Chapter 1 Flashcards
Economics
The study of how people make choices under conditions of scarcity and of the results of those choices for society
Assumes people are rational
The Scarcity or No-Free-Lunch Principle
Resources available to satisfy boundless needs and wants are limited.
Having more of one good thing usually means having less of another.
‘There’s no such thing as a free lunch.’
The cost-benefit principle
An individual (or firm or society) takes an action if, and only if, the extra benefits from taking that action are at least as great as the extra costs.
Opportunity cost (of an activity)
The value of the next best alternative that must be
foregone in order to undertake that activity
Economic surplus
The benefit of taking an action minus the cost of taking that action
Only undertake those actions that create additional surplus.
The role of economic models
conomists use the cost-benefit principle as an abstract model of how an idealized rational individual would choose among competing alternatives.
The model is a simplified representation of reality.
Four Important Decision Pitfalls
Measuring costs and benefits proportionally
Ignoring opportunity (i.e. implicit) costs
Failure to ignore sunk costs
Failure to understand the average – marginal distinction
Measuring costs and benefits proportionally
Many decision makers treat a change in cost as insignificant if it constitutes only a small proportion of the original amount. Absolute money amounts, not proportions, should be employed to measure costs and benefits.
Ignoring opportunity (i.e. implicit) costs
When performing cost-benefit analysis of an action, it is important to account for all relevant opportunity costs, defined as the values of the most highly valued alternatives that must be forgone in order to carry out the action. A resource (such as frequent-flyer coupon) may have a high opportunity cost, even if you originally got it ‘for free’, if its best alternative use has a high value. The identical resource may have a low practical cost, however it has no good alternative issues.
Failure to ignore sunk costs
When deciding whether to perform an action, it is important to ignore sunk cost (costs that cannot be avoided even if the action is not taken).
Sunk costs
Costs that are beyond recovery at the moment a decision must be made.
Failure to understand the average – marginal distinction
Decision makers often have ready information about the total cost and benefit of an activity, and from this it is simple to compute the activity’s average cost and benefit. A common mistake is to conclude that an activity should be increased if its average benefit exceeds its average cost. The Cost-Benefit principle tells us that the level of an activity should be increased if, and only if, its marginal benefit exceeds its marginal cost.
Marginal cost
The increase in total cost that results from carrying out one additional unit of an activity
Marginal benefit
The increase in benefit that results from carrying out one additional unit of an activity
Average cost
The total cost of undertaking n units of an activity divided by n
