Economics - The Study of Opportunity Cost

Economics and Opportunity Cost

Economics: Rooted in the Greek word for household management.
- Involves decisions about:
  - Labor allocation.
  - Production quantities.
  - Production methods.
  - Pricing strategies.
  - Revenue distribution.
Economic roles: Everyone participates in the economy.
- Consumers: purchasing goods/services.
- Employees: working for wages.
- Investors: buying shares or investing in human capital (education).
- Entrepreneurs, financiers, prosumers, regulators, policymakers: contributing to supply and demand systems.

Decisions = Choices: Every choice means foregoing other options.
- Individuals: daily spending decisions.
- Businesses: decisions about what, when, and when to stop producing.
- Societies: decisions about resource allocation.
Two Basic Economic Concepts:
- Unlimited wants and needs.
- Scarcity of finite resources.
Definitions:
- Economics: The study of how scarce resources are allocated and used to satisfy unlimited human wants.
- Scarce: Not freely available and lacking an infinite source.
- Resource: Anything consumed directly or used to produce consumable goods.
Scarcity: Arises when needs exceed available resources.
- Scarcity implies choosing, which means losing alternatives.
- Illustrates the principle that "There’s no such thing as a free lunch."
Opportunity Cost: Every choice involves giving something up.
- Individuals: deciding between class or sleep, gym or gaming, food or clothes, spare time vs. income.
- Society: deciding between guns vs. butter, efficiency vs. equality and justice.
- A trade-off always occurs.
Opportunity Cost Defined: The value of the next best alternative that is foregone when a choice is made.
- The non-realized benefit of the best alternative.
Opportunity Cost: The forgone alternative of the choice made.
- "What you would have done had you not done what you did!"

Microeconomics: Focuses on specific markets and segments of the economy.
- Examines consumer behavior, individual labor markets, and the theory of firms.
Macroeconomics: Studies the entire economy.
- Looks at aggregate variables like aggregate demand, national output, and inflation.
Micro vs. Macro Examples:
- Micro: Effect on price of a good, supply of a good, individual consumer behavior, individual labor market.
- Macro: Inflation, employment/unemployment, aggregate demand (AD), productive capacity of economy.
Economists and Models:
- Observe the real world.
- Build abstract models and theories (induction).
- Use models to make predictions and hypotheses (deduction).
- Collect and analyze data to test and adjust models (induction).
Models are Simplifications: Simplified representations of reality using assumptions.
- Common simplifying assumptions:
  - Ceteris paribus: all else equal.
  - Humans are rational and act in self-interest.
  - Firms maximize profits.
  - Buyers and sellers have perfect information.

Two Simple Economic Models: Production Possibility Frontier (PPF) and Circular Flow Diagram.
Production Possibilities Frontier (PPF): A graph showing the combinations of goods that can be produced given available resources and technology.

Production Possibilities Frontier: A graph that relates the amounts of different goods that can be produced in an economy, given available resources (inputs) and the state of technology.
PPF Concepts:
- Attainable points: On or inside the curve.
- Unattainable points: Outside the curve.
- Unemployment: Represented by points inside the curve.
- Pareto efficiency: Points on the curve.
Increasing vs. Constant Opportunity Cost:
- Increasing: Additional resources required to produce an additional unit grow as more output is produced (likely with differing skills).
- Constant: Additional resources required to produce an additional unit remain the same (likely with identical skills); PPF would be a straight line.
PPF and Key Concepts:
- Scarcity and choice.
- Opportunity cost.
- Efficiency (Pareto-efficient).
- Heterogeneity in inputs.
- Relationship between efficiency and justice/equality.
- Effect of increases in productivity.
- Sources of economic growth.
PPF Example: Illustrates scenarios with berries and rabbits, showing attainable, unattainable, and inefficient production levels.
Changing Opportunity Cost: As production shifts between goods, the opportunity cost changes.
- Shows the trade-offs, e.g., the opportunity cost of one more rabbit may be 40 berries lost.

Increase in the availability of resources.
Increase in the ability of resources to produce goods & services.
Generalized Growth: An increase in the ability of resources to produce all goods.
Specialized Growth: An increase in the ability to produce a particular good.

The Economy as a System: Natural balance between production and consumption.
Circular Flow Model: Shows the interactions of all economic actors.
- Markets: Where interactions take place.
- Actors: Entities interacting.
- Flows: Money and real flows between actors on markets.
Circular Flow Diagram Components:
- Households, Firms, Government, Rest of the World.
- Factor Markets, Goods and Services Markets, Foreign Exchange Markets.
- Flows of payments, labor, savings, taxes, goods, and services.
Holistic View: Incorporates society, commons, and the Earth (environment).

Key Concepts:
- Marginal Analysis.
- Positive and Normative Analysis.
- Economic Incentives.
- Fallacy of Composition.
- Correlation vs. Causation.

Optimization Assumption: People try to maximize some objective.
Definitions:
- Marginal benefit: The increase in benefit from an action.
- Marginal cost: The increase in cost from an action.
- Net benefit: The difference between all benefits and all costs.
Rational Decision-Making: Rational people compare marginal benefits and marginal costs.
Marginal: Little, incremental changes to an existing plan or action.
- Past costs are irrelevant (bygones are bygones).
Example: Optimal study time.

Positive Analysis: Understanding how things are and why.
- Answers can be right or wrong.
- Helps understand economic agents' behaviour and linkages between economic variables = "What is".
Normative Analysis: Understanding how things should be.
- Answers are subjective.
- Focuses on how to achieve a goal in the best way = "What should".

The mistake that the total economic impact is simply equal to the sum of individual parts.

Direct Correlation: Higher level of one variable is associated with a higher level of the other.
Causation: A change in one variable causes a change in another.
Inverse Correlation: Higher level of one variable is associated with a lower level of the other.
Conditions for Causation: For A to be the cause of B:
- A is correlated to B.
- A precedes B.
- Other causes for A and B must be excluded.