Topic 1 – page 1
Principles of Microeconomics
Topic 1
Introductory Concepts and Models
Text Reference
XChapter 1
XChapter 7 pages 170- 187
Topic 1 – page 2
Principles of Microeconomics
Topic 1 Outline:
SPositive statements
SNormative statements
Scarcity
VTrade-offs
ÁBenefits
ÁCosts
- Opportunity cost
- Sunk costs
ÕMarginal Analysis
- Marginal benefit
- Marginal cost
- Marginal net benefit
ÕModels – binary and non-binary decision making
- marginal analysis
Topic 1 – page 3
Principles of Microeconomics
What is Microeconomics?
It is the study of the choices individuals make when faced
with limited “resources” but unlimited “wants”.
XDecision-making is at the level of the individual person,
household or firm.
XDecisions-makers are referred to as the economic agents.
Principles of microeconomics try to explain the
societal outcomes that result from those decisions
or choices.
Topic 1 – page 4
Principles of Microeconomics
Methodology of Economics
Models are used in economics to explore the decisionsmaking behaviour of different economics agents.
Models simply allows us to use basic concepts to the analyze
choices and the consequences of each decision. We can
explore “outcomes” logically and thoroughly.
Models create a means of making predictions about
behaviour and changes in behaviour to the decision making
process.
Topic 1 – page 5
Principles of Microeconomics
Normative and Positive Statements
► Positive Statement: a state about what is.
-Descriptive statement
Example: The sales tax rate in BC is currently 6%.
► Normative Statement: a state about what should be.
-Proscriptive statement
Example: The sales tax rate in BC should be lower.
Topic 1 – page 6
Principles of Microeconomics
Models in Economics
Recall, models allow us to take basic concepts and analyze
them thoroughly and logically.
All models initially have assumptions and use deductive
logic to arrive at conclusions.
Models are generally simplifications of reality; not reality.
They tend to be only as good as the assumptions on which
they were constructed.
The objective of Topic 1 is to develop a few simple
models to understand some key concepts in
economics.
Topic 1 – page 7
Principles of Microeconomics
Model 1: Simple Individual Decision-making
My phone is destroyed by water damage when falling in the
ocean and I can only afford one new phone.
I have two choices: purchase an IPhone 5 or a Samsung.
.
The MOST I am willing to pay is:
► $750 for an IPhone
► $700 for a Samsung phone
Topic 1 – page 8
Principles of Microeconomics
The best prices are:
► $699 for an IPhone
► $639 for a Samsung phone
What should I do?
ÕThe IPhone purchase buys $750 worth of happiness at the
cost of $699. ´That is a net gain of happiness of $51.
ÕThe Samsung buys $700 worth of happiness at a cost of
$639. ´That is a net gain of happiness of $61.
I get a greater net gain from the Samsung, even though I
prefer an IPhone.
Topic 1 – page 9
Principles of Microeconomics
Generalizing gives us a basic model of decisionmaking:
When faced with two mutually exclusive options, choose the
one with the greatest net gain. This will maximize satisfaction
or happiness.
What were the assumptions of this model?
Scarcity!
Decision-making is only meaningful in the face
of scarcity.
Topic 1 – page 10
Principles of Microeconomics
Scarcity
If all tings were simultaneously possible, no choices would
have to be made.
In reality, almost all resources are scarce.
Examples: money, time, labour, oil, clean air, clean water,
etc.
Scarcity means choices must be made about how to allocate
resources across competing uses in an efficient and optimal
manner.
Topic 1 – page 11
Principles of Microeconomics
Trade-offs!
Economics decision-making is all about making tradeoffs.
Allocating more resources to one activity generally
requires allocating fewer resources to some other
activity.
Topic 1 – page 12
Principles of Microeconomics
Topic 1 – page 13
Principles of Microeconomics
Topic 1 – page 14
Principles of Microeconomics
Topic 1 – page 15
Principles of Microeconomics
When deciding which phone to purchase I am trading off:
→The extra benefit if I choose one over the other against the
extra cost I incur if I choose one over the other.
IPhone to Samsung → $51 more happiness (benefit)
IPhone to Samsung → $61 more cost
ÕBenefit of choosing IPhone over Samsung is less
than the cost.
Topic 1 – page 16
Principles of Microeconomics
Benefits and Costs
Õ If we have scarcity, this implies that all activities have
benefits and costs.
Benefit of an activity is measured as the good stuff that
comes from that particular activity.
The benefit of an activity can be monetary or non-monetary.
(How do you put a price on a feeling?)
However, we often find it is easier to put a monetary value on
non-monetary benefits. (Even if it is an imperfect monetary
estimate.)
Topic 1 – page 17
Principles of Microeconomics
The cost of an activity is all the good stuff that must be given
up when resources are allocated to that activity are taken
away from some alternative activity.
Like benefits, costs are monetary and non-monetary.
Time is a great example of a non-monetary cost. However,
“time” is often translated in to monetary costs.
Topic 1 – page 18
Principles of Microeconomics
Opportunity Cost
A good economic analysis includes ALL Costs.
To do this, economists use the concept of opportunity cost.
For any activity, there are often many alternatives to which
the resources could have been allocated.
Example: The time and money spent buying a Samsung
phone could have been spent on the IPhone, another brand of
phone, a used phone, a refurbished phone, etc..
Which of these other options is the correct
measure of the cost of buyer a Samsung
phone?
Topic 1 – page 19
Principles of Microeconomics
It would have been the alternative phone that would
have been chosen if the Samsung phone was not an option.
IPhone!
The alternative activity that would have been chosen is used
to calculate the opportunity cost of that activity.
