Week 1

Introduction to Economic Principles

What is economics?
• Economics is the study of the allocation of scarce resources to meet
unlimited human wants
• ____________________ – is concerned with decision-making by individual
economic agents such as firms and consumers (*cough cough* this class
*cough cough*)
• ____________________ – is concerned with the aggregate performance of
the entire economic system
• ____________________– relies upon facts to present a description of
economic activity
• ____________________– relies upon principles to analyze behavior of
economic agents
Assumptions
• Economic models of human behavior are built upon ____________
that permit rigorous analysis of real world events without
_____________________
• Model building – models are abstractions from reality
• Occam’s Razor – the best model is the one that best describes reality and is the simplest
• Simplifications
• “Ceteris paribus”  __________________________________
• There are problems with assumptions
• Too simple – the models are inconsistent with observed reality - therefore they are faulty and
require modification
• Too complex – the model cannot be easily communicated or its implications easily understood
Is economics useful?
• Economics provides an objective mode or analysis
• _____________________
• Economists use rigorous models that are predictive of human
behavior
• Scientific approach
• _________________ logic – creates principles for observation
• _________________ logic – hypothesis is formulated and tested
Positive vs Normative
• _________________ economics – is concerned with what is
• “The current unemployment rate is 20%.”
• _________________ economics – is concerned with what should be
• “The unemployment rate should not exceed 5%.”
Try to sort these statements
• “Health expenditure accounts for 25% of the budget.”  _______________
• “A higher carbon emissions tax should be implemented to combat climate change.” 
_______________
• “Inflation this year was 3%.”  _______________
• “The increase in the minimum wage has shown a negative correlation with the employment
rate in various empirical studies.”  _______________
• “The government should increase spending on education to improve the quality of life of the
population.”  _______________
• “A country’s economic growth is positively correlated with the level of investment in human
capital.”  _______________
• “Defense spending should not exceed 10% of the budget.”  _______________
• “Social services expenditure should not be more than 40% of the national income.” 
_______________
The Economic Problem
• The economic problem involves the allocation of resources among competing
wants
• The economic problem exists because there is scarcity
• Scarcity arises because of two facts
1. there are __________________________________
2. there are __________________________________ available to meet those wants
• Scarcity exists because we do not have sufficient resources to produce everything we want
• Rivalry
• Goods/resources are considered __________________________________ if one agent
consuming the good/resource _______________ another agent’s ability to use that
good/resource
• Example:
• If I eat the last piece of cheesecake, my sister can’t eat it
• The cheesecake is a rival good #SiblingRivalry
Economic Resources
• _________ - includes space (i.e., location), natural resources, and what is
commonly thought of as land
• _________ is paid rent
• _________ - are the physical assets used in production - i.e., plant and equipment
• _________ is paid interest
• _________ - is the skills, abilities, knowledge (called human capital) and the effort
exerted by people in production
• _________ is paid wages
• _________ _________ - (risk taker) the economic agent who creates the
enterprise
• _________ _________ is paid profits
• _________ - a manner in which resources are combined to produce commodities
Core Principles of Economics
• The Cost-Benefit Principle
• The Opportunity Cost Principle
• The Marginal Principle
• The Interdependence Principle
The Cost-Benefit Principle
• Cost-benefit principle – costs and benefits are the incentives that shape
decisions
• Before you make a decision…
• Evaluate the ________________________________ associated with that choice
• Pursue that choice only if ____________________________________
• Example: You’re hungry and are considering buying a granola bar from a
vending machine after class. The granola bar costs $2.
• Do you decide to buy the granola bar?
• Dilemma: How do you compare the benefit with the costs?
• Solution: Convert costs and benefits into dollars by evaluating your
_______________________________
Willingness to Pay
• Willingness to pay – to convert nonfinancial costs or benefits into their monetary equivalent,
ask yourself: “What is the most I am willing to pay to get this benefit (or avoid that cost)?”
