Chapter 1 Key Vocabulary: Opportunity Cost and Interdependence

The Cost-Benefit Principle

• Core idea: Make decisions by comparing benefits to costs; choose options where benefits exceed costs.

• Economic surplus: \text{Economic surplus} = \text{Total benefits} - \text{Total costs}

• Rational decision rule: Maximize economic surplus by including all relevant costs and benefits.

The Opportunity Cost Principle

• Key definition: The value of the next-best alternative given up when making a choice.

• Not always monetary: Includes time, effort, and foregone options.

• Scenario 2 Analysis: If choosing homework, the opportunity cost is hanging out with friends (the next-best alternative).

  • Ranking example: 1. Work on homework, 2. Hang out with friends, 3. Watch Netflix, 4. Take a nap. Choosing homework means giving up hanging out with friends.

Scarcity and Trade-offs

• Scarcity: Limited resources force trade-offs in all choices (e.g., money, time, natural resources).

• Consequence: Using resources on one activity reduces availability for others, making opportunity costs unavoidable.

Calculating Opportunity Cost: Attending School vs. Working Full Time

• Scenario: Attending school vs. working. Annual school costs include tuition and books (60{,}000).

• Forgone annual wages from quitting job: 70{,}000

• Opportunity cost of attending school (per year): sum of tuition and forgone wages: 60{,}000 + 70{,}000 = 130{,}000

What counts as an opportunity cost

• Includes: Direct payments (tuition) if they wouldn't occur otherwise; forgone salaries or interest.

• Excludes: Expenses that would occur regardless (e.g., rent, food).

• Definition: Encompasses both financial (tuition, forgone salary) and non-financial costs (time, effort).

Applying the opportunity cost principle

• Observation: During economic downturns (2008 recession, COVID), movie/streaming consumption rises.

• Reason: The opportunity cost of time shifts, making cheaper, more accessible leisure options more attractive.

How entrepreneurs think about opportunity cost

• New business vs. current job: Forgone wages from quitting are an opportunity cost.

• Investing money: Forgone interest/returns from a bank/stock market are an opportunity cost.

Sunk costs

• Key definition: A cost already incurred and irreversible.

• Impact: Not an opportunity cost for current decisions; good decision-makers ignore sunk costs.

• Example: A 12 movie ticket is sunk if you dislike the movie; your future decision (stay or leave) should maximize happiness, not justify the spent ticket.

Opportunity Cost vs. Sunk Cost

• Distinction: Sunk costs are unavoidable past expenditures; opportunity costs are foregone alternatives relevant to the current decision.

Production Possibilities Frontier (PPF)

• Definition: Shows attainable output sets with scarce resources, illustrating trade-offs.

• Frontier: Maximum possible production given resources/technology.

• Scenario: 3 hours study time allocated between economics and psychology.

• Example time-allocation (points on PPF):

  • (Hours Psych, Hours Econ) = (0,3) \implies (Boost Psych, Boost Econ) = (0,24)

  • (1,2) \implies (4,16)

  • (2,1) \implies (8,8)

  • (3,0) \implies (12,0)

• Interpretation: Moving along the PPF, gaining points in one subject costs points in the other (opportunity cost).

• Efficient allocations: On the PPF curve (all 3 hours used).

• Inefficient allocations: Below the PPF (not all time used).

• Unattainable allocations: Beyond the PPF (require improved productivity/resources).

• Takeaways: PPF visualizes trade-offs and opportunity costs; efficient use is on the frontier; improving productivity shifts frontier outward.

Key take-aways: Opportunity cost and decision making

• Opportunity cost is the most valuable alternative sacrificed.

• Scarcity makes opportunity costs and trade-offs unavoidable.

• Ignore sunk costs in current decisions.

• PPF visualizes opportunity costs.

Chapter 1 Summary

• Core Principles: Cost-Benefit, Opportunity Cost, Marginal, Interdependence.

• Central questions: Do benefits exceed costs? What is the next best alternative? Is there a marginal improvement? Everything is connected by scarcity and interdependence.

The Marginal Principle (Marginal Analysis)

• Marginal: Additional or one more unit.

• Core question: Is one more unit a good choice?

• Key definitions:

  • Marginal Benefit (MB): Extra benefit from one additional unit.

  • Marginal Cost (MC): Extra cost from one additional unit.

• Decision rule: Take action if MB > MC.

• Rational Rule: Keep doing a behavior as long as MB > MC; stop when MB = MC to maximize economic surplus.

Applying the marginal principle: Example with a restaurant

• Analyze hiring additional workers by comparing marginal benefits (increased revenue from more meals) vs. marginal costs (worker wage, ingredient costs).

• The marginal decision process applies to any choice about how many units to add.

Marginal principle in practice: a decision flow

1. Determine question type (how many/whether to do something).

2. Compare MB and MC for the next unit.

3. If MB \ge MC, accept the unit; otherwise, stop.

4. Continue until MB = MC to maximize economic surplus.

Connecting Concepts

• Interdependence principle: Choices interact with others' choices, market developments, and future expectations.

• Marginal decisions can shift based on these interactions.

Interdependence Principle: What changes in the world mean for your choices

• Core idea: Your best choice depends on four factors:
  1) Your other choices
  2) Others' choices
  3) Developments in other markets
  4) Expectations about the future

• Decisions are not made in isolation.

Interdependence in detail

• Individual choices: Limited resources link choices (e.g., movies affect dining out).

• Economic actors: Others' choices (purchasing, hiring) influence your options.

• Markets: Price changes in one market affect choices in others (e.g., childcare costs influence work decisions).

• Time: Today's decisions shape future opportunities (e.g., grad school vs. job).

Chapter 1 Key Terms (Glossary overview)

• Cost-benefit principle

• Economic surplus

• Opportunity cost

• Production possibility frontier (PPF)

• Sunk cost

• Marginal principle

• Marginal cost

• Marginal benefit

• Rational rule

• Scarcity

• Interdependence principle

• Sunk costs ignored in current decision making

• Willingness to pay

Summary reminder: core ideas to memorize

• Cost-Benefit: Benefits exceed costs?

• Opportunity Cost: What is given up?

• Marginal: Incremental optimization?

• Interdependence: Choices connected across people, markets, time.

Quick reference formulas and definitions

• Opportunity cost: \text{Value of next-best alternative that is forgone}

• Sunk cost: Cost already incurred, irreversible; ignore in current decisions.

• Economic surplus: \text{Total benefits} - \text{Total costs}

• Marginal concepts: \text{Marginal Benefit} = \text{additional benefit}; \text{Marginal Cost} = \text{additional cost}

• Rational rule for marginal decisions: Continue if MB > MC; stop when MB = MC.

• PPF interpretation: On frontier = efficient, inside = inefficient, outside = unattainable.