We begin our economics unit by spending a week laying the groundwork and introducing some core concepts. Today, we will introduce the subject and its specialized vocabulary. We will also cover three core principles: the scarcity principle, the incentive principle and the cost-benefit principle.
In determining the optimal (or best) class size, we are dealing with costs and benefits. As I change one, so must the other factor respond. As I decrease class size, my overall costs increase but my learning outcomes improve. I’d probably achieve the best outcome with a 1:1 teacher-to-student ratio but the costs would be tremendous. Who would pay those costs? For public schools and universities, the taxpayer would see their taxes increase. In a private school, tuitions would go up.
“There Aint No Such Thing as a Free Lunch” means that every benefit has an associated cost. Another way to think of this is that you can’t get something for nothing. Our desires, our wants are infinite. Everyone wants to improve their situation. Everyone wants to do better. No matter how rich we are, we always want more. Yet, there is a finite amount of stuff in the world. Every moment of every day we make decisions based on trying to maximize our benefits while minimizing our costs. Every moment of every day we prioritize based on having limited resources. Even those who are fabulously wealthy still deal with the biggest limited resource of all: time. Concept check: given that raising teacher pay should raise overall costs, class sizes will probably increase.
One of the frequent criticisms of economics is the “rational person” assumption. The mathematical models used by classical economists require the assumption of consistent rational action to work properly. It’s not as far-fetched as it sounds – all living creatures seek out pleasure and avoid pain, which is just another way of saying all living creatures seek to maximize their benefits while minimizing their costs. But if you were here for the first week of class, you know that our brains have two thinking systems, System I (instinctual and quick) and System II (rational and slow). System II thought is always rational. System I thought is prone to errors and bias. Current behavioral economists use the term “bounded rationality” to describe how humans are rational when they think things through but can be prone to errors or bias if forced to choose quickly. The System I biases put bounds or constraints on our System II rational thought.
“Perfect information” is another controversial assumption used in classical economics. This means the rational person fully understands all the benefits and costs associated with any action and thus, will always make the rational choice. This is certainly true of some situations – you probably know which soft drink is your favorite. But could you pick your 5th-favorite over your sixth-favorite? Also, do cigarette smokers fully understand the costs associated with the pleasures of nicotine? Some people mock these assumptions in an attempt to discredit economics. But all scientific theories use simplifying assumptions to make the theories easier to model mathematically, easier to teach and learn. The theory of gravity reduces everything down to a two-body problem even though in the real world, there are an infinite number of forces acting simultaneously. The two-body assumption allows us to use math to explain gravity and the trade-off between accuracy and usefulness is a good one.
As economics has developed as a social science, economists have gotten more sophisticated with their assumptions. In particular, economists that study markets have realized that perfect information results in better, more efficient markets. Situations in which only one person involved in a trade has accurate information can result in bad outcomes. In the used car example here (first formulated in 1970 by economist George Akerlof in a landmark paper called “The Market for Lemons”), buyers will never offer the peach price of $10,000 because if they are wrong (and recall, they don’t know which type they’re getting), they will be out $5,000. If buyers only offer $5,000 – then peach sellers will never sell at that price. As you might imagine, buyers offering prices will never exceed $7,500 as that minimizes their potential loss based on the 50-50 shot of getting a peach over a lemon. At THAT price, only lemons will be sold as sellers won’t accept a deal that results in them taking a loss. This is NOT an optimal outcome and demonstrates the bad things that happen when information in a market is one-sided (asymmetrical).
The Cost-Benefit Principle says that rational people only choose things in which the benefits equal or exceed the costs. Notice that in situations in which there is perfect information, there so be NO economic surplus. In our lemon example, if perfect information existed, peaches would sell for exactly what they are worth ($10 k) as would lemons ($5 k). Notice that on the graph, the optimum point is where the difference between benefits and costs is at its greatest (i.e., the point of the greatest economic surplus).
