ECON 101 Lecture Notes - Diminishing Returns, Shortage, North American Free Trade Agreement

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Published on 16 Apr 2013
– Thinking Like an Economist
I. Studying Choice in a World of Scarcity
Costs Matters:
Scarcity is a fact of life!
oNever 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
Scarcity Principle
The scarcity principle: the available resources are limited relative to our
(boundless) needs and wants
Because of a Security:
oTradeoffs 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
and students
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
informal considerations
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
economic values
People are Rational
Economists assume that people are RATIONAL: that they know their goals and
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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
oEconomic 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
oi.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
oRational decisions depend upon opportunity costs
oOpportunity cost is value of the next best alternative
Determine the reservation price
A crucial economic concept – with many practical applications
Example: Selling Roses
oTo 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
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oIe. The benefits minus the direct plus indirect opportunity costs
o1. The roses will wilt by tomorrow morning and be valueless
o2. You have nothing else to do but to sell the roses (only two alternatives
for spending your time)
o3. Selling the roses on the sidewalk has no direct cost and generates a
revenue of $8. Thus the benefit are $8
o4. 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
oThe economic surplus of selling the roses on the sidewalk is $8 – ($30-
$10) = -$12
oThe economic surplus of selling the roses downtown is ($30-$10) $8=$12
oComparing the economic surpluses tells us that selling downtown is the
better alternative
Role of Models
An ‘Abstract Model” is a simplified description capturing essential elements of a
oIt allows logical analysis
oIt includes only the major forces at work and will always ignore many
details (facts)
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
oYou 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.
oShould you buy the computer game, and if so, where?
oTo 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!
oIf 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?
oTo 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
oIn this analysis you are using money as a measure of benefits and costs:
oYou 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
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