Economics: Decision Making and Economic Models

Flashcards covering Chapter II: Decision making, explicit and opportunity costs, net benefit calculations, economic cost formulas, decision rules, economic models, and the Malthusian Model.

At what level do economists analyze the economy to understand how broad economic systems operate?

Economists look directly at the micro-level: how individual human beings make choices, including decisions made by individuals, firms (or their owners and managers), and governments.

In economic decision-making, what term describes the benefit or subjective satisfaction received from an action?

Utility (or subjective satisfaction).

What is an explicit cost?

The direct, out-of-pocket monetary expense required to make a choice happen (for example, the price of a concert ticket, transportation, or merchandise).

What is the definition of an opportunity cost in economics?

The net benefit you give up by choosing an action over the next best alternative. It is strictly the value of the single next best option passed up, not the sum of all other options.

According to cost-benefit analysis, what is the decision rule for whether you should take an action (such as going to a concert)?

You should take the action if, and only if, the economic benefit (utility) is greater than the sum of the explicit cost and the opportunity cost ($\text{Economic Benefit} > \text{Explicit Cost} + \text{Opportunity Cost}$).

What does willingness to pay (WTP) measure?

The maximum amount you would be willing to pay for something. The higher your willingness to pay, the more you value the activity or good.

What is the formula for net benefit, and what is the net benefit of attending a concert if the ticket costs $25\,\text{EUR}$ and your willingness to pay is $55\,\text{EUR}$?

$\text{Net Benefit} = \text{Willingness to Pay} - \text{Direct Cost}$. For the concert, $\text{Net Benefit} = 55\,\text{EUR} - 25\,\text{EUR} = 30\,\text{EUR}$.

In the lecture's example, how is the $22\,\text{EUR}$ net benefit of babysitting determined?

It is calculated as the payment received minus the cost of the effort as evaluated by the individual ($\text{Payment Received} - \text{Cost of Effort}$).

What is the general decision rule when choosing among several available alternatives?

Choose the alternative that provides the highest net benefit.

If attending a concert yields a net benefit of $30\,\text{EUR}$ and the next best alternative (babysitting) yields a net benefit of $22\,\text{EUR}$, what is the opportunity cost of attending the concert?

$22\,\text{EUR}$ (the net benefit of the single best alternative given up, babysitting).

What is the formula for calculating economic cost?

$$\text{Economic cost} = \text{Explicit Costs} + \text{Implicit Costs (Opportunity cost)}$$

If the direct financial cost of a concert ticket is $25\,\text{EUR}$ and the opportunity cost of attending is $22\,\text{EUR}$, what is the total economic cost of attending the concert?

$47\,\text{EUR}$, calculated as $25\,\text{EUR} + 22\,\text{EUR} = 47\,\text{EUR}$.

What are the three equivalent rules for deciding whether to choose an option (such as attending the concert)?

1. Rule 1: Choose the option that gives the highest net benefit ($30\,\text{EUR} > 22\,\text{EUR}$).
2. Rule 2: Choose an option if willingness to pay is greater than its economic cost ($55\,\text{EUR} > 47\,\text{EUR}$).
3. Rule 3: Choose an option if its net benefit is greater than its opportunity cost ($30\,\text{EUR} > 22\,\text{EUR}$).

Why are the rules "$\text{Willingness to Pay} > \text{Economic Cost}$" and "$\text{Net Benefit} > \text{Opportunity Cost}$" mathematically equivalent?

Because $\text{Economic Cost} = \text{Direct Cost} + \text{Opportunity Cost}$, the inequality becomes $\text{Willingness to Pay} > \text{Direct Cost} + \text{Opportunity Cost}$. Subtracting direct cost from both sides yields $\text{Willingness to Pay} - \text{Direct Cost} > \text{Opportunity Cost}$, which simplifies to $\text{Net Benefit} > \text{Opportunity Cost}$.

What is an economic model?

A simplified representation of reality that does not reproduce every detail, but simplifies reality so economists can focus on relationships important for answering a specific question.

Why do economists need to simplify reality by constructing models?

Reality is extremely complex (involving millions of consumers, firms, taxes, prices, wages, technologies, and resources). Simplification makes it easier to understand how individual factors affect the economy and answer specific questions.

Which three groups use economic models, and for what purposes?

1. Scientists (economists and social scientists) to interpret the past and understand economic relationships.
2. Governments and central banks to help make and evaluate economic policy choices.
3. Corporations and consultancies to make forecasts and support business decisions.

What are the four characteristics of a good economic model?

1. It includes the essential features of the economy relevant to the question.
2. It excludes unimportant details.
3. It helps understand and explain some aspect of the economy.
4. It is consistent with the evidence we observe.

What is the core principle of "One Model — One Question"?

An economic model can never give a complete picture of the entire economy; a model designed to answer one question (e.g., how prices affect demand) may be inadequate for another question (e.g., explaining differences in national economic growth).

According to this diagram of the Malthusian Model, what cycle of events follows an improvement in technology when living standards are low?

1. Average output per farmer rises
2. Population rises
3. Less land per farmer
4. Average output per farmer falls
5. Population is larger but living standards are back to the original level.