Definition: The opportunity cost of an activity is the value of
the next best alternative use of the resources allocated to that
activity.
Costs are always opportunities foregone.
→In economics, when we say cost we always mean
opportunity cost.
Topic 1 – page 20
Principles of Microeconomics
The proper measure of the cost of something includes all the
things we must give up to have that thing.
Example: IPhone versus Samsung phone
Costs and Benefits of IPhone:
- Benefit (happiness):
$750
- Cost of phone:
-$699
- Cost of not purchasing a Samsung -$61
“happiness
profit” we
would get
from Samsung
Benefits – Costs = 750-699-61= -$10
Once we account for the outside options, and IPhone is not
such a good deal!
Topic 1 – page 21
Principles of Microeconomics
In this example, the price of a phone is an explicit cost.
Explicit costs are those that involve paying money.
Explicit cost is only part of the opportunity cost of buying and
IPhone.
The cost of giving up the Samsung option is an implicit cost.
Implicit costs do not involve paying money, but are
important.
Topic 1 – page 22
Principles of Microeconomics
Good decision-making requires we account for both types of
costs.
ÕOpportunity costs include explicit and implicit costs.
The true cost of an IPhone equals its explicit price ($699) and
the implicit cost ($61) of foregone happiness of a Samsung
phone.
Topic 1 – page 23
Principles of Microeconomics
Binary Decisions
Binary decisions are decisions that have only two outcomes:
Yes or No.
The general decision rule for binary decisions is:
If benefits minus costs are positive, then this is the
right choice. Remember all the costs!
Topic 1 – page 24
Principles of Microeconomics
Sunk Costs
Economists make a distinction between costs that are sunk
and cost that are not.
Sunk costs are those costs that cannot be recovered, no
matter what decision you make.
Sunk costs should not influence your decision-making since
they are incurred anyway.
Topic 1 – page 25
Principles of Microeconomics
Example:
Suppose I have purchased the Samsung phone and I am
locked into a contract. That evening my husband comes
home and has a free IPhone from a client and offers it to me.
I cannot take my phone back to the store.
What should I do?
Is it relevant that I have already paid for my Samsung phone?
Topic 1 – page 26
Principles of Microeconomics
Cost-Benefit Analysis:
If I take the free IPhone:
- I gain $750 of happiness
- I am out the $639 I paid for my Samsung phone
- I forgo the $700 of Samsung happiness
If I take the Samsung phone
- I gain $700 of happiness with the phone
- I am out the $639 I paid for the Samsung phone
- I forgo the $750 of IPhone happiness
Topic 1 – page 27
Principles of Microeconomics
If I take the free IPhone:
- I gain $750 of happiness
- I am out the $639 I paid for my Samsung phone
- I forgo the $700 of Samsung happiness
If I take the Samsung phone
- I gain $700 of happiness with the phone
- I am out the $639 I paid for the Samsung phone
- I forgo the $750 of IPhone happiness
→No matter what choice I make, I am out the $639.
→I cannot get that back, no matter what.
It is unrecoverable, sunk.
Because it is sunk, it should no influence my choice.
Topic 1 – page 28
Principles of Microeconomics
Non-Binary Decisions and Marginal Analysis
ÕNot all decisions are “yes” or “no” choices.
ÕMany decisions are “how much” choices.
We model “how much” decisions using marginal analysis.
►We effectively break down “how much” decisions into
portions or smaller units of “yes” or “no.”
Topic 1 – page 29
Principles of Microeconomics
Example:
How many cups of coffee should I drink at McDonald’s
before I come to work?
Note: this “how much” decision will be a series of ‘yes or no’
decisions. I do not need to buy all the coffee at once; my
purchases will be sequential over the course of the morning.
Assuming that my aim is to maximize my happiness, we need
to compare my happiness gained from each cup to the cost of
each cup.
Topic 1 – page 30
Principles of Microeconomics
Marginal Analysis:
Coffee
1
Benefit ($ of happiness)
$5
Cost $ Difference
$1.25
$3.75
2
$3
$1.25
$1.75
3
$1
$1.25
-$0.75
Each additional cup of coffee is worth less to me.
Coffee is $1.25 per cup.
How much should I drink?
Topic 1 – page 31
Principles of Microeconomics
Õ The first two cups give me more happiness than they cost.
Õ The 3rd cup buys me $1 worth of happiness, which is less
than the cost of coffee.
I should buy only 2 cups.
The coffee decision is an example of marginal analysis.
We push out the marginal of our choice and ask “was that
step worth it?
Should we take the next step?
Each step is what we call a “marginal” choice.
Topic 1 – page 32
Principles of Microeconomics
Each step requires us to compare the marginal benefit (MB)
to the marginal cost (MC).
If MB of coffee > than MC of that coffee, drink it.
Given an activity:
Õ The marginal benefit (MB) is the additional benefit gained
by doing one more unit of that activity.
Õ The marginal cost (MC) is the additional cost incurred by
doing one more unit of the activity.
Õ Marginal Net Benefit (MNB) = MB-MC
All “how much” decisions are analyzed in this way.
Topic 1 – page 33
Principles of Microeconomics
All that changes as choice environment changes is what
makes up the MB and MC terms.
Coffee
1
MB of coffee
$5
MC of coffee Difference
$1.25
$3.75
2
$3
$1.25
$1.75
3
$1
$1.25
-$0.75
Decision rule is buy another cup of coffee if MB > MC.
Or buy another coffee if MNB > 0.
Topic 1 – page 34
Principles of Microeconomics
MB = benefit gained from an additional unit
MC = cost incurred from an additional unit
Decision rule for non-binary choices:
If MB > MC, do more
If MB < MC, do less