

a movement along the demand curve, yielding a change in the quantity demanded

Movement along the demand curve:

A price change causes a movement from one point on a fixed demand curve to another point on the same demand curve.

Change in the quantity demanded:

The change in the quantity associated with movement along a fixed demand curve.

Key take-aways: Market demand

Market demand curve: The total quantity demanded by the entire market at each price.

 Four-step process to estimate market demand.

 Add up the quantities from each consumer at each price.

When the price of the good changes, you simply move along the existing demand curve to that new price point.

 Move from one point to another point.

 This price change triggers a change in the quantity demanded (not a change in demand)

What Shifts Demand Curves?

Visualizing increases and decreases in demand

Naming and understanding the six factors that shift the demand curve

Increase in demand:

A shift of the demand curve to the right.

Decrease in demand:

A shift of the demand curve to the left

interdependence principle

everything is connected

The six factors that shift the market demand curve:

1. Income

2. Preferences

3. Prices of related goods

4. Expectations

5. Congestion and network effects

6. The type and number of buyers... but not a change in price

Normal Good:

A good for which higher income causes an increase in demand

Inferior Good:

A good for which higher income causes a decrease in demand

Complementary Goods:

Goods that go well together. Your demand for a good will decrease if the price of a complementary good rises.

Substitute Goods:

Goods that replace each other. Your demand for a good will increase if the price of a substitute good rises, and it will fall if the price of a substitute good fall.

Network Effect

When a good becomes more useful because other people use it. If more people buy such a good, your demand for it will also increase.

Congestion Effect:

When a good becomes less valuable because other people use it. If more people buy such a product, your demand for it will decrease.

Key take-aways: What shifts a demand curve?

Increase in demand: A shift of the demand curve to the right.

 An increased quantity is demanded at each and every price.

Decrease in demand: A shift of the demand curve to the left.

 A decreased quantity is demanded at each and every price.

Six factors shift the demand curve.

 Be Careful: The effect of changing income depends on whether the good is normal or inferior.

 Be Careful: The effect of changing the price of a related good depends on whether the two goods are complements or

substitutes.

Shifts versus Movements Along Demand Curves

Summarizing key points:

 Shifts versus movements

 Change in quantity demanded versus change in demand

Individual Supply: What You Sell, at Each Price

Defining, drawing, and understanding an individual business’s supply curve

 Ceteris Paribus

 The Law of Supply

Individual supply curve:

A graph plotting the quantity of an item that a business plans to sell at each price.

In other words, the supply curve visually summarizes the selling plans of a business, and how those plans vary with price:

The Law of Supply:

The tendency for quantity supplied to be higher when the price is higher.

Key take-aways: Individual supply

The individual supply curve plots the quantity a person plans to sell at each price, holding all other factors constant (ceteris paribus).

 Other factors that impact a person’s selling plans will be assessed later.

The Law of Supply: As the price rises, the quantity supplied rises.

 Or, equivalently, as the price falls, the quantity supplied falls.

Your Decisions and Your Supply Curve

Being a seller in a perfectly competitive market setting

 Sellers are price-takers

Examining Marginal Benefits and Marginal Costs

The Rational Rule for Sellers

Variable costs:

Those costs like labor and raw material that vary with the quantity of output you produce.

Fixed costs:

Those costs that don’t vary when you change the quantity of output you produce

The Rational Rule for Sellers in Competitive Markets:

Sell one more unit if the price is greater than (or is equal to) the marginal cost.

 Keep producing until Price = Marginal Cost

Marginal product:

The increase in output that arises from an additional unit of an input, like labor.

Diminishing marginal product:

The marginal product of an input declines as you use more of that input.

Key take-aways: Your decisions and your supply curve

In perfectly competitive markets, sellers are price-takers.

The Rational Rule for Sellers: Sell one more unit if the price is greater than (or equal to) the marginal cost.

 Keep selling until Price = Marginal Cost

Your supply curve and your marginal cost curve are one and the same.

Diminishing marginal product sets the stage for rising marginal costs.

 Hence, the supply curve is upward-sloping.

Market Supply: What the Market Sells

Add up individual supply to discover market supply

Market supply is upward sloping

Movements along the supply curve

Market supply curve:

A graph plotting the total quantity of an item supplied by the entire market, at each price.

Movement along the supply curve:

A price change causes a movement from one point on a fixed supply curve to another point on the same curve.

Change in the quantity supplied:

The change in quantity associated with movement along a fixed supply curve.

Key take-aways: Market Supply

Market supply curve: The total quantity supplied by the entire market at each price.

 Four-step process to estimate market supply

 Add up the quantities from each supply at each price.

When the price of the good changes, you simply move along the existing supply curve to that new price point.

 Move from one point to another point.

 This price change triggers a change in the quantity supplied (not a change in supply).

What Shifts Supply Curves

Visualizing increases and decreases in supply

Naming and understanding the five factors that shift the supply curve

The five factors that shift the market supply curve:

1. Input prices

2. Productivity and technology

3. Prices of related outputs

4. Expectations

5. The type and number of sellers ... but not a change in price

Productivity growth

Producing more output with fewer inputs.

Complements-in-Production:

Goods that are made together. Your supply of a good will increase if the price of a complement-in-production rises

Substitutes-in-Production:

Alternative uses of your resources. Your supply of a good will decrease if the price of a substitute-in- production rises.

Key take-aways: What shifts a supply curve?

Increase in supply: A shift of the supply curve to the right.

 An increased quantity is supplied at each and every price.

Decrease in supply: A shift of the demand curve to the left.

 A decreased quantity is supplied at each and every price.

Five factors shift the demand curve.

 Be Careful: A change in the price does NOT shift supply.

 Be Careful: The effect of changing the price of a related output depends on whether the two products are complements or substitutes in production.

Shifts versus Movements Along Supply Curves

Summarizing key points:

 Shifts versus movements

 Change in quantity demanded versus change in demand

Shift versus Movement Along Supply

price movement change in the quantity supplied

other factors change shift change in supply itself