Economics Core Principles: Cost-Benefit Analysis

• Economics studies how people make choices.
• Economics offers the four core principles to provide a systematic framework for analyzing individual decisions.

The Core Principles

• Making decisions requires understanding the incentives that shape choices.
• There are four incentive principles: cost-benefit, opportunity cost, marginal and interdependence.

Cost-Benefit Principle

• Decision-makers must evaluate the full set of costs and benefits associated with choices.
• Decision-makers must pursue a choice only if the benefits are at least as great as the costs.
• Costs and benefits are the incentives that shape decisions.
• Willingness to pay converts nonfinancial costs or benefits into their monetary equivalent.
• "What is the most I am willing to pay to get this benefit (or avoid that cost)?"
• Cost-benefit analysis still allows for unselfish decisions.

Economic Surplus

• Economic surplus is the total benefits minus the total costs flowing from a decision and is a measure of how much a decision improves well-being.
• Decisions should maximize one’s economic surplus.
• One generates an economic surplus every time a decision aligns with the cost-benefit principle.

Framing Effects

• Framing effects occur when decisions are affected by how choices are described or framed.
• Avoid framing effects, which alter one's own decisions.
• The underlying costs and benefits can seem different if framed to appear different.

Opportunity Cost Principle

• Opportunity cost constitutes the true cost of something, which is the next best alternative one has to give up to get it.
• Opportunity costs are trade-offs; it is what one relinquished to pursue an option.
• Scarcity means resources are limited and pursing one activity means forgoing the ability to pursue others.
• Scarcity makes tradeoffs inescapable
• If starting a business, one must ask 'Should I start a new business, or stay in your existing job?'
• If quitting the current job, you give up the paycheck, which is an opportunity cost.
• One must also ask, Should you invest your money in the new business, or leave in the bank (or the stock market)?
• Forgone interest is an opportunity cost associated with starting a business.
• Sunk costs cannot be reversed and exist in whatever choice one makes. They are not an opportunity cost. Sunk costs should be ignored.
• The production possibilities frontier (PPF) illustrates the trade-offs when deciding how to allocate scarce resources, such as time.
• Decisions can be visualized on a PPF graph.

Marginal Principle

• The marginal principle determines quantities incrementally.
• Break "how many" questions into a series of smaller marginal decisions that weigh marginal benefits and marginal costs.
• Marginal benefit is the extra benefit from one extra unit.
• Marginal cost is the extra cost from one extra unit.
• If something is worth doing, keep doing it until marginal benefits equal marginal costs.
• Economic surplus is maximized when the marginal benefit equals the marginal cost.

Interdependence Principle

• Best choices hinge on factors such as the other choices, the choices others make, developments in other markets, and expectations about the future.
• Individual choices are connected due to limited resources.
• Choices other people make shape the choices available.
• Decision to join the labor market depends on the availability of childcare.
• Changes in prices and opportunities in one affect choices in other markets.
• Decisions today shape future opportunities and decisions.