– Thinking Like an Economist
I. Studying Choice in a World of Scarcity
• Scarcity is a fact of life!
o Never enough time, money, energy, etc.
• Typically, in order to get the benefit of something we must give up something
else. (Eg. You can only spend your money or your time once!)
• The value of what we give up is the COST
• The scarcity principle: the available resources are limited relative to our
(boundless) needs and wants
• Because of a Security:
o Tradeoffs are widespread: having more of one good usually means having
less of another
• AKA the “No Free Lunch Principle”
Cost Matters: An Example
• Suppose smaller classes provide better education but also cost more to taxpayers
• What is the ‘best’ class size?
• If more resources are used to provide better education then those same resources
cannot be used to provide (Eg. Better health care)
The Cost-Benefit Principle
• The Cost-Benefit Principle: An individual (or a firm or a society) should take an
action if, only if, the extra benefits from taking the action are the least as good a
• Measuring the costs and benefits can be very difficult and very often involve
Benefits and Costs
* “money isn’t everything”
• But to make rational choices we must compare costs and benefits
• Are the benefits greater or less than the costs?
• To compare the benefits of a decision to the costs, benefits and costs must be
measured in comparable units
• In Canada, the Canadian dollar is most often used as the unit for measuring
People are Rational
• Economists assume that people are RATIONAL: that they know their goals and try to fulfill these goals as best they can with the limited resources they have
• Typically, people use the cost – BENEFIT PRINCIPLE to resolve the economic
tradeoffs they face
• If the is no scarcity – ie. No trade-offs, then there is no economic problem
• Not all decisions and choices involve only economic considerations
• Although many decisions that are taken based on non-economic considerations
(emotions, habits, culture, religion, decree, etc.) will have economic implications!
Reservation Prices in $$
• Buyer’s Reservation Price: the highest dollar price a buyer would be willing to
pay for any good or service
• It is interpreted as a Quantitative Measure of the benefit the buyer expects to
receive from the good or service
• Seller’s Reservation Price: the lowest dollar payment a seller would be willing to
accept for giving up a good or performing a service
• It could be taken as Quantitative Measure of the seller’s cost of the good or
Economic Surplus (Net Benefit)
• The benefit of taking an action minus the cost of taking that action
o Economic Surplus = Benefit – Cost
• Rational Decision Maker takes all actions that yield a positive economic surplus
• This defines what is meant by Rational Behavior
• If a market transaction is voluntary, both buyer and seller must think the deal
makes them better off
o i.e. both buyer and seller must derive an Economic Surplus from the deal
• It is a win-win situation
• Surplus – The benefit of taking an action minus the cost of taking that action
• Ex. If I can sell for $10 when my Seller’s Reservation price is $8, then my
economic surplus is $2
• If I can buy for $10 when my Buyer’s Reservation price is $13, then my
Economic Surplus is $3
• The relevant cost for economic decision making is: opportunity cost
• Opportunity cost: The value of the next-best alternative that must be forgone in
order to undertake an activity
o Rational decisions depend upon opportunity costs
o Opportunity cost is value of the next best alternative
Determine the reservation price
• A crucial economic concept – with many practical applications
• Example: Selling Roses
o To decide which alternative is the best we can use Cost- Benefit
Anaylysis. To that we need to calculate the Economic Surplus or Net
Benefit of each alternative o Ie. The benefits minus the direct plus indirect opportunity costs
o 1. The roses will wilt by tomorrow morning and be valueless
o 2. You have nothing else to do but to sell the roses (only two alternatives
for spending your time)
o 3. Selling the roses on the sidewalk has no direct cost and generates a
revenue of $8. Thus the benefit are $8
o 4. Selling the roes downtown has direct transportation costs of $10 and
generates a revenues of $30. Here the benefits are $30 minus the direct
costs, $10 – ie the benefits are $20
o The economic surplus of selling the roses on the sidewalk is $8 – ($30-
$10) = -$12
o The economic surplus of selling the roses downtown is ($30-$10) $8=$12
o Comparing the economic surpluses tells us that selling downtown is the
• Role of Models
• An ‘Abstract Model” is a simplified description capturing essential elements of a
o It allows logical analysis
o It includes only the major forces at work and will always ignore many
• For example, the Cost-Benefit Principle is an abstract model of Rational Choice
between competing alternatives
• In the example of selling flowers it may be fact that walking around downtown
wears out your shoes faster
• Example: Buying a Computer Game
o You are considering the purchase of a computer game at the campus
bookstore for $24 when someone tells you that you can buy the same
game downtown for $15. However, if you decide to buy downtown then
you have to walk for 30 minutes to get there.
o Should you buy the computer game, and if so, where?
o To fine out the benefit to you of the game you may ask yourself what is
the maximum amount of money you are willing to py for it. That is your
Reservation Price for the game!
o If your answer is more than $25 then you still need to decide where to buy.
