E C O N O M I C S : T H E S T U DY O F O P P O RT U N I T Y C O S T

CHAPTER 1

DEFINITION OF ECONOMICS

According to Guell:• Economics: the study of the allocation and use of

scarce resources to satisfy unlimited human wants

• Opportunity Cost• The forgone alternative of the choice madeOr• What you would have done had you not done what you

did.

OPPORTUNITY COSTS

• Point of both of these is that if you want to get more of one thing you typically have to give up something of another

We see these things all the time:1. In order to buy food I need to give up money2. In order to get money I have to give up some free

time and work more3. If I want to eat more potato chips I have to spend

less on bananas4. I spend time in school today to make money in

the future

The opportunity cost can be different over time

When you study you give up time when you could be doing something else.

The opportunity cost of your time probably is different:• On a Monday Evening• On a Saturday Night• During the Super Bowl• On thanksgiving• On the day you get married

PRODUCTION POSSIBILITIES FRONTIER

• We are going to start with a simple model to learn how economists formalize these things

• This is called a production possibilities frontier

• Just a fancy way of describing the the way in which we are limited in what we can get

PRODUCTION POSSIBILITIES FRONTIER

Imagine you are in charge of a small tribe on an island.

You have 2 workers and you want to allocate them between two different tasks: Hunting or Fishing

You know how good the workers are at each skill:

WORKERS

Workers Fish Deer

Bill 40 2

Sally 20 4

How do you assign them?There are 4 different possibilities that would lead to the following outcomes:

Fisherman Fish Deer

None 0 6

Bill 40 4

Sally 20 2

Both 60 0

FISH AND DEER

Deer

0 10 20 30 40 50 60 700

1

2

3

4

5

6

7

Fish

Inefficient

NOW SUPPOSE WE ADD A FEW MORE PEOPLE

Name Fish Deer

Donna 50 1

Bill 40 2

Jane 30 3

Sally 20 4

Carl 10 5

This gives us quite a few more options

POSSIBILITIES NOW

0 20 40 60 80 100 120 140 1600

2

4

6

8

10

12

14

16

Fish

Deer

WITH A LOT OF PEOPLE

Now it is going to look something like this:

Fish

Deer

Not Attainable

Attainable (but not efficient)

We are going to end up somewhere on the red line

Attainable (and efficient)

WHAT WILL I CHOOSE?

I know that I will be somewhere on the red lineBut where?

It depends how much I like venison as opposed to seafood

There is a tradeoff between fish and deer:The more deer I get the fewer fish I can get

Economics is fundamentally about making these kinds of tradeoffs

INCREASING OPPORTUNITY COSTS

When things are bowed out like this there are increasing opportunity costs

Suppose the PPF looks like what is on the next slide

Think about the opportunity cost of a Deer when• I have no Deer• I already have 4 Deer

0 2 4 6 8 10 12 14 160

1

2

3

4

5

6

Deer

Fish

If I have no Deer, the opportunity cost of a deer is

1 fish

If I already have 4 Deer, the opportunity cost of another is

5 fish

Increasing Opportunity Cost

HOMOGENEOUS WORKERS

Now suppose all workers are the same

Worker Fish Deer

Henry 20 2

Phil 20 2

Anne 20 2

Rachel 20 2

Barney 20 2

PPF WITH WORKERS SAME

0 20 40 60 80 100 1200

2

4

6

8

10

12

Fish

Deer

Here the opportunity cost is constant

The opportunity cost of 2 more deer is

20 fish regardless of how many deer I already have

BUDGET CONSTRAINT

This is also very similar to another really important concept: the budget constraint• Suppose you have $100 to spend on Deer and

Fish• The price of a fish is $1.00• The price of a deer is $10.00

• This will look exactly the same

THE BIG PICTURE

Circular Flow Model: A model that shows the interactions of all economic actors

• Markets are where the interactions take place (rectangles)

• Actors are the entities interacting (ovals)

MARKETS IN A CIRCULAR FLOW DIAGRAM

• Market: Any mechanism by which buyers and sellers negotiate an exchange• Factor Market: A mechanism by

which buyers and sellers of labor and financial capital negotiate an exchange.• Goods and Services Market: A

mechanism by which buyers and sellers of goods and services negotiate an exchange.• Foreign Exchange Market: A

mechanism by which buyers and sellers of the currencies of various countries negotiate an exchange.

ACTORS IN A CIRCULAR FLOW DIAGRAM

• Households

• Firms

• Government

THINKING ECONOMICALLY: MARGINAL ANALYSIS

•Optimization Assumption: an assumption that suggests that the person in question is trying to maximize some objective

•We usually assume people are maximizing utility or happiness

• Firms maximize profits

MARGINAL COSTS AND BENEFITS

• Marginal Benefit: the increase in the benefit that results from an action• Marginal Cost: the increase in the cost that

results from an actionGenerally we do things until the marginal cost=marginal benefit• If the marginal cost of fish I give up is greater

than the marginal benefit I get from more deer, then I have too many deer• If the marginal cost of fish is less than the

marginal benefit then I want more deer

POSITIVE AND NORMATIVE ANALYSIS

• Positive Analysis: a form of analysis that seeks to understand the way things are and why they are that way

• Normative Analysis: a form of analysis that seeks to understand the ways things should be

ECONOMIC INCENTIVES

• Incentive: something that influences the decisions we make

Examples:1. Hourly wage influences how many hours you work2. My grade scale influences how hard you study3. Price of gas influences how much gas you buy4. Taxes on pineapples influence how many

pineapples you eat5. Paying teachers based on students test scores

influences how they teach

UNINTENDED CONSEQUENCES

Thinking about policy the most important thing economics has to offer is that policies often affect incentives and these incentives can have unintended consequencesExamples:• Taxes• Teacher Cheating• Welfare(and other social programs)• Insurance• Safety Regulations

CORRELATION AND CAUSATION

If I was still teaching econometrics I would make a really big deal of this

Often what we learn in economics depends on data and how we think about data is important

Causation just means that one thing causes another

Correlation means that they are related in the data (tend to move together)

Things that are positively correlated:• Height/Weight• Wife’s Education/Husband’s education• GDP/Food Consumption

Things that are negatively correlated:• Unemployment/GDP Growth• Family Income/Family Size

Things that are not correlated have no relationship• Temperature here/weight of Vice President• Result of first die/result of second die

• Just because two things are correlated does not

mean that one causes the other

• Possibilities:• A causes B• A causes B and B causes A at the same time• Z causes both A and B

• These are not mutually exclusive• This is not a minor problem-it makes empirical

work in economics very difficult• As we will see in this course theory is not enough-

we need to combine models with evidence to really say anything strong about policy