Core Economics Notes: Scarcity, Costs, and Opportunity Cost

Economics and Scarcity

  • Economics is the study of choice under conditions of scarcity.
  • Scarcity means the amount of something available is insufficient to satisfy desires.
  • Core limitations we face: time and spending power are the two basic constraints; resources like food, sleep, and other needs can also be scarce.
  • Time: there are only 24 hours in a day, so we can’t do everything we want.
  • Spending power: money to spend is limited; you can’t satisfy all wants with the resources you have.
  • Because of scarcity, decisions have to be made; the foundation of economics is individual choices.

Four Core Principles of Economics

  • Cost-benefit principle: evaluate the full set of costs and benefits of any choice; pursue only if benefits are at least as large as the costs.
  • Opportunity cost principle: when making a choice, consider what you must give up—the next best alternative.
  • Marginal principle: think at the margin—would a little more or a little less improve the outcome?
  • Interdependence principle: decisions depend on other decisions (your own or others’), highlighting the interconnected nature of choices.

The Cost-Benefit Principle

  • Core idea: decisions are guided by comparing benefits and costs; you should pursue options where benefits ≥ costs.

  • Economic surplus (or total net benefit) concept:

    E_s = B - C

    where

    • $B$ = total benefits from the choice,
    • $C$ = total costs of the choice.

  • If $B
    leq C$, you’re worse off and wouldn’t choose it. If $B rame{ } C$ (i.e., $B r$ $C$ or $B
    eless$), you would choose it. The goal is to maximize $E_s$.

  • Willingness to pay (WTP): the maximum amount a person would be willing to pay to obtain a benefit. Quantifying benefits often requires estimating WTP.

  • Quantifying costs/benefits in dollars helps compare options, even when some benefits aren’t monetary.

  • Example: Google search value. Benefits from using Google are estimated at about 500 per year for the average American; cost is nearly zero, so the net benefit is about 500.

  • Coffee example (buyer-seller): If coffee costs 3 and a buyer’s WTP is 4, the buyer’s benefit is greater than the cost by 1, yielding an economic surplus of 1. The seller’s benefit is revenue; if the cost of producing the coffee exceeds the price, the seller wouldn’t sell.

  • Framing effect: how a decision is framed can influence choice, even if the underlying costs/benefits are identical. This can lead to non-rational framing biases.

    • Example framing: two plans to cut costs presented in different frames (Plan A vs Plan B; or Plan One vs Plan Two) can lead to different choices despite identical outcomes.
    • The core point: framing can affect decisions, but the actual outcome in terms of costs and benefits remains the same.

  • Practical illustration with Nerida (one-year car vs Uber decision):

    • Car purchase: buy brother’s 5-year Ford Focus for 10{,}000; expected resale for 8{,}000 after one year; net car cost = 10{,}000 - 8{,}000 = 2{,}000$.
    • Ongoing costs (per year): drive 5 miles to/from work, 5 days/week, 50 weeks/year; fuel efficiency 25 mpg; gas price 3/gal.
    • Additional costs: insurance; repairs estimated at 500/year; parking at 5/day.
    • Benefits of car: avoids Uber fares, saving 5{,}000 per year.
    • Cost components (as summarized in the example): car cost 2{,}000; gas; insurance; repairs 500; parking; total annual cost reported as 5{,}550; total annual benefit reported as 5{,}000.
    • Conclusion for Nerida: costs exceed benefits by 550 per year, so buying the car is not the better choice in this one-year frame.
    • Key takeaway: the decision depends on the comparison of total annual costs and benefits and the chosen timeframe.

  • Relative nature of costs/benefits: the comparison depends on the alternatives considered (the next best option).

The Opportunity Cost Principle

  • Definition: the opportunity cost of a choice is the value of the next best alternative forgone.

  • It exists for every decision and includes both monetary and non-monetary components.

  • Illustrative example: Nerida considering going back to school for an MBA.

