1. THINKING LIKE AN ECONOMIST: DEFINITIONS AND CORE PRINCIPLES
Economics: study of how people makes choices under conditions of scarcity and of the results of those choices for
the society
Microeconomics: economics that looks at individuals’ choices
Macroeconomics: economics of the performance of national economies and the policies used by governments used
to improve that performance
Normative economics: how people should behave
Positive/descriptive economics: how people will behave
Scarcity principle = no-free-lunch principle: having more of any good necessarily requires having less of something
else. The scarcity principle is true because our resources are limited.
Cost-benefit principle: an action should be taken if, but only if, its benefit is at least as great as its cost. The cost-
benefit principle is used to understand people’s choices.
!!! pitfalls of the cost-benefit principle when inconsistently applied
Incentive principle: if you want to predict people’s behaviour, you should look at their incentives
!!! Decision pitfalls:
- Measuring costs and benefits as proportions rather than absolute dollar amounts
- Ignoring implicit costs
- Failure to think at the margins: we should only think at the costs and benefits that would change whether the
action occurs and not those that would occur no matter what
Economic surplus=benefit of taking an action−cost of taking this action
Opportunity cost: value of everything you must sacrifice to engage in an activity
Opportunity cost=implicit cost+ explicit cost
Sunk cost: costs that are beyond recovery at the moment the decision is made
e.g. the sunk cost fallacy is paying for a movie ticket, finding out the movie is terrible, and staying to watch anyway just to get
your money’s worth. When you find out the movie is terrible, you should make a decision whether to sit through the bad movie
or to do something more meaningful with your time – the price you paid for the ticket should not affect your decision. The ticket
price is a sunk cost.
Marginal costs: increase in total cost for one additional unit ≠ Average cost: total cost divided by number of units
Marginal benefit: increase in total benefit from one additional unit of activity ≠ Average benefit: total benefit
divided by the number of units
The cost of the 5th units might be different from the first one.
, 2. COMPARATIVE ADVANTAGE AND THE PPC
= One person has a comparative advantage over another if his opportunity cost of performing a task is lower than
the other person’s opportunity cost
e.g. an attorney employs another attorney to redact his wills because it would take him two hours during which he could gain
10.000$ while hiring someone that will write it for him will cost him 400$
Maximum production = specialisation: A society does best when everyone concentrates on the activities for which
his opportunity cost is the lowest.
loss(amount givenup)∈A
Opportunity cost b=
gain (amount of increase )∈ B
e.g. Paula and Mary can both repair bikes and update web pages. Mary has an absolute advantage in both (= it takes her less
time)
Bikes Web loss web 10 1 loss web 30
Mary 20min 10min OC Mary = = = OC Paula = = =1
bikes
gain bikes 20 2 bikes
gain bikes 30
Paula 30min 30min
Production possibilities curve PPC: illustrates the combination of two goods that can be
produced with given resources
- Attainable point (point of the curve): any combination of goods that can be
produced using currently available resources
- Unattainable point (point above the curve): anycombination of goods that cannot be
produced using currently available resources
- Inefficient point (below the curve): all resources are not fully utilised
To find the perfect combination, construct the PPC for each worker and the cross will
give you the perfect combination.
Gain from specialization and trade:
- Benefits increase when difference in opportunity cost increase
- Without trade, each one can consume along with his PPC only
e.g. No trade = 8 pounds nuts + 8 pounds coffee => total output 32 pounds
Specialization = 12 pounds nuts + 12 pounds coffee => total output 48 pounds
The PPC represent current choices but changes can occur:
- More resources:
o Investment in capital
o Population growth = more workers
- Improvement in technology: more specialization
- Increase in knowledge
Specialization is easier when:
- Population density passes a threshold
- Markets are connected: transportation of goods and communication for services
- Legal framework support businesses
- Financial markets support start ups
, The other solution is outsourcing which is service work performed overseas.
3. SUPPLY AND DEMAND
- What: what good will be produced and how much?
- How: which technology and which resources are going to be used?
- For whom: how are outputs distributed? What is the need? What is the income?
