Mastering Economic Choices: A Guide to Essential Concepts

1. Econ 201Summer 2009Lecture 1.03 Essential Concepts and Terms

2. Basic Economics Vocabulary • Scarcity • Opportunity Cost • Tradeoffs • Benefit/Cost Analysis

3. Economics and Scarcity • Lionel Robbins (1932): • "the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses." • Scarcity means that available resources are insufficient to satisfy all wants and needs. • Absent scarcity and alternative uses of available resources, there is no economic problem. The subject thus defined involves the study of choices as they are affected by incentives and resources.

4. Scarcity • There are not enough resources to produce and consume all of the goods and services we desire

5. Scarcity • Limits on resources implies that decisions must be made about: • What to produce • How to produce it • Whom to produce it for • Could be done by: • Government direction (centrally planned economy) • Market forces (price signals)

6. Opportunity Costs • Scarcity implies that choices must be made • Choice implies that there is a trade-off or “opportunity cost” (foregone alternative) • Opportunity cost is defined as: • The value of a good, service or resource in its next highest valued use – consequence of scarcity • Every decision has an opportunity cost • Alaska: potential value of gold mining could disrupt Copper River Salmon run • Choice of academic majors • How to spend time or money

7. Opportunity Costs • Opportunity costs are not only “observable” economic costs, but also “unobservable” (or non-monetary) costs • Opportunity costs of time • Commute example • Car • Bus • Bike

8. Commute Example • Monetary costs associated with each alternative • Car • Initial purchase expense (fixed), O&M (variable: fuel, maintenance, depreciation, licenses, insurance, parking), time of commute • Bus • Time + fee • Bike • Initial purchase (bike and lock), O&M (tires, tune-ups, clothing), time of commute

9. Monetary Costs Are Only Part of the Picture • Non-pecuniary benefits/costs • Non-pecuniary: not directly measurable by $ • Car • Benefit: flexibility to come/go • Costs: traffic jams, road rage, finding a parking space • Bus • Benefits: reading time, “no hassle”

10. Monetary Costs Are Only Part of the Picture • Bus • Costs: no flexibility on time • Bike • Benefits: flexibility, improved health • Costs: bad weather, lighting • Choose the alternative that has the greatest net benefits

11. Basic principle of economic choice • Individuals [or firms] choose their actions on the basis of expected additional [net] benefits and cost to themselves • In this case -> alternative chosen will be the one that yields the largest net benefits • Paul’s “economizing process” • Modest changes in monetary costs and benefits can induce people to alter their behavior • Cold, wet weather increases the costs of bike commuting (or parking on the street)

12. Cost/Benefit Analysis • Proper framework for analyzing economic decisions is to compare the costs and benefits of the alternatives • Cost and benefits include not only directly observable/measurable economic costs and benefits, but also • Opportunity costs (e.g., time), • Non-pecuniary benefits

13. Key Terms • Common understanding of key terms • Use them as shorthand for the concept; but have a precise/exact meaning • Scarcity • There are not enough resources to produce and consume all of the goods and services we desire • Opportunity costs • What must be given up (next best alternative use) as a result of a decision or choice • “No such thing as a free lunch” (Milton Friedman) • Cost-benefit analysis • Every decision/action has tradeoffs