• Helpful Hint: Do not confuse “__________________” with “__________________” when doing this
conversion
• Using money and the measuring stick allows you to take into account the __________________ and
__________________ costs and benefits of a decision
• Example Continued: The benefit of the granola bar depends on how delicious it is to you
• Let’s say you are willing to pay up to $3 for the granola bar
• Costs: $2
• Benefits: $3
• Decision: buy the granola bar
• Take-away: Using the cost-benefit principle, we see the benefits exceed the costs, which is
why you buy the granola bar
• In cost-benefit analysis, money is the __________________, not the __________________
Economic Surplus
• Economic surplus – the __________________ minus the
__________________ flowing from a decision
• __________________ = __________________ – __________________
• It measures how much a decision has improved an agent’s well-being
• The cost-benefit principle allows us to __________________ our
economic surplus
• Example continued: You bought for yourself a granola bar
• You gained something worth $3 to you (the granola bar) in exchange for
something only worth $2 (your money)
• This exchange generated an extra $1 worth of benefits to you
• This $1 is your economic surplus
Framing Effects
• Framing effect – when a decision is affected by how a choice is
described or framed
• You should __________________ framing effects altering your own decisions
• Framing Effect Example:
• When an item’s price tag shows both the original price and the sale price
• Your choice should depend on the costs and benefits of that item — not on something
irrelevant, like how much the item cost in the past
Focus on the costs and benefits, not
how they are framed
• As CEO, you need to cut costs
• Your current plan is to lay off 6,000 employees
• You assemble a team to brainstorm alternative options
• Plan A: Saves 2,000 jobs with 100% certainty
• Plan B: Has a 1/3 chance of saving all 6,000 jobs but a 2/3 chance of
saving no jobs at all
• Which plan would you vote for?
Focus on the costs and benefits, not
how they are framed
• As CEO, you need to cut costs
• Your current plan is to lay off 6,000 employees
• You assemble a team to brainstorm alternative options
• Plan 1: Results in the certain loss of 4,000 jobs
• Plan 2: Has a 2/3 chance of losing all 6,000 jobs but a 1/3 chance of
losing no jobs
• Which plan would you vote for?
Focus on the costs and benefits, not
how they are framed
• What did you notice?
The Cost-Benefit Principle: Summary
• Evaluate the full set of benefits and costs for any given choice:
• Pursue the choice if the ____________________________________
• How much am I willing to pay to enjoy this benefit (or avoid this cost)?
• “Full set”  consider both __________________ and __________________
aspects
• Avoid being led astray by __________________
The Opportunity Cost Principle
• Allocations of resources imply that decisions __________________,
which in turn involves choice
• Every choice is costly; there is always the lost alternative  the opportunity
cost
• Opportunity cost - the next best alternative that must be foregone as a result of a
particular decision
• Focus on the __________________ associated with a particular
option
• What did you give up to pursue this option?
Opportunity Cost Example
• You have a 1-hour break between classes. You have many ways you
could spend this time:
• Hang out with friends
• Work on homework
• Take a nap
• Watch something on Netflix
• Whatever you choose to do, you are implicitly choosing not to do
something else
• That’s your opportunity cost
Opportunity Cost Example: Analysis
• Suppose you rank the options as follows:
1. Work on homework
2. Hang out with friends
3. Watch something on Netflix
4. Take a nap
• Given the ranking above, you would choose to work on homework for
the hour in between classes.
• What was the opportunity cost of your choice?
Opportunity Cost Example: Analysis
• What did you give up by working on homework in between classes?
• Answer: __________________________________
• Helpful Hint: The opportunity cost of working on homework is not
_______________________________________
• Rather, the opportunity cost is your ____________________________________
• Ask yourself, “__________________”
• Should I work on homework ___________________________
• Your answer to “________________” is the opportunity cost of the option
under consideration
Opportunity Costs: Trade-offs are
inescapable
• Every choice involves a trade-off; every choice has a cost
• Why? Because __________________
• __________________ - resources are limited; therefore, any
resources you spend pursuing one activity leaves fewer resources to
pursue others
• Limited __________________ – what could I spend my money on instead?
• Limited __________________ – there are only 24 hours in a day (we all have
a time-budget)
• Limited __________________________________ – people need rest…
• Limited __________________________________ – what else could be
produced with this machinery and labor?
Calculating Opportunity Cost:
Example
• Consider the costs of going to grad school or working full time
Graduate School Working Full time Opportunity Cost
• Tuition/Books costs • No tuition/book costs • __________________
• $60,000
• Quit current job • You earn $70,000 • __________________
• Apartment/food costs • Apartment/food costs • __________________
• $24,000 • $24,000 • __________________
• 10 hours/day studying • 10 hours/day working

Total opportunity cost per year of going to graduate school = __________________

What counts as an opportunity cost?