Central planning The market
Decisions made centrally: by individuals or small groups Production and distribution decisions left to individuals
of individuals interacting = people decide for themselves in the
e.g. agrarian societies: production for themselves and only capitalist/fee market economy
one family is in charge of big production or Soviet Union BUT there are still controls = mixed-economy
Market: all the buyers and sellers of a good
- Early economists (Smith and Marx): a price is determined by its costs of production
- C19th: price is the value people derived from goods
- Alfred Marshall: supply and demand curve
Demand curve: schedule or graph showing the quantity Supply curve: graph or schedule showing the quantity
of a good that buyers which to buy at each price of a good that sellers wish to sell at each price
- Substitution effect: change in the quantity - Sellers’ reservation price: smallest amount for
demanded of a good that results because buyers which a seller would be willing to sell an
switch to or from substitutes when the price of the additional unit (generally equal to marginal cost)
good changes - If the price is less than the opportunity cost: sell
- Income effect: change in the quantity demanded of a more
good that results because a change in the price of a - The low-hanging fruit principle explains the
good changes the buyers purchasing buyer upward sloping supply curve: take advantage of
- Buyers’ reservation price: largest amount buyers your most profitable resources first
would be willing to pay for a good
Market equilibrium: balanced situation in which all forces at work within a system are cancelled by others:
Equilibrium price and equilibrium quantity: price and quantity for which the demand and the
supply intercept = no unexploited opportunities for individuals
surplus supply=supply−demand surplus demand=demand−supply
No cash on table: surplus maximised = no opportunity to gain from additional sales
'
Buyer s surplus=buyers reservation price−market price
' '
Selle r surplus=market price−seller s reservation price
Total surplus=buyer s ' surplus+seller s ' surplus=buyer s' reservation price−seller s' reservation price
Efficiency principle: equilibrium price and quantity are efficient if:
- Sellers pay all the costs of production
- Buyers receive all the benefits of their purchase
Marginal cost = marginal benefit
Economic efficiency: all goods produced at their socially optimal level. The socially optimal quantity maximises total
surplus for the economy from producing and selling a good
Economics: study of how people makes choices under conditions of scarcity and of the results of those choices for
the society
Microeconomics: economics that looks at individuals’ choices
Macroeconomics: economics of the performance of national economies and the policies used by governments used
to improve that performance
Normative economics: how people should behave
Positive/descriptive economics: how people will behave
Scarcity principle = no-free-lunch principle: having more of any good necessarily requires having less of something
else. The scarcity principle is true because our resources are limited.
Cost-benefit principle: an action should be taken if, but only if, its benefit is at least as great as its cost. The cost-
benefit principle is used to understand people’s choices.
!!! pitfalls of the cost-benefit principle when inconsistently applied
Incentive principle: if you want to predict people’s behaviour, you should look at their incentives
!!! Decision pitfalls:
- Measuring costs and benefits as proportions rather than absolute dollar amounts
- Ignoring implicit costs
- Failure to think at the margins: we should only think at the costs and benefits that would change whether the
action occurs and not those that would occur no matter what
Economic surplus=benefit of taking an action−cost of taking this action
Opportunity cost: value of everything you must sacrifice to engage in an activity
Opportunity cost=implicit cost+ explicit cost
Sunk cost: costs that are beyond recovery at the moment the decision is made
e.g. the sunk cost fallacy is paying for a movie ticket, finding out the movie is terrible, and staying to watch anyway just to get
your money’s worth. When you find out the movie is terrible, you should make a decision whether to sit through the bad movie
or to do something more meaningful with your time – the price you paid for the ticket should not affect your decision. The ticket
price is a sunk cost.
Marginal costs: increase in total cost for one additional unit ≠ Average cost: total cost divided by number of units
Marginal benefit: increase in total benefit from one additional unit of activity ≠ Average benefit: total benefit
divided by the number of units
The cost of the 5th units might be different from the first one.
