9
S
CHAPTER
[L
I
WHAT Is
How EcoNoMisTs THINK
EcoNoMIcs
Money Cost Versus Real Cost
How Economists Think
ECONOMISTS, AS INDIVIDUALS, ARE LIKE EVERYONE
else. They have their own private objectives and agen
das and have opinions about all sorts of economic
and noneconomic issues. You have perhaps already
thought that the seven economic questions are
political. They are. They have an enormous influence
on the quality of human life and they generate fierce
argument and debate.
Economists, as professionals, try to stand clear of
the emotion, and to approach their work with the
detachment, rigor, and objectivity of a scientist. The
first step in this process is to identify the fundamental
problem from which all economic questions stem.
That fundamental problem—the economic prob
lem—is the fact that we have limited resources but
unlimited wants.
Scarcity
When wants exceed the resources available to satisfy
them, there is scarcity. Scarcity is everywhere. People
want good health and long life, material comfort,
security, physical and mental recreation, and knowl
edge. None of these wants is completely satisfied for
everyone; and everyone has some unsatisfied wants.
Although many Canadians have all the material com
fort they want, many others do not. No one feels
entirely satisfied with her or his state of health and
expected length of life. No one feels entirely secure,
even in this post—Cold War era, and no one has enough
time for sport, travel, vacations, movies, theatre, read
ing, and other leisure pursuits.
Scarcity is not poverty. The poor and the rich face
scarcity. A child wants a 75 can of soft drink and a
50 pack of gum but has only $1.00 in her pocket.
She experiences scarcity. A wealthy student wants to
go to a party on Saturday night but also wants to
spend that same night catching up on late assign
ments. He experiences scarcity. Even parrots face
scarcity—there just aren’t enough crackers to go
around.
Choice and Opportunity Cost
Faced with scarcity, people must make choices. When
we cannot have everything we want, we choose
Not only do I want a cracker—we d( want a cracker.’
Drawing by MIodill, ©1985 The New hirker .IJagazine. Inc.
among the available alternatives. The concepts of
scarcity and choice give a definition of economics.
Economics is the study of how people make choices
to cope with scarcity. Because scarcity forces choice,
economics is sometimes called the science ofchoice-.-.
the science that explains the choices that people make
and predicts how choices change as circumstances
change.
Choosing more of one thing means having less of
something else. Expressed another way, in making
choices, we face costs. Whatever we choose to do, we
could have chosen to do something else instead.
There is no such thing as a free lunch. This popular
phrase is not just a clever throwaway line. It expresses
in a vivid way the central idea of economics that
every choice involves a cost.
Economists use the term opportunity cost to
emphasize that making choices in the face of scarcity
implies a cost. The opportunity cost of any action is
the best alternative forgone. The best action that you
choose not to do—the forgone alternative—is the
cost of the action that you choose to dos.
Opportunity cost is the best alternative forgone.
It is not all the possible alternatives forgone. An exam
ple will make this clear. Your economics lecture is at
8:30 on a Monday morning. You contemplate two
alternatives to attending the lecture: staying in bed
for an hour or going jogging for an hour. You can’t
stay in bed and go jogging for that same hour. The
opportunity cost of attending the lecture is not the
cost of an hour in bed and the cost of jogging for an
hour. If these are the only alternatives you contem
plate, then you have to decide which one you would
do if you did not go to the lecture. The opportunity
cost of attending a lecture for a jogger is a forgone
hour of exercise; the opportunity cost of attending a
lecture for a late sleeper is a forgone hour in bed.
We
olten
express
cost in terms of money. But this is just a convenient
uflit and is not a measure of opportunIty cost. For
example the $40 spent on a book is not available for
,pending on four $10 CDs, So if four CDs are the
best alternative forgone, the opportunity cost of a
book is four CDs.
It is especially viral to look behind the money
costs when the amount that money will buy changes.
in
For example a book that today costs $40, cost $25
the
that
fact
this
from
conclude
1987. Yu can’t
opportunity cost of a book has increased. To calculate
the change in the opportunity cost of a book, you
need to know the money cost of the alternative for
gone in 1987 and today. If in 1987 a CD cost $25,
the opportunity cost of a book has indeed
increased—from one CD in 1987 to four CDs today.
Why? Because book prices have increased and CD
prices have decreased.
The key points are that it is fine to express
opportunity cost in money units so long as you
remember that this is just a convenient measure and
that you can’t compare opportunity costs in money
units between different times when the value of mon
ey has changed.
