Summary

  • Economics gives you a toolkit to study choices and solve problems
  • There are Four Core Principles that govern the choices made in economics
  • Cost Benefit Principle: Using costs + benefits to shape decisions
  • Willingness to Pay is a way to convert nonfinancial costs to monetary benefit
  • Economic Surplus is when the benefits exceed the cost of a choice
  • Good economists avoid Framing techniques
  • Opportunity Cost Principle: The true cost of something is the next best alternative you have to give up to get it.
  • Scarcity affects what choices we have since we have a finite amount of resources
  • Sunk Cost is an expense that is incurred regardless of the choice made

What is Economics?

Economics is simply the study of choices.

  • It uses rational and analytic thinking along with scientific techniques to analyse choices across a variety of topics
  • The study of Economics gives you a toolkit to approaching, understanding, and solving problems

Four Core Principles of Economics

Although Economics is a vast field that encompassed all sorts of decision analysis and problem solving, it is often encompassed into Four Core Principles

Cost-Benefit Principle

Costs and benefits are incentives that shape decisions

Before making a decision:

  • Evaluate full set of costs and benefits of choice
  • Pursue that choice iff (if and only if): $$\text{benefits}\ge \text{costs}$$

Example 1:

Let’s say you want to buy a $2 granola bar because you’re hungry. How do you properly evaluate the benefits compared to the costs?

This is difficult because “hunger” doesn’t necessarily have a monetary value. To solve this we can convert the costs and benefits into dollars by evaluating your willingness to pay

Willingness to pay

The practice of converting nonfinancial costs into monetary value.

  • “What is the most I am willing to pay to either get this benefit or avoid this cost”
  • Want to pay and willing to pay are not the same
    • We all “want” everything for cheap, but that is not the maximum amount we would pay for something

Example 1 (cont.):

If we are willing to pay up to $3 for the bar,

  • Cost: $2
  • Benefit: $3
  • Economic Surplus: $1

Using the cost-benefit principle, the benefits exceed the costs, so you should buy!

Money can be used as a standard to judge the costs and benefits from a decision

  • Money is not necessarily an objective from a Cost-Benefit analysis
  • Benefits can also include happiness,

Economic Surplus

Formula: $$\text{Total Benefits}-\text{Total Costs}=\text{Economic Surplus}$$ As long as you follow the cost-benefit principle, you should generate economic surplus.

Framing

Businesses use clever sales tactics to cloud your cost-benefit analysis.

Example 2:

A store listing their original price and sales price together.

The original price is irrelevant to the benefits the product will give you.

Opportunity Cost Principle

“If the opportunity cost of something is what you must give up to get it, then it’s the difference between the consequences of making that choice and the consequences of the next best alternative.”

In other words, the true cost of something is the next best alternative you have to give up to get it.

  • Costs could include time, resources, strength, etc
  • What are you losing by choosing a particular option?

Example 3:

You have an hour to either:

  • Hang out with friends
  • Do homework
  • Take a nap

By choosing one option, I am sacrificing the other choices

Opportunity cost is usually an ordered list of choices.

  • If the first best choice isn’t an option, move to the next best one down the list.

Scarcity

A limitation on resources

  • All choices have trade-offs and costs due to:
    • Limited money
    • Limited time
    • Limited will
    • Limited resources

Sunk Cost

A cost that has been incurred and cannot be reversed.

  • Regardless of what choice you make, you will always incur a cost
    • Since you have no choice in the cost, it is not an opportunity cost
  • Good decisions acknowledge sunk costs and ignore their influence

Example 4:

Let’s say you spend $15 dollars on a movie ticket but realize it’s a bad movie after watching the first 30 minutes. Do you either:

  • Continue to watch the movie since you spent $15?
  • Leave immediately and do something else with your time?

The smart choice is to leave immediately. Regardless of whether or not you wait for the end of the movie, you have lost $15. Therefore use your time wisely and do something else.

Personal Note

  • Don’t watch bad movies kids.