It is worth it to you to walk downtown to save $10?
o To find out the cost to you of walking downtown you may ask yourself
what is the minimum amount of money you have to be paid in order to do
it. That is your Reservation Price for walking downtown
o In this analysis you are using money as a measure of benefits and costs:
o You can decide on your reservation prices for bot the game and for
walking downtown they you have all the information you need in order to
make a rational decision!
Rational Choices • Rational people will attempt to apply the cost-benefit principle
o But exact calculations cost time & effort
o So people use their intuition & rules of thumb
• Hence people can often make mistakes or make inconsistent choices
• But basic economic principles can be a useful guide to good decision making, and
a useful predictor of behavior
Decisions about more or less
• Often we make decisions about how much to do about something
• A rational person pursues an activity so long as, for each unit activity:
o The additional benefits exceed the additional costs
• Marginal Benefit
o The increase in total benefit that results from carrying out one additional
unit of an activity
• Marginal Cost
o The increase in total cost that results from carrying out one additional unit
of the activity
Optimal Level of an Activity
• If the Marginal Benefits are Decreasing and the Marginal Costs are Increasing
with the level of the activity then:
o If the marginal benefit is greater than marginal cost then Increase the level
of the activity
o And if the marginal benefit is less than the marginal cost then Decrease
the level of the activity
• The Optimal Level of an Activity is such that marginal benefit equals the
o Marginal benefit = Marginal Cost
o MB = MC
Fig 1.1 The Marginal Cost and Benefit of Additional RAM
Three Common Pitfalls
Pitfall #1: Ignoring significant Opportunity Costs
• Rational decisions require us to recognize all the significant opportunity costs
• Opportunity Cost
= the value of the next-best alternative that must be forgone in order to
engage in a particular activity
What’s ‘Free’? • Using a good we already own is usually not free:
o Could be sold in the marketplace instead
o Could be used for another purpose
• Possible sales proceeds or value in best alternative use are examples of
• Always ask yourself – what am I giving up?
o If I spend more time on one question on the exam, how many marks am I
giving up by not answering other questions?
• Pay now or Pay later?
o You are always better off if you can delay payment – unless you have to
pay interest or incur other costs because you are delaying you payment!
• Delaying a payment means money can be invested (and earn interest) in the
• Opportunity cost of paying now, instead of paying later, is the foregone interest
Time Value of Money
• A given dollar amount today is equal to a larger dollar amount in the future
• A given dollar in the future is equal to a smaller dollar amount today
• Money can be invested in an interest-bearing account in the meantime
• Banks paying interest on borrowed money are simply reimbursing the lend for the
opportunity cost to the lender of not being able to use (invest) the money today
Relationship between Costs and Benefits
• A reciprocal relationship exists between costs and benefits
o When you take an action and do not receive a benefit that you otherwise
would have, then that is an opportunity cost of taking the action
o When you take an action and do not pay a cost an you otherwise would
have, then that is a benefit of taking the action
Pitfall #2: Failure to ignore Sunk costs
• Sunk Costs: are those costs that will be incurred whether or not an action is taken
o Eg. Money that you cannot recover
• Since the sunk costs cannot be recovered they are irrelevant to a decision to take
o Sunk costs should NOT be counted on for decision-making purposes
• Rational decision makers compare benefits to only the additional costs that must
be incurred to take an action
Example: Your car breaks down
Suppose you paid $5000 for the car and that you still owe $3000 on the car loan
Now the engine just broke!
- As is, it can sell for $200 - It will cost $1500 to fix the engine. After the repair it can sell for $2000
Which costs are relevant to your decision?
Which costs are sunk costs and should be ignored?
What’s the optimal decision?
Pitfall #3: Failure to Understand the Difference Between Average and Marginal
People often compare Average Benefits to Average Costs when they make decisions
However, the relevant costs and benefits are always the Marginal Costs and Benefits!
Average Costs and Benefits cannot tell you anything that you couldn’t learn from the
corresponding Total Costs and Benefits!