The opportunity cost of a good or ser
value of the time spent obtaining it.
the
includes
vice
If it takes an hour to visit your dentist, the value of
that hour must be added to the amount you paid
your dentist. We can convert time into a money cost
by using a person’s hourly wage rate. If you take an
hour off work to visit your dentist, the opportunity
cost of that visit (expressed in units of money) is the
amount that you paid to your dentist plus the wages
that you lost by not being at work. Again, it’s impor
tant to keep reminding yourself that the opportunity
cost is not the money itself but thegoods and services
that you would have bought with the money.
Time Cost
Not all of the opportunity costr
that you incur are the result of your own choices.
Sometimes others make choices that impose opportu
nity costs on you. For example, when someone
smokes at a table next to you in a restaurant, you bear
a cost. Also your own choices can impose oppothinity
costs on others. For example, when you enjoy a cold
drink from your refrigerator, part of its opportunity
cost, borne by others, is the increased carbon dioxide
in the atmosphere resulting from burning coal to gen
erate the electricity that powers your refrigerator.
External Cost
Marginal Analysis
Marginal analysis is a fundamental idea that perme
ates economics. The core of the idea is that people
make choices in small steps—or at the margin. They
decide whether to do a little bit more or a little bit
less of an activity. To make such a decision, they com
pare the cost of a little bit more of the activity with
its benefit. For example, to decide when to stop read
ing this book, you compare the cost of sticking with
it for another five minutes with the benefit you
expect (hope) it will bring. When you get to the
point at which the cost of another five minutes read
ing exceeds the benefit, you quit.
The cost of a small increase in an activity is called
marginal cost) For example, suppose your personal
computer has 2 megabytes of memory and you are
thinking about increasing its memory to 3 megabytes.
The marginal cost of increasing your computer’s
memory is the cost of the additional megabyte of
memory you are thinking about installing.
The benefit that arises from a small increase in an
activity is called marginal benefit. For example, mar
ginal benefit is the benefit you will get from one
additional megabyte of memory in your computer,
not the benefit you’ll get from all 3 megabytes that
you will have if you add one more megabyte. The
reason is that you already have the benefit from
2 megabytes, so you don’t count the benefit of these
2 megabytes as resulting from the decision you are
now making.
To make your decision about computer memory,
you compare the marginal cost of 1 megabyte with its
marginal benefit. If the marginal benefit exceeds the
marginal cost,’you buy the extra memory. If the mar
ginal cost exceeds the marginal benefit, you stick with
what you’ve got.
When the marginal benefit of an action exceeds
the marginal cost, taking the action adds to total
benefit by more than it adds to total cost. When the
marginal cost of an action exceeds the marginal bene
fit, nor raking the action adds to total benefit by
more than it adds to total cost. By evaluating margin
al costs and marginal benefits, people are able to use
their scarce resources in the way that makes them as
well off as possible.
the
The term marginal cost has a narrower technical definition:
the
cost of increasing output by one unit. This technical use of
here.
term is just a special case of its more general meaning used
11
10
CHAPTIR
I
WHAT Is
WHAT ECONOMISTS
EcoNoMIcs
Substitution and Incentives
Competition and Second Round
Effects
When opportunity costs change, people change their
actions Another central principle of economics,
called the principle of substitution, is that when the
opportunity cost of an activity increases, people sub
stitute other activities in its place. Every activity has a
substitute. Skiing is a substitute for skating; surfing is
a substitute for skin diving; drinking Coke is a substi
tute for drinking Pepsi; studying economics is a sub
stitute for taking dance training. A substitute might
be similar to the original—Pepsi and Coke—or quite
different—economics and dance.
If the opportunity cost of Coke increases, some
people will substitute Pepsi for Coke; if the opportu
nity cost of studying economics increases (by a really
large amount), some people will substitute dance for
economics. The closer the substitutes, the greater is
the degree of switching that takes place when the
opportunity cost changes.
Substituting away from more costly activities
towards less costly ones is responding to incentives.
An incentive is an inducement to take a particular
action. The inducement may be a reward—a carrot—
or a penalty—a stick. Changes in opportunity
costs—in marginal costs—and changes in marginal
benefits change the incentives that people face and
lead to changes in their actions. For example, longdistance phone companies give their customers an
incentive to make calls in the evenings and at week
ends by offering lower prices at those times. Ski
resorts cut prices during the summer to create an
incentive that encourages people to use winter vaca
tion facilities all year. Electric power utilities charge
higher prices to industrial users at peak times.
