Lecture 2: Introductory Microeconomics: Scarcity, Trade, and Decision-Making

The Central Economic Problem: Scarcity and Decision Theory

• The Central Economic Problem: The fundamental issue that individuals and societies must address is scarcity.

• Implications of Scarcity: Because resources are limited, scarcity necessitates making decisions regarding the usage and allocation of available resources.

• Impact on Well-being: The manner in which resources are utilized directly affects the well-being of individuals and society as a whole.

Decision Theory in Economics

• Cost-Benefit Framework: Decisions are analyzed based on the association of actions with specific benefits and costs.

• The Objective Function: In economics, the goal is typically to maximize "net benefit."

• Net Benefit Formula:     $NB = TB - TC$     Where:

  • $NB$ is Net Benefit.

  • $TB$ is Total Benefit.

  • $TC$ is Total Cost.

• Rationality: A rational decision-maker seeks the optimal action, which is defined as the action that maximizes net benefit.

• Firm Application: A primary example is a firm's objective to maximize profit, defined as total revenue minus total costs:     $\text{Profit} = \text{Revenue} - \text{Costs}$

Measuring Costs: Opportunity Costs and Sunk Costs

• Resource Measurement: When a choice is made to take an action, the resources consumed by that action are no longer available for other uses. Therefore, the cost of an action must be measured in terms of those resources.

• Opportunity Cost Defined: The opportunity cost of an action reflects the value of resources used in taking that action in their next best alternative use.

• Evaluation of the Concept: Opportunity cost is non-trivial and often differs from simple price-tag values.

• Example: The iPhone:

  • The market price (cost of purchase) might be listed as $\$1,000$ on Apple’s website.

  • The cost of owning an iPhone for a year involves different considerations, as identified by economic thinking, which changes how decisions are evaluated compared to simple accounting.

Sunk Costs

• Definition: Sunk costs reflect the value of resources that were already utilized or committed before a decision about a current action was made.

• Decision Principle: At the moment of choosing an action, resources already used should not influence the decision. Consequently, the value of those resources (sunk costs) should not be considered as part of the opportunity cost.

Application Case Study: Easter Break Decision

• Scenario: You are choosing how to spend the Easter break between two primary options.

• Option A: Bali Trip:

  • Explicit Cost: Booking travel for $\$1,000$.

• Option B: Stay Home/Netflix:

  • Requires a paid subscription worth $\$10$, but you are already a subscriber for the month (making this a sunk cost).

• Common Opportunity Cost: Choosing either option results in missing 3 days of part-time work, which pays $\$100$ per day. This represents a total lost income (opportunity cost) of:     $3 \times \$100 = \$300$

Gains from Trade: Absolute vs. Comparative Advantage

Illustrative Example: Leonard and Sheldon

Leonard and Sheldon share a house and have two tasks: cooking and laundry. Gains from trade are explored through their different production capabilities.

• Production Scenario:

  • Sheldon: Produces 1 basket of laundry and 4 meals.

  • Leonard: Produces 2 baskets of laundry and 12 meals.

• The Offer (Proposed by Leonard):

  • Sheldon spends 12 hours a week on laundry to produce 3 baskets.

  • Sheldon gives 1.5 baskets of laundry to Leonard in exchange for Leonard cooking him 5 meals a week.

• Post-Trade Outcomes:

  • Sheldon: Ends up with 1.5 baskets of laundry and 5 meals (an improvement over his initial 1 basket and 4 meals).

  • Leonard: Reallocates his time to produce 1 basket of laundry and 18 meals. After the trade, Leonard has 2.5 baskets of laundry and 13 meals (an improvement over his initial 2 baskets and 12 meals).

Key Concepts of Advantage

• Absolute Advantage: The ability to produce a good using fewer inputs (e.g., less time) than another producer. In the example, Leonard has an absolute advantage in both cooking and laundry.

• Comparative Advantage: The ability to produce a good at a lower opportunity cost than another producer.

  • Leonard's Comparative Advantage: Cooking (his opportunity cost for meals is lower than Sheldon's).

  • Sheldon's Comparative Advantage: Laundry (his opportunity cost for laundry is lower than Leonard's).

• Fundamental Principles:

  • While one person can have an absolute advantage in all tasks, it is impossible to have a comparative advantage in both tasks.

  • Gains from trade arise specifically from differences in opportunity costs and comparative advantages.

Rational Decision-Making: Marginal Analysis

Marginal Units

• Marginal Benefit (MB): The increment in total benefits gained from taking an action or increasing the level of activity by one unit.

• Marginal Cost (MC): The increment in total costs incurred by taking an action or increasing the level of activity by one unit.

Optimization Rules

• To maximize net benefit, an individual should increase the level of activity as long as $MB \geq MC$.

• If MB < MC, increasing the activity further reduces net benefit ($NB$ falls) and is no longer optimal.

Case Study: Hiring Workers for a Computer Store

• Context: Matt Manager is hiring workers for a store.

• Constants:

  • Hourly Wage ($MC$): $\$20$ per worker.

• Variable Benefit (Diminishing Marginal Returns):

  • 1st worker contribution: $\$60$ per hour.

  • Diminishing rate: Each subsequent worker’s contribution decreases by $\$15$ per hour.

• Hiring Logic:

  • Worker 1: $MB = \$60$, $MC = \$20$ (MB > MC, Hire).

  • Worker 2: $MB = \$45$, $MC = \$20$ (MB > MC, Hire).

  • Worker 3: $MB = \$30$, $MC = \$20$ (MB > MC, Hire).

  • Worker 4: $MB = \$15$, $MC = \$20$ (MB < MC, Stop).

Algebraic Approach to Optimization

• Objective: Maximize $NB(x) = TB(x) - TC(x)$.

• Method: Use calculus to differentiate the net benefit function with respect to the activity level $x$ and set the derivative to zero.

• Formula:     $\frac{dNB(x)}{dx} = \frac{dTB(x)}{dx} - \frac{dTC(x)}{dx} = MB(x) - MC(x) = 0$

• The Optimal Quantity: The optimal level of activity, denoted as $x^*$, is the value that satisfies:     $MB(x^*) = MC(x^*)$

• Net Benefit Trends:

  • When MB(x) > MC(x), $NB$ is rising.

  • When MB(x) < MC(x), $NB$ is falling.

Algebraic Example

• Given:

  • $TB(x) = 10x$

  • $TC(x) = x^2$

  • $NB(x) = 10x - x^2$

• Derivatives (using power rule $\frac{df(x)}{dx} = anx^{n-1}$):

  • $MB(x) = 10$

  • $MC(x) = 2x$

• Setting for Optima:     $10 - 2x = 0$     $2x = 10$     $x^* = 5$

Administrative Details: ECON10004 Coursework

• Department: Economics, University of Melbourne.

• Lecturer: Eik Swee.

• Assessment Component: Pre-tutorial Quiz:

  • Schedule: Quizzes go live on the LMS every Thursday.

  • Deadline: Due Sunday night at 23:59 (11:59 PM).

  • Attempts: Students are allowed two attempts per quiz (unlimited time per attempt).

  • Submission Policy: Starting a quiz does NOT mean completing it. Failure to submit results in a score of zero.

  • Grading: Only the best 9 of 11 quiz scores count toward the final grade (totaling 5%).