- Costs that do not vary with the level of an acitivitiy
- All sunk costs are fixed costs, but not all fixed costs are sunk costs. Some
fixed costs may not have to be incurred until the action is or has been taken
- Costs that do vary with the level of an activity
Fixed Costs, Variable Costs and the Optimal Level of an acitivity
- Marginl Costs are the additional costs of increasing the level of the activity by
one unit (ie. The Marginal Costs are the additional Variable Costs)
- In deciding whether to increase the level of an activitiy we must compare the
additional variable costs (MC) to the additional benefits (MB.)
- In particular, Fixed Costs are NOT involved1
Positive Net Gain
Comparing the marginal costs to marginal benefit of the next unit tells us hether or not
the next unit yields a net gain
- If the net gain is positive, then the next unit should be produced
- If the net gain is negative then the next unit should not be produced
NASA has a space program that undertakes 4 launches per year. The total cost of the
program is $20 billion and the total benefit is estimated to be $24 billion NASA is now considering if it should expand this program to 5 launches per year
The fact that total benefit is greater than total cost tells us that the program as a whole is
Also, since the average benefit is $6 billion while the average cost is $5 billion may
suggest that it would be worthwhile to add a fifth launch
However, suppose the relationship between number of launches and total cost is as
Launch TC AC MC
1 6 6 6
2 8 4 2
3 12 4 4
4 20 5 8
5 30 6 10
If the benefit of the 5 launch is, as above, $6 billion then the 5 launch should not be
undertaken because the Marginal Cost, $10 billion, is greater than the Marginal Benefit,
Optimal Allocation of Resources: Maximizing Total Output
Allocate each unit of a resource to the production activity that has the highest marginal
Balance the allocation so that the marginal net benefit is the same in every activity
If the marginal net benefits are not equalized, re-allocation of resources will increase
Coconuts per Day
North End South End
People Coconuts People Coconuts
1 12 1 6
2 16 2 12
3 19 3 18
4 21 4 24
Example 2: Coconuts per Day
North End South End
People Coconuts People Coconuts
1 8 1 6
2 16 2 12
3 24 3 18
4 32 4 24
The Optimal Allocation of People is the allocation that maximizes total output.
Micro and Marco
- Choices of individuals
- Behaviour of specific markets
- Prices and quantities
- Performance of national economies
- Government policies to change performance
- Unemployment rate and the price level
The scope of macro and micro are different
However, both are trying to predict behavior that is based on scarcity
Clear thinking about economic problems will always account for Tradeoffs: having more
of one good thing usually means having less of another
Using your insights from economics to make sense of observations from everyday life
Learning economic principles enables us to see the ordinary details of life in a new light
- eg. Look for differences in costs and benefits CHAPTER 2
Generalize or Specialize?
People who do all (or most) of their own tasks
Problems: “Jack-of-all-trades” but “Master of none”
Self-sufficiency is the advantage
Low productivity is the disadvantage
Focus on fewer tasks & trade to satisfy wants
Each person is more productive – hence greater total output
Absolute vs. Comparative Advantage
A person has an absolute advantage over another person if
- The first person takes fewer hours (or uses fewer resources) to perform a task
than the other person
A person has a comparative advantage over another person if
- The first persons opportunity costs of performing the task is lower than the other
person’s opportunity cost
- is measured in terms of input sacrificed
- is measured in terms of Opportunity costs – ie. Output sacrificed
Principle of Comparative Advantage
If each person (or country) concentrates on the activities for which his or her opportunity
costs are lowest, then the total combined benefit is the greatest This is true even if one party has absolute advantage over the other’s in terms of all
If the opportunity costs are equal then the total combined benefit is the same for any
allocation of activities
Sources of Comparative Advantage
- Inborn talent plays a role – but only to start
- Education, training, and experience
- Differences in natural resources
- Differences in accumulated Physical and Human Capital
- Differences in cultural, social, economic, legal and administrative
Production table for Rick and Beth:
Updating Webpages Repair Bicycles
Rick 3 per hour 6 per hour
Beth 2 per hour 2 per hour
Update Webpages Repair Bicycles
Time Spent Output Time Spent Output
Rick 4 hours 12 pages 4 hours 24 bicycles
Beth 2 hours 4 pages 6 hours 12 bicycles
Total Output: 16 pages 36 bicycles
Update Webpages Repair Bicycles
Time Spent Output Time Spent Output Rick 0 hours 0 pages 8 hours 48 bicycles
Beth 8 hours 16 pages 0 hours 0 bicycles
Total Output: 16 pages 48 bicycles
Calculating Opportunity Costs for Rick
Opportunity Costs of Updating Webpages:
OCw = loss of repaired bicycles/gain in updated webpages = 6/3 = 2
Opportunity Costs of Repairing Bicycles:
OCb= loss in updated webpages/gain in repaired bicycles = 3/6 = ½
Calculating Opportunity Costs for Beth
Opportunity Costs of updating webpages:
OCw = loss of repaired bicycles/gain in updated webpages = 2/2 = 1
Opportunity Costs of Repairing Bicycles:
OCb= loss in updated webpages/gain in repaired bicycles = 2/2 = 1
The Production Possibilities Curve
- A graph that describes the maximum amount of one good that can be
produced for every possible level of production of the other good.