Opportunity costs are the value of what you give up when you make an economic decision. For example, perhaps my two options for a Saturday are 1) work a shift at McDonald’s and earn $50 or 2) go see a movie which costs $10. In this case, my explicit costs are $10 (the cost of the movie ticket) but my choice to see the movie also means I am giving up my shift at work, which carries an implicit or opportunity cost of $50. My TOTAL cost for seeing the movie is $50 (implicit plus explicit). If we assume I’m rational, then I must be getting at last $50 in benefit from seeing that movie.
A penny provides one cent worth of benefit. How much does it actually cost you to pick it up? Your time is a valuable and limited resource. Let's say your time is worth $10 an hour and picking up a penny would take you 5 seconds. At $10/hour, your time is worth 10/3600 or about one-fifth of a cent per second. 5 seconds of your time is worth exactly one cent at $10/hour. So yes, under those conditions, you should pick the penny up. You would not, however, climb down a storm drain to retrieve a penny. Nor would you worry about a penny if your time was worth more than $10 an hour. Notice in this example, all our costs are implicit or opportunity costs. The act of bending down to pick up the penny is considered to be free in the explicit sense.
The Incentive Principle says that when you change the costs or benefits associated with a choice, you will change outcomes. In the Affordable Care Act, people that refuse to sign up for insurance have to pay a tax penalty. This negative incentive is designed to encourage more people (more HEALTHY people) to sign up for insurance. Without the incentive, healthy people tend to avoid insurance, leaving only sick people wanting insurance, driving up the cost of insurance for all that are covered. Getting more healthy people to sign up lowers overall costs.
We often take the mental shortcut of assuming that “bigger is ALWAYS better” so we get more excited about saving 50% off a tank of gas than from saving 1% on the purchase of a new laptop. In our example, 50% off gas and 1% off a laptop yield the same benefit - $20. So we should be willing to drive downtown to get those benefits, assuming that the cost of a drive downtown is less than or equal to twenty dollars.
We know that you must get at least $100 in benefit from seeing Chance or you wouldn’t have spent $100 on the ticket in the first place. So if you don’t buy a replacement ticket, you are out the $100 you paid for the first ticket. Your cost is $100. Now you buy a replacement ticket. Your total cost is now $200 BUT you get to see Chance, resulting in a benefit to you of (at least) $100. Either way, your economic surplus is zero. So you should buy the replacement ticket. If you think of your first, lost ticket as a sunk cost (unrecoverable) then OF COURSE you should buy a replacement ticket at the same original price.
Total costs are easy to understand and the concept of average cost is also very intuitive. We tend to have a problem with the concept of marginal costs however. Marginal costs are the cost of one additional unit. In the example given, we are looking not at costs but at production. As we add employees, we increase production. But notice, each extra employee has a different impact on production – the marginal production varies, eventually becoming negative as the number of employees reaches 8. At that point, our average production is still about 4 toys per employee per hour. But by adding the 8th worker, I actually decrease total production from 28 to 27, giving me a marginal production of -1. In this example, it would be irrational to add the 8th employee.
Most people overeat to the point of being uncomfortable at buffet-style restaurants. They seem to be following an implicit goal of trying to lower the average cost of the food they consume. As your mother may have told you – “eat until you are full then stop”. She knew that as you continue to eat, the pleasure you get from eating decreases while the discomfort you get from being full increases. At some point, the marginal benefit from your last bite of food is matched exactly by the marginal cost (the discomfort) of a full belly. That’s where you should stop.
Assume that we are looking at value (whether it be benefit or cost) on the vertical axis and quantity on the horizontal axis. As quantity increases, the benefit of each additional unit goes down while the cost of each additional unit increases. In our Golden Corral example, the quantity represents the amount of food you are eating. Note the intersection of MB and MC represents the “sweet spot”, where you’ve eaten just enough to be comfortably full. These types of intersections are often called “equilibriums” in that they represent a stable, optimal solution.
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