• Some out-of-pocket costs
• The $60,000 tuition is an out-of-pocket financial cost, and also an opportunity cost
• Wouldn’t have had this expense if you continued working full time
• Not all out-of-pocket costs
• The $24,000 spent on apartment and food is spent either way, and therefore is not an opportunity
cost of attending school
• Non-out-of-pocket financial costs
• The $70,000 salary you forgo by not working is not something you pay directly, but it is money that
you give up, and thus is an opportunity cost
• Not all time costs (nonfinancial)
• You do not count all 10 hours of study time as an opportunity cost since your job requires 10 hours
of your time
• Thus, relative to your next best alternative, the time spent studying is not an opportunity cost of
school
How entrepreneurs think about
opportunity cost
• The opportunity cost principle allows entrepreneurs to evaluate
whether or not to start a business:
• Should you start a new business, or stay in your existing job?
• If you quit your current job, you are giving up the paycheck that comes with it
• Forgone wages are an opportunity cost
• Should you invest your money in this new business, or leave it in the bank (or
the stock market)?
• If you take your money out of the bank (or stock market), then you will not be earning
interest on that money
• This forgone interest (or the forgone investment opportunity) is an opportunity cost
associated with starting your new business
Sunk Costs
• Sunk cost – a cost that has been
incurred and cannot be reversed
Good decision makers
__________________ sunk costs
• __________________ incorporate
past, irreversible costs into your
current cost-benefit analysis
• Sunk costs are irrelevant to the
current decision at hand because
these costs are associated with
every alternative moving forward
Sunk Cost: Example
• You bought a movie ticket for $12
• Within the first 30 minutes, you realize the movie is horrible
• Question: Do you continue watching the movie, or leave?
• Answer: __________________
• ______________________________________________________________
• ______________________________________________________________
Production Possibilities Frontier
• Production Possibilities Frontier (PPF) –
shows the different sets of output that are
attainable with your scarce resources
• The PPF illustrates the trade-offs you
confront when deciding how to allocate
your scarce resources (like your time)
Example: You have 3 hours per night of
study time for economics and/or psychology
• 1 hour toward econ  8-point boost in
grade
• 1 hour toward psych  4-point boost in
grade
Production Possibilities Frontier
Moving along your PPF reveals your
opportunity costs
• Every hour you devote to studying psychology
is one less hour you can devote toward
economics
Visualizing the Opportunity Cost:
• For example, moving from point A to B along
the PPF you see that to gain 4 points in
psychology, you had to sacrifice 8 points in
economics
• The opportunity cost of adding 4 points to
your psychology grade is earning 8 fewer
points in economics
Production Possibilities Frontier
Any allocation of time such that you are on your
PPF is an efficient use of your resources (A, B, C)
• All 3 hours of study time are being used
• No time is being wasted
Any allocation of time such that you are below your
PPF is an inefficient use of your resources
• At points marked with an X, time is being wasted
(not all 3 hours are being used)
You can only reach a point above your original PPF
(N) if you increase your productivity in some way
(new study techniques)
• Otherwise, points beyond your PPF would be
unattainable
The Opportunity Cost Principle:
Summary
• The opportunity cost is the most valuable alternative you had to give
up to pursue your choice
• Even if the choice has _________________________, there is ____________
a cost because every choice has an __________________ associated with it
• __________________ makes opportunity costs (trade-offs) inescapable
• Good decision makers ______________________________________
• The _________________________________ can be used to visualize the
opportunity costs we face
The Marginal Principle
• Marginal Principle – decisions about quantities are best made
incrementally
• You should break “__________________” questions into a series of
smaller, or __________________, decisions weighing the marginal
benefits and marginal costs
• __________________ – the extra benefit from one extra unit (of
goods purchased, hours studied, etc.)
• __________________ – the extra cost from one extra unit
Quantity Decisions
• Instead of: “how many workers should I hire?”
• Simplify to: “Should I hire __________________ worker?”
• Apply the cost-benefit principle to this marginal decision to answer
the question “should I hire __________________ worker?”
• What are the extra benefits of hiring __________________ worker? —
marginal benefit
• What are the extra costs of hiring __________________ worker? — marginal
cost
• Hire the additional worker if the marginal benefit exceeds the
marginal cost
Which decisions are marginal
decisions?
• How many slices of pizza should I eat?
• ___________________
• How many classes should I take this semester?
• ___________________
• Should I attend class?
• ___________________
• How many hours should I spend watching Netflix?
• ___________________
• Should I go to the gym?
• ___________________
• How many reps should I do?
• ___________________
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Visualizing the Marginal Principle
• Determine what type of choice you face
• If it is a “how many?” decision
• break it down into a series of smaller marginal
decisions (“should I buy one more?”)