- For example, cutting sugar cane or picking nuts. The more time spent doing
one, the less time there is available for another.
Attainable Versus Unattainable Points
- Any combination of goods that can be produced using currently available
- Any combination of goods that cannot be produced using currently available resources.
Efficient versus Inefficient Points
- Any combination of goods for which does not allow an increase in the
production of one good without a reduction in the production of the other
- Any combination of goods for which allows an increase in the production of
one good without a reduction in the production of the other.
Calculating Opportunity Cost
Susan’s Opportunity Cost of Picking Nuts:
OCnuts = loss in sugar/gain in nuts = 12/24 = ½
Susan’s Opportunity Cost of Sugar
OCsugar = loss in nuts/gain in sugar = 24/12 = 2
The PPC illustrates the Scarcity Principle
- More of one means less of another!
Principle of Increasing Opportunity Cost
- In expanding the production of any good, first employ those resources with
the lowest opportunity cost, and only afterwards turn to resources with higher
Opportunity Costs of Production
Cutting Sugar Cane Picking Nuts
Susan 24/12 = 2 12/24 = ½
Tom 6/6 = 1 6/6 = 1
Isolation and Self-Sufficiency
Production = Consumption
Susan 9 6
Tom 3 3
Totals 12 9 Specialization and Trade
Sugar Nuts Sugar Nuts
Susan 6 12 9 7.5
Tom 6 0 3 4.5
Totals 12 12 12 12
Changes in PPC
- Increases in productivity of both outputs shift the PPC out
- Increases in productivity in one but not the other output pivot the PPC
outwards around one of its endpoints
Gains from Specialization (a)
- Specialization produces gains for all, even when one person enjoys an
absolute advantage in both taks
- Uses differences in individual skills
- Deepens skills via practice
- Breaks tasks into simple steps multiplies the productivity of workers
Gains from Specialization (b)
- This is the most important explanation of the difference in income levels
Look at figure 2.9 Circular Flow Chart
Even Specialization has Costs
- Most people enjoy variety in the work they do
- Increased specialization means less variety
- Overspecialization results in repetitive tasks
- Specialization leads to greater dependence on others to satisfy our needs.
(ie. more inter-dependence)
Smoothly Bowed PPC
Production Possibilities Curve: - Smooth because of a large population
- Downward-sloping – shows scarcity principle
- Increasing Opportunity Cost
- Greater production of one good results in rising opportunity cost of producing
more of that good.
Comparative Advantage and International Trade
- Each trading partner can benefit from trade, even if one partner is absolutely
- Without trade, the opportunity cost of producing is higher than it would be if
trade occurred, hence output is lower.
Production Possibilities and Trade (with reference to Figure 2.11)
At the Production Point E: Without Trade:
OC(nuts) = 56/8 = 7 kg of sugar
OC(sugar) = 56/8 = 7 kg of nuts
At the Production Point E: With Trade:
OC(nuts) = 1 kg of sugar
OC(sugar) = 1 kg of nuts
Trade and the Small Nation
- Each trading partner can potentially benefit from trade, but the smaller
partner’s gain is of greater consequence to them than the gain is to the larger
- The larger partner may demand implicit conditions for trade to take place.
(eg.Canada’s softwood lumber exports to the USA)
- Do financial gains from trade compensate for loss of autonomy? – No
Volume of Trade
- The volume of international trade has grown substantially over time
- Most nations are quite heavily involved in international trade and in many
cases produce only a fraction of their total supply (use) of any good or service.
- Potential gain from trade is the differences in domestic opportunity costs and
global opportunity costs.
Trade and Economic Development - Foreign Aid can be extremely important in specific circumstances
- Today it is almost universally recognized that access to international(global)
markets is a necessary condition for general economic development, growth,
and improved standards of living.
- All countries that enjoy high standards of living are heavily involved in
Why Trade Barriers? (a)
- If exchange is beneficial, why would anyone oppose it?
