Topic 1 - Thinking as an Economist

From Uni Study Guides
Jump to: navigation, search

Contents

Microeconomics 1 - ECON1101

This is an introductory economics course that focuses on the theory of markets and the application of that theory in the real world. More details can be found here

In the first topic you will learn foundational concepts that are critical for success later on in this course. The prescribed textbook for this course is Principles of Microeconomics 3ED [1]

What is Economics?

Simply stated, Economics is the study of how people make choices under conditions of scarcity & the results of those choices on society. More importantly, Microeconomics is the study of how firms and households make decisions in allocating their scarce resources.

Other Sub Categories of Economics

  1. Positive Economics attempts to explain what happens and why
  2. Normative Economics attempts to explain what should or ought to happen

The Scarcity Principle

In real life, people are faced with choices. If you choose to go to soccer you cannot study for economics. The scarcity principle recognises that there is no free lunch and individuals face trade-offs. They must compromise between their competing interests, more of 'x' means less of 'y'.

The Cost Benefit Principle

Before making any decisions, individuals must weight up the costs and benefits that would result from their choice. The Cost Benefit Principle states that an should undertake a particular action if the marginal benefits exceed the marginal costs. We can use this model to predict behaviour however there are 2 key assumptions:

  1. Rationality
    • We assume people are rational and compare the costs and benefits of alternative actions. Often this assumption can be questioned as emotions can easily impede rational decision making
  2. Ceteris Paribus
    • All other variables remain unchanged

Costs, Benefits and Surplus

In utilising the cost benefit model, people will always attempt to maximise their economic surplus. Surplus is the difference between all the benefits and all the costs.

When accounting for costs, both explicit and implicit costs must be acknowledged while sunk costs must be ignored.

  • Explicit Costs
    • A direct outlay of cash or money for something. E.g. The $10 paid for a sandwich
  • Implicit Costs
    • Can be thought of as the opportunity lost in choosing something. E.g. the time taken to walk to the sandwich shop
  • Sunk Costs
    • Unrecoverable costs that are the result of past decisions that should not effect future decisions.
      • For example, in an infrastructure project you have already spent $500,000,000 the project required an additional $250,000 but will only provide benefits of $100,000. The surplus in this case is (negative) -$150,000 and thus no additional investment should be put into the project. In this case the $500,000,000 is a sunk cost and should be ignored in the cost benefit model

Opportunity Cost is defined as the value of the next best alternative. This is the economic surplus (benefits less costs) of the next best option. In a 2 choice decision, a person must weigh up the marginal costs and benefits associated with each decision and the outcome not chosen was the persons opportunity cost. For example, you can choose between participating in soccer or cricket. Cricket gives you $20 of benefits whilst soccer only provides $14. However, a game of cricket takes 4 hours and a soccer game take only 2 hours. You value your time at $4 an hour. The surplus of playing cricket is $4 and $6 for soccer. Cricket is your opportunity cost ($4) since you would choose soccer.

When evaluating the costs and benefits of qualitative examples, the following questions are often useful

  • Costs
    • What is the minimum dollar value I'd want to be paid to do it
  • Benefits
    • What is the maximum dollar value that I would pay to have someone do this for me.

Common Pitfalls

  1. Failing to account for all opportunity costs
    • Ask questions that highlight the trade-off
  2. Failing to ignore sunk costs
  3. Failing to account for all benefits
  4. Failing to measure costs and benefits in absolute dollar terms rather than as proportions
  5. Failing to know when to use average costs/benefits & when to use marginal costs/benefits
    • Use marginal to work out to what extent the activity should be pursued
  6. Failure to incorporate time into C/B thinking. Need Discount future costs & benefits into present values

Reservation Prices

  • A buyers reservation price refers to the highest price he or she would be willing to pay
  • A sellers reservation price refers to the lowest price he or she would sell for

References

  1. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
Personal tools
Namespaces

Variants
Actions
Navigation
Toolbox