ECON 101 - Fall 2024 - University of Waterloo - Chapter 1 Principles of Economics PDF

Chapter 1: The four core principles of economics P ROF ESSO R M I K A L S KU T ERU D ECO N 1 0 1 – FA L L 2 0 2 4 U N I V ERSITY O F WAT ER LO O What is an economy? “Lord of the Flies” by William Golding published in 1954. Airplane...

Chapter 1: The four core principles of economics P ROF ESSO R M I K A L S KU T ERU D ECO N 1 0 1 – FA L L 2 0 2 4 U N I V ERSITY O F WAT ER LO O What is an economy? “Lord of the Flies” by William Golding published in 1954. Airplane crashes on a remote Pacific island. Survivors are a group of boys aged 6 to 12. Scarce resources available on the island for survival. What to produce (hunt and gather)? How to produce? Who does what? Who gets what? Examples of economic systems 1. Tribal hunter-gatherer societies (“Dances with Wolves”) Tribal members hunt wild animals and search for edible grains and plants Production shared equally 2. Slavery (“Gladiator”) Technological advances (e.g., iron replaces wooden plough) result in surplus production (above subsistence) Incentive for powerful individuals to enslave workers through violence/war 3. Feudalism (“Braveheart”) Nobility seized land, re-allocated it to serfs, who worked small plots to produce for themselves, and were taxed in exchange for protection 4. Market capitalism (most of the world today, including Canada) Industrial revolution brought farmers into factories Production and distribution of goods and services through competitive markets The principled approach to economics Economics is the study of economies or economic systems. Economists are people who do economics. 250 years of economic thought has led to some core ideas or “principles of economics.” The goal of this course is not to memorize definitions or facts about the economy. The goal is to learn how to “do economics” by thinking like an economist. At the core of economics are four principles. As you’ll see, these principles are highly relevant to your everyday life. They will help you to make better decisions in your personal and professional life. The “atoms” of economics are individual decisions. In understanding how people make choices, we begin to understand what gets produced, who produces it, and who gets what. 1. Cost-Benefit Principle Only pursue options when the benefit is at least as big as the cost. But how to compare costs and benefits that don’t have explicit dollar values (“nonfinancial”)? What is the most that you’d be willing to pay to obtain the benefit or to avoid the cost? But not everything is about money. But sometimes the benefit goes to someone else. But costs and benefits are sometimes uncertain. But sometimes there are framing effects. Costs and benefits are the economic incentives that lead people to make the choices they do. Economic surplus The difference between the benefit you receive and the cost you incur is the economic surplus. It is a measure of how much your choice has raised your economic well-being. Every time we buy something, we receive some economic surplus, but what about the seller of the good? The selling price is a benefit to the seller. If the cost of producing the good is less than the selling price, they also receive a surplus. Both the buyer and seller are better off. This mutual gain from voluntary exchange lies at the heart of all economic transactions. Economic transactions are not “zero-sum games.” 2. Opportunity Cost Principle The true cost of something is what you must give up to get it. What you give up is the next best alternative. This is the opportunity cost of a choice. Sometimes the opportunity cost of a choice is much bigger than the direct cost. What is the cost of every hour spent gaming? The biggest cost isn’t the gaming hardware and software. The biggest cost is the loss of time that could have been spent doing something else. 2. Opportunity Cost Principle What is the cost of attending today’s ECON 101 lecture? Full-time tuition is $9,000 per year. With 10 courses, that’s $900 per course. With 24 lectures per lecture, that’s $37.50 per lecture. For international students, the cost is $237.50 per lecture. Should this out-of-pocket cost affect your decision of whether to attend a lecture? No, because you must pay it whether you attend today’s lecture. It’s an example of a sunk cost. The cost that matters for your decision is the 90 minutes of time that could have been spent doing something else such as earning a wage in the labour market. Choices require resources, whether its our income, time, or energy. But these resources are scarce. The scarcity of resources means that whenever we choose to do something, we are necessarily giving up (“foregoing”) doing something else. When asking yourself whether to make a particular choice, always include “or” followed by the next best alternative in your question. Four important lessons about opportunity costs 1. Some out-of-pocket costs are opportunity costs. ◦ Your rent costs at university are a cost if you otherwise would have lived at home rent-free. 2. Sometimes the biggest opportunity costs are not out-of-pocket costs. The cost of acquiring a four-year degree are four years of foregone earnings in the best job you could have got with your high school diploma. 3. Not all out-of-pocket costs are opportunity costs. ◦ Your food costs at university are not an opportunity cost, since you would still have needed to eat. 4. Some nonfinancial costs are not opportunity costs. ◦ Studying and passing university exams requires hard work, but if the next best alternative is a job that also requires equally hard work, then this cost should not be included. Economic phenomena consistent with the opportunity cost principle 1. Most Canadians have romantic relationships during their teen years but why do so few get married during their teen years? 2. Why are there fewer stay-at-home moms? 3. Why are more Canadians born in September and October than in February and March? 4. Why are terminally ill people more willing to take unproven experimental drugs? 5. Why are there often leftover snacks at business meetings? Production possibilities frontier (PPF) You have 3 hours/night to study economics or psychology. Each hour spent studying increases your grade but by more in economics than psychology. The PPF shows the possible improvements in your grades. Notice it impossible to improve one grade without reducing the other. What is the opportunity cost of a one percentage point increase in your psychology grade? Features of PPFs 3. The Marginal Principle Up to now, we have only considered binary choices (either/or choices). But many choices in life involve decisions about “how many” or “how much”? The marginal principle says decisions about quantities are best made incrementally. We should break them down into a series of marginal decisions comparing the incremental benefits and costs of buying one more. The rational rule The rational rule says we should continue doing something as long as the marginal benefit of doing a little more exceeds the marginal cost. Following the rational rule ensures that economic surplus is maximized. The rational rule The rational rule says we should continue doing something as long as the marginal benefit of doing a little more exceeds the marginal cost. Following the rational rule ensures that economic surplus is maximized. The rational rule The rational rule says we should continue doing something as long as the marginal benefit of doing a little more exceeds the marginal cost. Following the rational rule ensures that economic surplus is maximized. 4. The Interdependence Principle Your best choice in any situation doesn’t happen in a vacuum but depends on: 1. Your other choices ◦ You have limited resources (income, time, attention, productive/cognitive capacity, wealth) so your choice in any situation affects the availability of resources in other situations. 2. The choices of other decision makers ◦ The resources available to you depend on the resources used by others. This scarcity results in competition between economic agents (people, business, governments) and your decisions. 3. Dependencies between markets ◦ Your choice in any market (labour, housing, credit) depend on what is happening in other markets. 4. Dependencies over time ◦ Your choice today is affected by your choices yesterday and your expected future choices.