The Economic
Point of View
Glen Whitman
Dept. of Economics
CSUN
The Economic Model of
Pretty Much Everything
Goals
Constraints
Choices
Example: The Consumer
Satisfaction of Preferences
Income, Prices
Buying Decisions
Example: The Firm
Profit Maximization
Technology, Factor
Prices, Consumer Demand
Prices, Product Characteristics,
Store Location, Hours...
The Basic Lesson of All Economics:
Incentives Matter

Alter constraints to alter choices.
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What you reward, you get more of.
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What you punish, you get less of.
Thinking About Incentives
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Non-economist: “People are like robots; they
follow their programs.”
Lousy economist: “People respond to
incentives in foreseeable ways.”
Good economist: “People respond to
incentives, often in unforeseeable ways.”
Incentives: Getting It Wrong

Vipers in an Italian town
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Socialized healthcare in Canada
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The Soviet nail quota

Incentive pay for welders and secretaries
The Soviet Nail Quota
“Who needs a nail as big as that?”
“Who cares? The important thing
is we fulfilled the plan for nails in
one fell swoop.”
Incentives: Getting It Right

Think about the goals of those you’re trying to
influence.

Check for compatibility between what you want
and what you’re rewarding/punishing.

Beware of substitution effects.
Opportunity Cost Preview:
Is This a Profitable Business?
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You are the sole proprietor and manager of a
massage parlor.
Weekly revenue: $7000
Weekly expenditures: $6200
What is your profit?
Is This a Profitable Business?
continued

You could have worked somewhere else instead
of being self-employed.
Forgone salary: $1000/week

Accounting profit
= $7000 - $6200 = $800/week

Economic profit
= $7000 - $6200 - $1000 = -$200/week
Opportunity Cost Preview:
Is This a Profitable Investment?

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You are given $1,000,000 to manage.
You spend all year managing the money.
By the end of the year, you have gained $60,000.
Was this a wise investment?
Is This a Profitable Investment?
continued

You could have had another job.
Forgone income: $45,000

You could have put the money in the bank.
Forgone interest (at 5%): $50,000

Economic Profit
= $60,000 - $45,000 - $50,000 = -$35,000
Opportunity Cost
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Opportunity cost = the value of the next best
opportunity forgone in making a choice
Includes explicit costs: wages, rent payments,
etc.
Also includes implicit costs:
forgone income from owner’s time
 forgone income from firm-owned assets
 forgone interest on capital

The Economic Telecommunications
System

A market economy relies on people to use
information they don’t have.

Two features of the market make this possible:
The price mechanism
 The profit/loss mechanism

The Price Mechanism

Prices are signals of scarcity.

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Higher prices imply greater scarcity.

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Scarcity: the relationship between how much people
want of something and how much there is
People consume less, economize more
Lower prices imply lower scarcity.

People consume more, economize less
The Profit/Loss Mechanism

Above-normal profits in an industry attract
entry of more firms.

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More resources allocated to this use
Below-normal profits in an industry force the
exit of existing firms.

More resources allocated to other uses
The Price-Profit Process
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Increased demand for a good/service leads to
higher prices.
Higher prices lead to higher profits.
Higher profits attract more firms.
Greater competition drives prices and profits
back down.
Net effect: more resources pulled into
production of this good/service.
Seeking Profit in a Dynamic
Marketplace
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Profits are usually transitory: in the long run,
they tend to disappear.
But the transition time is crucial.
Various factors can speed up or slow down the
transition time, including barriers to entry.
Some of these factors may be under your
control.
Summary:
Thinking Like an Economist

Always think about the incentives you have and
the incentives you create.

Take into account all costs of your choices, not
just the explicit ones.

Maintain a dynamic perspective to keep up with
the market.