Week 1 lecture Notes

The four core principles of economics:

1. The Cost Benefit Principle

2. The opportunity cost principle

3. The marginal principle

4. The interdependence principle

The Cost Benefit Principle:

• These are the incentives that shape decisions

• Before making a decision, evaluate the full set of costs and benefits associated with that choice - pursue the choice if the benefits are at least as great as the costs.

Example: You want to buy a 2 dollar granola bar after class as you are hungry. Do you buy it?

Dilemma: How do you compare benefit with cost?

Solution: Convert costs and benefits into dollars by evaluating your willingness to pay.

But what is willingness to pay?

To convert nonfinancial costs or benefits with there monetary equivalent, ask what you are willing to pay to get or avoid the cost (note this is not what you want to pay).

Coming back to the example - if you are willing to pay three dollars, the benefit exceeds the cost and you buy the granola bar.

Note:

• Money is the measuring stick not the objective

• Cost benefit analysis allows for unselfish decisions.

• 'Full Set' consider both financial and nonfinancial aspects

Economic surplus: the total benefits minus total cost - measures how much a decision improves your wellbeing.

Framing effect: when a decision is affected by how a choice is described or framed. Sellers try to cloud your cost benefit analysis e.g. when a clothing item displays original and sale price. Your choice should not be influenced by how much an item cost in the past.

The opportunity cost principle:

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

• Cost are not always obvious - sometimes you have to give up more than money.

• Consider trade-offs

Example:

You have a one hour break between class. What do you do?

• Hang with friends?

• Study?

• Watch Netflix?

What ever you choose, you are implicitly choosing not to do something else. That is your opportunity cost.

Suppose you rank the options in order of importance:

1. Study

2. Hang with friends

3. Watch Netflix

You choose to study and the opportunity cost of this is hanging with friends (Note: the opportunity cost is not all the options but rather the next best option.)

Every choice involves a trade off and has a cost due to scarcity.

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

Limited Money, Limited time, limited attention, limited production resources.

Sunk Cost: a cost incurred that cannot be reversed. It exists in whatever choice you mak, and hence is not an opportunity cost.

• Good decision makers ignore this cost.

• Example: you bought a 12 dollar movie ticket and half way in realise the movie is boring - do you stay or leave.

• You leave - your time is valuable and you loose the 12 dollar value of the ticket if you stay or leave.

Marginal Principle: decisions about quantities are best made incrementally.

• Break 'how many' questions into a series of smaller, or marginal, decision 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

Quantity Decisions - instead of How many workers should I hire? Ask Should I hire 1 more worker?

Apply the cost-benefit principle to this marginal decision to answer the question 'Should I hire one more worker?'.

• What are the extra benefits - marginal benefit

• What are the extra costs - marginal cost

• Hire the additional worker if marginal benefit outweighs marginal cost.

Visualising the Marginal Principle:

1. Determine what type you face:

   1. If it is a 'how many' decision break it into a smaller marginal decision like shouyld I buy one more?

2. Weigh the marginal benefit against marginal cost

   1. Cost benefit principle applied to a marginal decision

3. Apply the marginal principle iteratively until you eventually decide against one more unit and then stop.

The marginal principle and the rational rule:

• Benefits > Cost it is a good choice

Rational Rule: If something is worth doing, keep doing it until your marginal benefits equal your marginal costs.

Every additional unit you acquire using the marginal principle will increase your economic surplus (economic surplus = benefit - cost).

The Interdependence Principle:

Your best choice depends on:

• Your other choices

• The choices others make

• Developments in other markets

• Expectations about the future

When any of these factors change your best choice may change.

Dependence:

Individual:

your choices are connected as you have limited resources.

• If you see a movie, you cant eat out as much as you have limited income.

• If you spend time studying law, you cant spend as long studying economics.

• If you put your main in the oven, you cant cook your entrée (limited production capacity)

Markets:

Changes in prices and opportunities in one market affect the choices you might make in other markets.

• Declining interest rates in credit market make it less expensive to get a mortgage which might lead to you buying a home in the housing market.

• Decision to join labour market depends on availability of high-quality, low-cost childcare options in the childcare market.

People and Business:

The choices made by other economic actors (people, business, government) shape the choices available to you.

• If apple hires talents software engineers other company's in the area cant.

• If your friend gets an internship, their is a lower chance you can get hired at the same company.

Time:

Is it better to act today or tomorrow?

• Should I buy gas today or next week? Decision depends on if you think prices will fall.

• Should I go to grad school and get my MBA? This affects future job opportunities and salary.