The Four Core Principles of Economics
Chapter 1: The Four Core Principles of Economics
Sections:
A Principled Approach to Economics
CP 1: The Cost-Benefit Principle
CP 2: The Opportunity Cost Principle
CP 3: The Marginal Principle
CP 4: The Interdependence Principle
Economics as a Lens
Economics is often misunderstood as strictly about:
Money
Stock markets
Business and Government policy analysis
True Interpretation: Economics is fundamentally a way of thinking about choices.
It provides insight into:
Business decisions
Personal daily decisions
Definition: Economics is the study of choices, serving as a toolkit to analyze individual and collective decisions.
Core Principles: A systematic framework for analyzing decisions.
CP 1: The Cost-Benefit Principle
Definition: The Cost-Benefit Principle posits that costs and benefits are the incentives that shape decisions.
Decision-Making Process:
Evaluate all associated costs and benefits before deciding.
Act only if benefits are at least equal to costs.
Example Scenario: You are hungry and considering buying a $2 granola bar from a vending machine. The dilemma involves weighing the benefit of the granola bar against its cost.
Willingness to Pay
Willingness to Pay (WTP): Refers to the maximum amount you are willing to spend to obtain a benefit or avoid a cost.
Distinction: Do not confuse "want to pay" with "willing to pay."
Example: If you value the granola bar at $3 (WTP), and it costs $2, the economic decision would be to purchase it, as benefits exceed costs.
Economic Surplus
Definition: Economic surplus is defined as total benefits minus total costs, which reflects the improvement in well-being derived from a decision.
Example: Purchasing the granola bar valued at $3 costs $2, resulting in an economic surplus of $1.
CP 2: The Opportunity Cost Principle
Definition: Opportunity cost is the value of the next best alternative foregone when a choice is made.
Consideration: Always factor in opportunity costs beyond mere financial expenditures.
Scenario Analysis
Example: During a 1-hour break, choices include hanging out with friends, working on homework, napping, or watching Netflix.
Identification of Opportunity Cost: If you choose to work on homework, the opportunity cost is the enjoyment of hanging out with friends.
Ranking Choices: Prioritizing options helps clarify the opportunity cost. If ranked:
1. Work on homework
2. Hang out with friends
3. Watch Netflix
4. Take a nap
Your choice of option 1 means you forgo option 2 as the next best alternative.
Scarcity and Trade-Offs
Scarcity: Resources are limited which forces individuals to make trade-offs.
Manifestations of Scarcity:
Limited money: What could be spent instead?
Limited time: Only 24 hours in a day.
Limited attention and willpower.
Limited production resources: Alternatives for using machinery and labor are affected.
Calculating Opportunity Cost
Example Calculation:
Attending School:
Costs: $60,000 in tuition + $24,000 for living expenses.
Total cost potential: $130,000 (sum of costs).
Working Full Time:
Earn $70,000, but forego education opportunities and tuition costs.
Opportunity Costs:
Direct Out-of-Pocket Costs: Tuition, in this case, counts as an opportunity cost by choosing education.
Non-Out-of-Pocket Costs: Forgone salary of $70,000 from full-time work is also an opportunity cost.
Sunk Costs
Definition: Sunk cost is an irrelevant cost that has already been incurred and cannot be recovered.
Decision-making Implication: Avoid letting sunk costs impact current decision analysis.
Example of Sunk Cost: If a $12 movie ticket has been purchased but the movie is unenjoyable, the decision should be based on current enjoyment, not the sunk cost of the ticket.
CP 3: The Marginal Principle
Definition: The marginal principle involves making decisions about quantities incrementally.
Decisions should be broken into marginal benefits and marginal costs:
Marginal Benefit: The added benefit received from the consumption of an additional unit.
Marginal Cost: The added cost incurred to obtain that additional unit.
Application Example: Instead of deciding how many workers to hire in total, evaluate how many to hire incrementally by considering the marginal implications.
Rational Rule
Definition: The rational rule recommends continuing to engage in an activity until the marginal benefits equal the marginal costs.
Example: When deciding to consume an additional slice of pizza, consider both the marginal benefit (satisfaction from eating) and marginal costs (monetary cost and health implications).
Maximizing Economic Surplus
Example from Restaurant Decision:
Evaluating the cost of hiring workers versus the revenue generated from meals served helps determine the optimal number of employees.
CP 4: The Interdependence Principle
Definition: The interdependence principle states that your best choice depends on:
Your own choices
Choices made by others
Developments in other markets
Future expectations
Decision making must consider the larger network of interactions, emphasizing dependencies on various factors.
Application of Interdependence Principle
Personal Choices and Budgeting:
Spending decisions affect other choices like dining out based on limited income.
Economic Actors: Choices made by businesses or peers can shape available opportunities:
Example: Job competition impacted by others' hiring decisions.
Market Interconnections: Shifts in one market can affect choices in another:
Example: Interest rates impacting homebuying decisions.
Future Planning: Decisions made today can drastically influence future situations:
Example: Attending graduate school affects long-term career trajectory.
Key Takeaways
Cost-Benefit Principle: Evaluate the full set of benefits and costs before pursuing a choice.
Opportunity Cost: Always consider the most valuable alternative foregone.
Marginal Principle: Break down quantity decisions into marginal decisions to maximize economic surplus.
Interdependence Principle: Your decisions impact and are influenced by broader networks of choices andMarket contexts.