ECONOMICS: THE STUDY OF OPPORTUNITY COST 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 made Or 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 money 2.In order to get money I have to give up some free time and work more 3.If I want to eat more potato chips I have to spend less on bananas 4.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 WorkersFishDeer Bill402 Sally204 How do you assign them? There are 4 different possibilities that would lead to the following outcomes: FishermanFishDeer None06 Bill404 Sally202 Both600

FISH AND DEER Deer Fish Inefficient

NOW SUPPOSE WE ADD A FEW MORE PEOPLE NameFishDeer Donna501 Bill402 Jane303 Sally204 Carl105 This gives us quite a few more options

POSSIBILITIES NOW 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 line But 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

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 WorkerFishDeer Henry202 Phil202 Anne202 Rachel202 Barney202

PPF WITH WORKERS SAME 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 action Generally 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 work 2.My grade scale influences how hard you study 3.Price of gas influences how much gas you buy 4.Taxes on pineapples influence how many pineapples you eat 5.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 consequences Examples: 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