- International trade increases the total value of all goods and services produced
in the world, but it does not guarantee that everyone will share those benefits!
Why Trade Barriers? (a)
- E.G. concerns over NAFTA
- Canadian consumers would benefit from lower prices, but some thought that
Canada would lose, in particular, unskilled jobs to Mexico
- While it is possible that some jobs have been lost, others have been gained.
The net effect has not been significant one way or the other!
- Protection of domestic jobs and industries.
- It was also thought that NAFTA would lead to increased pollution.
- If NAFTA has led to increased production and consumption, and the evidence
suggests that it has, then it is quite likely that pollution has increased.
Why Trade Barriers? (b)
- A superpower may use trade as an instrument of foreign policy (refer to the
example of Cuba, above)
- If there is lots of foreign ownership, the benefits may mostly flow to
foreigners, rather than to the domestic population.
- Trade may lock existing comparative advantages into place, not allowing
improvements in this area.
All economies must answer the following questions:
- What should be produced?
- How should it be produced?
- For whom will it produced? Two Basic Economic Systems
- Central Planning
- Agrarian society
- Former Soviet Union
- Cuba, North Korea
A small number of individuals address these concerns:
- Establish production targets for factories and farms
- Plan how to achieve the goals
- Distribute the goods and services produced Chapter 3
- Capitalistic, free enterprise economies
- Outside of the Government sector, individual households are both consumers
- Ultimately households own everything and make decisions based on their own
- The markets provide opportunities for individuals to decide what is best for
The Three Basic Economic Questions
- What goods and services to produce: maximize income and profit
- How to produce: minimum cost
- Who gets what is decided by purchasing power (income and wealth) and
- How do consumers get the goods and services they want in the right quantities
- Most goods and services are allocated through market forces of supply and
- Why do some goods and services have shortages or surpluses while others do
- Sometimes markets do not work very well, sometimes government may
regulate the markets because they are not allocating goods and services
The Market System - In the Private Sector, individuals and firms interact in markets for goods and
services, within a framework of laws, regulations and customs.
- Individuals as Consumers decide primarily: - Which products to buy.
- Individuals as Producers decide primarily: - What, how and how much to
produce, - What prices to charge
- Most goods and services are allocated by markets, which often work
remarkably well in matching what consumers want with what firms produce
- Economics tries to explain why
- But markets do not always work well
- Economics tries to explain why not
- Markets need a framework of laws, regulations and customs to function
- Example: Property rights need to be defined and enforced if transactions are to
occur; markets are more efficient when consumers can rely on accurate
weights, measures and ads.
- So, economists also try to analyze how best to organize markets.
- Why are some goods cheap and others expensive?
- Through most of history, nobody really understood: the water-diamond
- Most thought prices were different because of differences in the costs of
- Others thought prices were different because of differences in the values to the
buyers from use and consumption.
- Today we know the answer: Both are important!
- A market for a good or service consists of all individuals who either do or
may buy and sell that good or service.
- Some markets may be physically located in a specific building or place.
- Eg. A stock market or an outdoor market.
Theory of a Competitive Market
- In the late 19 century the British economist Alfred Marshall developed the
theory of a Competitive Market.
- The analytical tools of this theory are:
- Market Supply
- Market Demand - Market Equilibrium
The Market Supply Curve
- Shows the total quantity of a good or service that all sellers are willing and
able to sell at each price.
- Illustrated in a graph or schedule
- Positive Relation between Price and Quantity:
- As price rises, a greater quantity can be sold because higher opportunity costs
can be covered
- Application of the Principle of Increasing Opportunity Costs: rising marginal
costs of producing additional units.
The Market Demand Curve
- Shows the total quantity of a good or service that all buyers are willing and
able to buy at each price.
- Illustrated in a graph or schedule.
- Negative Relation between Price and Quantity.
- As price rises, consumers want fewer items
- People switch to substitutes or people cannot afford as much.
- When all buyers and sellers are satisfied with their respective quantities at the
existing market price
- Then the market is in stable, balanced, unchanging situation.
- The supply and demand curves intersect.
- The intersection yields the Equilibrium Price and the Equilibrium Quantity.
When the existing price is the Equilibrium Price then the Total Quantity the buyers would
be willing and able to buy is exactly equal to the Total Quantity the sellers would be
willing and able to sell.
In other words, in a Market Equilibrium all buyers and all sellers can at least potentially
do exactly what they would be willing and able to do, given the existing price.
- If a market is not in equilibrium then the market situation is one of
Disequilibrium and there is either excess supply or demand.