Whenever some unusual event disrupts the nor
mal state of affairs, the economist always asks: How
will opportunity costs change and what substitutions
will arise from the changed incentives? For example, a
frost kills Florida’s orange crop and sends the price of
orange juice through the roof. This increase in price,
with all other prices unchanged, increases the oppor
tunity cost of orange juice and gives people an incen
tive to drink less orange juice and substitute other
fruit juices in its place. Or a bumper broccoli crop in
Canada sends the price of broccoli tumbling. This
decrease in price, with all other prices unchanged,
decreases the opportunity cost of broccoli and gives
people an incentive to eat more broccoli as a substi
tute for cauliflower and other vegetables.
Scarcity leads to competition. Each individual tries to
obtain as many goods and services as possible by
competing with other individuals. This competition
takes many forms. For example, producers compete
with each other for market share and seek the highest
profit available. PeopLe compete with each other for
jobs and seek the highest wages available (for a given
amount of work effort). Shoppers compete with each
other for bargains and seek the lowest prices avail
able. And students compete with each other for con
cert tickets, parking spaces, and places in heavily
demanded courses.
The effects of an economic disturbance are usual
ly spread out over time. The immediate effects are the
substitutioiss that peopie make in response to changes
in incentives. But these effects lead to second round
effects that ripple through the economy and in some
cases have effects that are quite different from the ini
tial or first round effects. Consider, for example, the
effect of a Florida frost. The first round effect of a
Florida frost is an increase in the price of orange juice
and a substitution of other fruit juices (say apple
juice) for orange juice. The second round effects are
the consequences of the increased competition for
scarce apples. Juice drinkers compete with apple
eaters for the available apples and the price of apples
increases. People now search for yet other substi
tutes—guava juice perhaps. As these second round
effects play out, a long chain of substitutions and
price change take place, all triggered by a simple
frost in Florida.
Economists try to predict seconc round effects
by considering all the main substitutions that are
likely as people compete with each other for the
available resources. Trying to predict the number of
vacant parking spaces on a busy day in Montreal or
New York City is a good example of the importance
of the effects of competition and of the distinction
between first round and second round effects. The
first round effect of a shopper going home is a vacant
parking space. But the first round effect is shortlived. Competition for parking spaces results in
vacant spaces being filled almost immediately. So,
taking account of competition and second round
effects, you predict that there are rarely any vacant
parking spaces!
Do
What Economists Do
L..
EcoNoMisTs WORK ON A WIDE ARRAY OF
problems and the questions at the start of this
chapter are just a small sample of what is covered.
Economic questions can be divided into two big
groups: microeconomic questions and macroeconom
ic questions.
Microeconomics and
Macroeconomics
And now a traffic update: A parking space has just
become available on Sixty-fifth Street between Second
and Third. Hold it! A bulletin has just been handed to
me. That space has been taken.”
Drawing by H. Martin; ©1987 The New Yorker Magazine. Inc.
R
E
V
I
E
W
The economic way of thinking is based on five core
ideas:
All economic problems arise from scarcity and
scarcity forces people to make choices and evaluate
opportunity cost.
Opportunity cost is the best alternative forgone,
not the money cost, and includes time cost and
external cost.
Decisions are made by comparing marginal benefit
and marginal cost.
i When the opportunity cost of an activity increas
es, the incentive to substitute an alternative
activity increases.
-s Competition creates ripples along the chain of
substitution—second round effects-that domi
nate the first round effects.
You’ve examined the types of questions that
economists try to answer. You’ve also seen something
of the way economists think and have learned the five
core ideas that guide that thinking. Your next task is
to move beyond ideas to actions and to study the
things that economists do.
Microeconomics is the study of the decisions of
people and businesses and the interaction of those
decisions in markets. The goal of microeconomics is
to explain the prices and quantities of individual
goods and services. Microeconomics also studies the
effects of government regulation and taxes on the
prices and quantities of individual goods and services.
For example, microeconomics studies the forces that
determine the prices of cars and the quantities of cars
produced and sold. It also studies the effects of regu
lations and taxes on the prices and quantities of cars.
Macroeconomics is the study of the national
economy and the global economy and the way that
economic aggregates grow and fluctuate. The goal of
macroeconomics is to explain average prices and the
total employment, income, and production. Macro
economics also studies the effects of government
actions—taxes, spending, and the deficit—on total
jobs and incomes. For example, macroeconomics
studies the forces that determine the average cost of
living in Canada, the total value of the nation’s pro
duction, and the effects of the federal budget on
these variables.
Although microeconomics and macroeconomics
have their own separate focus, they use a common set
of tools and ideas. Some problems have both a microeconomic and a macroeconomic dimension. An
example is the invention of video games and the
growth of the market in multimedia products.
Microeconomics seeks to explain the prices and
quantities of games, while macroeconomics explains
the effects on the total amount of spending and jobs
in the economy as a whole.
Economists not only work on a wide range of
questions. They also approach their work in a variety