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Economics 14

Lecture 1: Scarcity and Choice

definition of economics
scarcity
opportunity costs
marginal costs and marginal benefits

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Definition of Economics

Economists study the economy. In the economy, goods and services are produced, exchanged,
and consumed. So, economics is the study of the production, exchange, and consumption of
goods and services.

The subject matter of economics can be approached from two levels of analysis:
macroeconomics and microeconomics. Microeconomics looks at the production, exchange, and
consumption of goods and services at the level of an individual producer of the good or the
market in which a single good or service is exchanged or an individual consumer of the product.
The key word is individual; microeconomics deals with the behavior of the individual entities
that make up the economy.

Macroeconomics deals with the entire national economy. Rather than being concerned with the
production of a single good or service, say, vacuum cleaners, macroeconomics looks at the total
production of all goods and services including vacuum cleaners, coffee makers, and frozen pizza.
Rather than worrying about why the price of gasoline has risen or fallen over the last several
weeks macroeconomics is concerned with the inflation rate, a measure of how the average price
of all goods and services has changed.
Scarcity

Economics is

the study of the allocation of scarce resources among competing and insatiable needs so as to
maximize welfare.

Economists assume that people do not act randomly. Instead, people's behavior has a purpose.
We assume that people act in their own rational self-interest. People make the choices they
believe leave them best off.

Economics resources are used to produce goods and services. There are three categories of
economic resources:

1. land - raw materials and natural resources

2. labor - workers
3. capital - buildings, machinery, factories, equipment

Each of the resources exists in a finite, limited quantity.

We assume that people have unlimited wants. There is always something that people want more
of. Since we have a limited amount of resources, we can produce a limited amount of goods and
services. No matter how large that amount is, we cannot produce enough to satisfy everyone's
unlimited wants. This is known as scarcity and much of economics looks at how people cope
with scarcity.

Opportunity Costs

Because resources are scarce, people must make choices. A choice is a comparison of
alternatives. For example, suppose I had a choice of having Kix, Cheerios, or Lucky Charms for
breakfast, and I decided to eat the Lucky Charms. When I chose to eat the Lucky Charms I was
simultaneously choosing not to eat Cheerios and not to eat Kix. I gave up the chance to eat the
Cheerios or the Kix. What I gave up has a value. This value is called the opportunity cost.

Every choice has an opportunity cost. Opportunity cost is the value of the next best alternative.
Since I chose the Lucky Charms, my opportunity cost is the Cheerios or the Kix, whichever I
most prefer.

For an accountant, the cost of an activity is the out-of-pocket expenses, all of the money paid to
undertake the activity. For an economist, the cost of an activity is everything given up for it,
including opportunity costs. For example, what are the total costs of a college education?

tuition $44,000
books 3,200
beer costs 4,800
transportation 4,800
opportunity costs 56,000
total costs $112,800

Instead of attending college you could be doing something else such as working or backpacking
across Europe. That something has a value to you; the value of whatever you would have done if
you had not attended college is the opportunity cost of going to college.

Let's say you would have found a job making sandwiches at Sheetz and would have made
$14,000 a year. Then, your opportunity cost of attending college would be the wages you could
have earned instead.

Marginal Costs and Marginal Benefits

Most decisions are not of the all or nothing variety. Most decisions involve choosing a little more
or a little less of something. Rational decision making involves comparing the costs and benefits
of that incremental change. Loosely put, the additional costs of undertaking some activity are
called the marginal costs. The additional benefits of engaging in that activity are called the
marginal benefits. If the marginal benefits are greater than the marginal costs, do it; otherwise,
do not.

Should you have come to class today? Let's compare the marginal costs and benefits.

marginal costs
gas, other car expenses $2.00
paper & ink used 0.25
opportunity costs (sleeping) 1.00
breakfast 2.00
total marginal costs $5.25

marginal benefits
knowledge $0.50
higher lifetime income due to better economics grade 0.25
earned because you learned about opportunity costs
in class today
were able to socialize with other students 2.00
total marginal benefits $2.75

So, since the marginal costs of attending class today are greater than the marginal benefits,
rational behavior dictates that you should not have come to class today.

But, many of you did attend class today. There are two possible explanations. One, you've all
behaved irrationally. You came to class knowing that the marginal benefits were smaller than the
marginal costs. However, it is not a good idea to assume that so many people have behaved
irrationally. So, second, we have incorrectly measured the costs and benefits.

marginal costs
gas, other car expenses $2.00
paper & ink used 0.25
opportunity costs (sleeping) 1.00
breakfast 2.00
total marginal costs $5.25

marginal benefits
knowledge $0.50
higher lifetime income due to better economics grade
earned because you learned about opportunity costs 0.25
in class today
were able to socialize with other students 2.00
spent 50 minutes with me 2.51
total marginal benefits $5.26