• Weigh the marginal benefits against the
marginal costs
• __________________ applied to a marginal
decision
• Apply the marginal principle iteratively
until you eventually decide against
buying one more unit, and then stop
The Marginal Principle and the
Rational Rule
• Whenever the benefits of a choice exceed the cost, it is a good
choice  cost-benefit principle
• When you do marginal analysis, you iteratively apply cost-benefit to
figure out if “__________________” is a good choice
• __________________– if something is worth doing, keep doing it MB = MC
until your marginal benefits equal your marginal costs
• Connecting Concepts:
• Every additional unit you acquire using the marginal principle will increase
your economic surplus
• Recall: economic surplus = benefits – costs
• Economic surplus is __________________ when the marginal
benefit equals the marginal cost
• If you follow the marginal principle, then every unit you end up buying will
be “__________________”
Using the rational rule to maximize
your economic surplus
You decide to open a restaurant  How many workers should you hire?
Benefits of an additional worker: Costs of an additional worker:
• You can prepare and serve more meals, which • An additional worker means additional wages
brings in additional revenue must be paid
• You can sell each meal for $25: • $300 a week per additional worker
• Revenue = $25 x meals served • Additional meals will require you to purchase
additional ingredients
• $10 per additional meal
Other relevant costs:
• Your rent costs $500 per week
• The opportunity cost of your time is $1,000 per week
Running a Restaurant: Costs and
Benefits of an Additional Worker
Marginal Total Costs Profit or
Number Total Benefits Marginal
Meals Benefit
($10 per meal + Economic
of (revenue = $25  $300 per waiter Cost
Served (change in + $500 rent + (change in total Surplus
Workers number of meals)
total benefit) $1,000 for your cost) (total benefits less
time) total costs)

2 160 $4,000 $3,700

3 210 $5,250 $4,500
4 250 $6,250 $5,200
5 280 $7,000 $5,800
6 300 $7,500 $6,300
7 310 $7,750 $6,700
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The Marginal Principle: Summary
• The marginal principle tells you to break “how
many” decisions into a series of smaller,
marginal decisions
• If the marginal benefit __________________ the
marginal cost, then buy that additional unit
MB = MC
• Continue to buy additional units as long as the
marginal benefit is at least as large as the marginal
cost (__________________)
• __________________ when the marginal benefit
equals the marginal cost
• Economic surplus is __________________ when
marginal benefit equals marginal cost
The Interdependence Principle
• Interdependence principle: Your best choice depends on…
• your __________________ choices
• the choices __________________
• developments in __________________
• and __________________ about the __________________
• When any of these factors changes, your best choice might change
• You are not making decisions in __________________
• You are part of a larger network
• Rivalry
Dependence between each of your
individual choices
• Your own choices are all __________________ because you have
__________________ resources:
• Your decision on how much to spend on movies will impact how often you
can eat out because you have limited income
• Your decision on how much time to dedicate to studying economics affects
the time available for studying psychology because you have limited time
• Because you only have one oven (i.e., you have limited production capacity),
you may not be able to prepare the main dish, and all the side dishes for
dinner tonight
Dependence between economic
actors
• The choices made by __________________________ (people,
businesses, governments, etc.) shape the choices available to you:
• If Microsoft hires the most talented software engineers in Seattle, then there
will be fewer talented people available for other Seattle-based tech
companies to hire
• If your friends all have chosen to buy iPhones, you may also want to buy an
iPhone to maximize OS compatibility across phones
• If your classmate gets hired for an internship, then your chances of getting
hired at that same company have decreased
Dependence between markets
• Changes in __________________ and __________________ in one
__________________ affect the choices you might make in other
__________________ :
• Declining interest rates in the credit market make it less expensive to get a
mortgage, which might lead you to buy a home in the housing market
• Your decision to join the labor market as a worker depends on the availability
of high-quality, low-cost child care options in the child care market
Dependence through time
• Is it better to act today, or tomorrow?
• Should I buy gas today, or next week?
• My decision depends on whether I think gas prices will fall or not next week
• Should I buy a hybrid car now, or wait a few years for the technology to get
even better?
• Furthermore, decisions today shape future opportunities and
decisions
• Should I go to grad school and get my MBA?
• This decision not only affects your future job opportunities but also your salary
The Interdependence Principle:
Summary
• Optimal decisions depend on multiple factors
• Dependence between each of your individual choices
• Dependence between economic actors
• Dependence between markets
• Dependence through time
Core Principles of Economics
• The Cost-Benefit Principle  __________________
• The Opportunity Cost Principle  __________________
• The Marginal Principle  __________________
• The Interdependence Principle  __________________