    • Direct monetary cost: tuition of 60{,}000 per year, for two years (full-time).
    • Foregone income: quitting her current job with a salary of 70{,}000 per year.
    • Room and board: estimated at 24{,}000 per year (costs that may be incurred regardless of the decision, so some argue it’s not purely incremental).
    • Time commitment: 10 hours per day spent studying vs working.
    • Annual opportunity cost if she pursues the MBA: 60{,}000 + 70{,}000 = 130{,}000 per year.
    • Over two years, the annual opportunity cost of 130k amounts to a total of 260{,}000.
    • Important nuance: room and board and some other costs may be present regardless of the decision; what matters for opportunity cost is the incremental or forgone items (e.g., the salary) that differ between options.

  • Lessons from opportunity cost:

    • Out-of-pocket costs vs. opportunity costs (monetary vs. non-monetary forgone benefits).
    • Not all monetary costs are true opportunity costs; some costs exist regardless of the decision.

  • Everyday applicability: evaluate true opportunity costs when choosing how to allocate scarce time, money, and other resources.

  • Suggested heuristic: ask yourself, "Or what?" to identify the next best alternative and compare it against your chosen option.

  • Societal and entrepreneurial perspective:

    • For entrepreneurs, the opportunity cost of using personal savings is the foregone investment income (e.g., if you withdraw money from a savings account earning 3%, the foregone interest is an element of the cost of starting the business).
    • The decision rule remains: start the business if benefits ≥ costs, where costs include both monetary costs and opportunity costs.

  • The true cost of college (in the real world):

    • Tuition is a major direct cost, but the true cost also includes room and board, other living expenses, and the opportunity costs of not earning income while in school.
    • Some costs (like housing) would be incurred regardless of attendance; these should be carefully considered to determine incremental costs.
    • Benefits of college can change over time (e.g., during the pandemic, benefits of in-person college were diminished, yet many still pursued higher education).
    • Opportunity costs are highly individual; the same MBA decision can have different opportunity costs for different people depending on potential earnings and alternatives.

  • Quick decision heuristic for opportunity cost:

    • Ask, "Or what would I do instead?" to identify the next best alternative and weigh it against the chosen option.

  • Sunk costs and decision making:

    • Sunk cost: a cost that has already been incurred and cannot be recovered.
    • Sunk costs should be ignored in current decision making.
    • Example in the MBA decision context: tuition already paid (non-refundable) is a sunk cost and should not affect the decision to continue or drop the program.

  • Foregone interest (owner’s money) and other explicit examples:

    • When an entrepreneur uses personal savings, the foregone interest or investment income is part of the cost of starting the business.
    • The decision should focus on the incremental benefits and costs relative to the next best alternative.

  • Framing, sunk costs, and behavioral notes:

    • Framing can mislead if we rely on presentation rather than underlying economics.
    • Sunk costs should not bias decisions toward continuing a losing path.
    • Ethical and practical implications: accurately accounting for opportunity costs leads to better resource allocation in both personal finance and business strategy.

Key Takeaways and Quick References

  • Core definitions:
    • Scarcity: limited resources relative to desires; forces choice.
    • Economic surplus: E_s = B - C.
    • Willingness to pay: maximum amount a person would pay for a benefit.
    • Opportunity cost: value of the next best alternative forgone.
    • Sunk cost: a cost that has already been incurred and cannot be recovered; ignore in new choices.
  • Decision rules:
    • Cost-benefit: choose if benefits ≥ costs; maximize $E_s$.
    • Consider marginal changes: would a little more/less improve the outcome?
    • Consider interdependence: decisions affect and are affected by others.
  • Practical examples and applications:
    • Coffee purchase: quantify costs and benefits; decide based on net benefit and WTP.
    • Google search: high perceived benefit with minimal cost demonstrates high economic surplus.
    • Framing effects in cost-cutting decisions: identical outcomes can be perceived differently depending on presentation.
    • Nerida’s car decision: compare annual costs vs. benefits; Uber as an alternative when car costs outweigh benefits.
    • MBA decision: evaluate tuition + foregone income against benefits of higher future earnings; consider time costs and other living costs as needed.
  • Formulas to remember:
    • Economic surplus: E_s = B - C
    • Opportunity cost (annual): OC = ext{Value of next best alternative forgone} (e.g., OC = 60{,}000 + 70{,}000 = 130{,}000 per year in the MBA example)
    • Sunk cost principle: ignore sunk costs in decision making.