The Economic Way of Thinking

Monday, September 14, 2015

11:13 AM

The economic Problem: Scarcity requires choices

ScarcityWe live in a world with scarcity:
Individual: Limited budget, limited time
Society: limited resources to produce goods
Crucial implication - we confront the problem of scarcity by making
CHOICES
Limited resources- we have to make choices. Why make choices? We
confront scarcity.
What is economics: formal study of how rational people make choices.
DEMAND and SUPPLY
PROBLEM:
Buys ticket in advance- $75, takes taxi for $40. Lost ticket. Does individual buy
$100 regular price ticket?
Observations:
This is an economics problem
If you are rational, there is a "correct" answer.
Rational/Economic Decision Making
Two key building blocks:
1 Opportunity Cost- the opportunity cost of an action is what one forgoes
(gives up) by not taking the BEST alternative action.
Observations:
Opportunity cost includes time costs as well as money costs(class examples
emphasize this fact)
If opp cost is high, one is less likely to take action
Examples
You choose to attend a hockey game, and the ticket price is $75.
What is the opportunity cost of attending the hockey game:
Insight: to identify the opportunity cost of taking an action, one must identify
the next best alternative. (what is the next best alternative what are you
giving up)
if your next best alternative is to work for two hours and earn $50, opportunity
cost is $125 (75+50)
Insight: the opp cost of spending $1 is $ 1 (since you could spend this dollar on
other goods or services)
In 2002, you bought a rare book for $200. In 2010, you could have sold the
book for $500. Today you could sell the book for $100.
If you decide to give the book to a friend and the next best alternative is to sell
it, what is the opp cost of your gift?
0(you have already paid for it)
ANSWER:
It is $100.

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What you paid in 2002, or what you could sold the book for in 2010, are NOT
relevant. TODAY IS TODAY
The opp cost is NOT zero (although you own the book) since you could sell the
book today for $100 and this is your next best alternative.

APPLICATIONS:
In 2014, the US economy recovered from a deep recession and unemployment fell
sharply.
QUESTION:
Would you predict that the number of students enrolling in US universities
increased, fell, or was unchanged in September 2014 compared to September 2013.
Insights:
1 One must identify the opp cost of attending uni and how this opp cost changes
if unemployment falls
Opp cost of attending uni for one year
1 If next best alternative is full time work at $30,000 per year.
Tuition/books- $15k
Foregone Earnings- $30,000
Total- $45k (Opp Cost)
1 If nxt best alternative is to work full time, but no work is available (due to high
unemployment)
Tuition/Books- 15k
Foregone earnings- Nil
Opp Cost 15k
RESULT:
University enrolments will fall in September 2014.
For many, employment is the next best alternative to attending University
When the opp cost of taking an action is high, the action is less likely to be
taken
Suppose the benefits of attending university is as follows:
Individual A: $150l
Indiidual B:75k
Individual C: $25
If the opp cost incewases from 15k to 45k, individual C will not attend
University.

Should you operate a hotdog stand:

Revenue (per 8 hour day)
100 hot dogs at $4=$4.00 $400
Direct costs (per 8 hr)
Rent (for stand) - $150
Hot dogs, buns (!100
Difference: 150 ($400 less $250)
Non economist: yes, since it is profitable.
Economists: Insufficient information
Must identify the opp cost of your time
If you could earn $20 per hour ,your opp cost for an 8 hour day is 160. This
exceeds $150, and it would not be profitable for you to operate this hot dog
stand.

If you could earn only $10 per hour, your opp cost for an 8 hour day is 80. This
is less than 150, and it would be profitable for you to operate the hot dog
stand.
Why do few medical doctors operate a hot dog stand?
The opp cost of their time is so high (doctors are the highest earning
profession)

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OPP Cost: a more challenging example (to master concept)

You decide to attend a concert, which costs 100. You value the concert at 300
Your next best alternative is to go to a restaurant, which you value at $75 and
costs you 50.
Questions
What is the opp cost to you attending the concert?
$125 (100 (ticket price) plus (benefit of eating in restaurant (75(value to you)50 (What you have to pay)))
How does this opp cost change if the value to you attending the concert is
$500 instead of $300
300 is not anywhere. Value of the benefit to you does not influence anything
The opp cost of taking an action does not depend on the value to you of the
action taken (opp cost measures what you give up) when you take an action
Intuition: in this example, you would not attend the concert if the value to you
was less than 100 (the price of the ticket) however, if you choose to attend the
concertt the opp cost is the same value to you

Marginal Analysis