, 2. COMPARATIVE ADVANTAGE AND THE PPC
= One person has a comparative advantage over another if his opportunity cost of performing a task is lower than
the other person’s opportunity cost
e.g. an attorney employs another attorney to redact his wills because it would take him two hours during which he could gain
10.000$ while hiring someone that will write it for him will cost him 400$
Maximum production = specialisation: A society does best when everyone concentrates on the activities for which
his opportunity cost is the lowest.
loss(amount givenup)∈A
Opportunity cost b=
gain (amount of increase )∈ B
e.g. Paula and Mary can both repair bikes and update web pages. Mary has an absolute advantage in both (= it takes her less
time)
Bikes Web loss web 10 1 loss web 30
Mary 20min 10min OC Mary = = = OC Paula = = =1
bikes
gain bikes 20 2 bikes
gain bikes 30
Paula 30min 30min
Production possibilities curve PPC: illustrates the combination of two goods that can be
produced with given resources
- Attainable point (point of the curve): any combination of goods that can be
produced using currently available resources
- Unattainable point (point above the curve): anycombination of goods that cannot be
produced using currently available resources
- Inefficient point (below the curve): all resources are not fully utilised
To find the perfect combination, construct the PPC for each worker and the cross will
give you the perfect combination.
Gain from specialization and trade:
- Benefits increase when difference in opportunity cost increase
- Without trade, each one can consume along with his PPC only
e.g. No trade = 8 pounds nuts + 8 pounds coffee => total output 32 pounds
Specialization = 12 pounds nuts + 12 pounds coffee => total output 48 pounds
The PPC represent current choices but changes can occur:
- More resources:
o Investment in capital
o Population growth = more workers
- Improvement in technology: more specialization
- Increase in knowledge
Specialization is easier when:
- Population density passes a threshold
- Markets are connected: transportation of goods and communication for services
- Legal framework support businesses
- Financial markets support start ups
, The other solution is outsourcing which is service work performed overseas.
3. SUPPLY AND DEMAND
- What: what good will be produced and how much?
- How: which technology and which resources are going to be used?
- For whom: how are outputs distributed? What is the need? What is the income?
Central planning The market
Decisions made centrally: by individuals or small groups Production and distribution decisions left to individuals
of individuals interacting = people decide for themselves in the
e.g. agrarian societies: production for themselves and only capitalist/fee market economy
one family is in charge of big production or Soviet Union BUT there are still controls = mixed-economy
Market: all the buyers and sellers of a good
- Early economists (Smith and Marx): a price is determined by its costs of production
- C19th: price is the value people derived from goods
- Alfred Marshall: supply and demand curve
Demand curve: schedule or graph showing the quantity Supply curve: graph or schedule showing the quantity
of a good that buyers which to buy at each price of a good that sellers wish to sell at each price
- Substitution effect: change in the quantity - Sellers’ reservation price: smallest amount for
demanded of a good that results because buyers which a seller would be willing to sell an
switch to or from substitutes when the price of the additional unit (generally equal to marginal cost)
good changes - If the price is less than the opportunity cost: sell
- Income effect: change in the quantity demanded of a more
good that results because a change in the price of a - The low-hanging fruit principle explains the
good changes the buyers purchasing buyer upward sloping supply curve: take advantage of
- Buyers’ reservation price: largest amount buyers your most profitable resources first
would be willing to pay for a good
Market equilibrium: balanced situation in which all forces at work within a system are cancelled by others:
Equilibrium price and equilibrium quantity: price and quantity for which the demand and the
supply intercept = no unexploited opportunities for individuals
surplus supply=supply−demand surplus demand=demand−supply
No cash on table: surplus maximised = no opportunity to gain from additional sales
'
Buyer s surplus=buyers reservation price−market price
' '
Selle r surplus=market price−seller s reservation price
Total surplus=buyer s ' surplus+seller s ' surplus=buyer s' reservation price−seller s' reservation price
Efficiency principle: equilibrium price and quantity are efficient if:
- Sellers pay all the costs of production
- Buyers receive all the benefits of their purchase
Marginal cost = marginal benefit
Economic efficiency: all goods produced at their socially optimal level. The socially optimal quantity maximises total
surplus for the economy from producing and selling a good
