AF1605 Introduction to Economics

Topic 1: The Scope of Economic Analysis

Lecturer: Chau Tak Wai

School of Accounting and Finance

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 What is economics?
 Opportunity cost
 Production Possibility Frontier (PPF)
 Microeconomics vs Macroeconomics
 The economic way of thinking: cost-benefit analysis

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 Wants and needs are unlimited.

 However, resources and technology available to us are limited.

 We are facing the problem of scarcity.

 We have to make choices on the priority of the wants to be satisfied.

 One possible way to define Economics:

 Economics is the social science that studies the choices that
individuals, businesses, governments, and entire societies make as
they cope with scarcity, what influence these choices, and the
arrangements that coordinate these choices.

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 1. It is about resources allocation.
 What to produce?
 How to produce?
 For Whom to produce?

 2. It is about choices.
 Economics assumes that people are rational (based on cost-benefit
analysis) when they make choices.
 Rational choice is the basis of economic thinking. This can help us
understand human decisions for a much broader range of issues.
 Economics is everywhere.

 3. It is mainly about market mechanism.

 Market is the most popular and successful resource allocation
mechanism so far.
 Some special streams of economics are about other forms of
allocation mechanisms.
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 Every economy has to answer the following economic questions:

 What to produce: Should we produce cars, food, houses, medical

services … ? If so, how much to produce?
 How to produce: What is the method of production for each product?
Use more machines or use more workers?
 For whom to produce: Who can enjoy the outputs? How to determine
who can get the good or service?

 In the market economy, most economic decisions are guided by the

decentralized market system: individuals as consumers and/or producers
make their decisions guided by the market mechanism (e.g. using price as
signal).
 In the command economy, these economic decisions are made by the
government (centralized).
 In reality, there is a mix of two.
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 With limited resources, we have scarcity.
 When we choose to satisfy certain wants, at the same time, we have
to give up the opportunity to satisfy other wants.
 “There is no such thing as free lunch.” (Milton Friedman)
 There are always trade-offs.

 Opportunity cost measures how much we need to give up.

 We assume that given the fixed time/resources, we have a list of
things that we can do with it, but we can only do ONE of them.
 If you do not do the option being evaluated, you would just do the
best ONE remaining. Only the best one matters.

 Definition: The opportunity cost of doing an action is the value

(benefit) of the best alternative that must be given up in order to
undertake that action. (The benefit from the highest-valued option
forgone.)
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Example

 Suppose you can use these two hours to do either one of the
following in the order of preference:
 Attend the economics lecture
 Self-study at home
 Watch a movie
 Sleep for 2 hours
 If you have decided to use the two hours to attend the economics
lecture, what is the opportunity cost of taking this action?
 Benefits from all the other options? Or just one of them? Which
one?
 Why?

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In-class self-assessment exercise:

 You would like to work for a part-time job this Saturday afternoon
to earn some money. You will have 2 hours to work. The hourly
salary of the available jobs are as follows:
 1. Assistant at a convenient store: $70.
 2. Assistant at a café: $100
 3. Assistant in the library $60.
 4. Assistant to a professor: $80.
 Suppose there are no other benefits and costs associated to these
options.
 How large is the opportunity cost of working as an assistant at a
café for the 2 hours this Saturday?
 A. $70 B. $100 C. $160 D. $200
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 The core idea of economics:

 Unlimited Wants + Limited Resources

 Problem of scarcity

 Have to make choices

 Opportunity cost arises

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 The core idea of economics can be illustrated by the Production
Possibility Frontier (PPF).

 In an economy, resources and technology for production are limited. The

amount of output produced is therefore also limited.

 PPF shows the combination of goods and services that can just be
produced using the existing resources and technology.
 Given the amount of one good, the point on the PPF shows the maximum
amount of the other good that can be produced.
 Any points above the PPF are not feasible.

 Assume we can produce only two goods: bikes and smartphones.

 In order to produce more bikes with a fixed amount of resources and
technology, we have to reduce the production of smartphones.
 To produce more bikes, we have to give up producing some smartphones.
 To produce more smartphones, we have to give up producing some bikes. 10
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 Downward sloping
 With fixed resources and technology, one needs to give up producing
an amount of the other goods to free up resources to produce more
one good.
 The existence of opportunity cost:
The amount of the other good you have to give up in order to produce
one more unit of this good.

 Concave to origin (bending away from the origin)

 When more of one good is produced, the resulting reduction in the
other good will generally become larger and larger.
 Increasing opportunity cost.
 Reason for increasing opportunity cost: resources are not uniform:
resources better for producing one good would be used first. Increasing
production will draw resources less suitable to produce more of it.
 If resources can be uniformly used to produce the two goods, the PPF
becomes a downward sloping straight line.
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 PPF can illustrate the following three important concepts
corresponding to the core ideas

 Scarcity: We cannot attain production points outside the PPF

due to insufficient resources given the technology.

 Choice: To decide the production point on the PPF.

 Opportunity cost: we have to give up producing an amount of

one good in order to produce more of another good.

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 Microeconomics (Topic 1 – 6) studies the behavior of individuals, e.g.,
individual consumer, individual producer, individual market.
 Major topics in microeconomics:
 Price mechanism: Demand, supply and market.
 Production and cost.
 Market structure.
 Market failure.

 Macroeconomics (Topic 7 – 9) studies the behavior of the aggregate

economy.
 Major topics in macroeconomics:
 Aggregate output measurement and determination.
 Money and banking
 Inflation and unemployment.

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 The Economic perspective:
 People make rational choice using the cost-benefit principle.
 Benefit is the gain or pleasure that something brings you.
 Cost is what you must give up to get something. Remember in
economics we are concerning about the opportunity cost.
 Economic surplus from taking an action is the benefit of taking
that action minus its cost.
 Benefit and cost can be stated in monetary terms for easier
comparison, but not necessarily so.

 The Cost-Benefit Principle:

 People make decisions to maximize economic surplus.
 If we are deciding whether to have an additional unit or not, the
additional benefit and cost are known as marginal benefit (MB)
and marginal cost (MC) respectively. Then, one will have the
additional unit (the Xth unit) if
𝑴𝑩 𝑿 ≥ 𝑴𝑪 𝑿
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 How many cups of coffee you are willing to buy from the café a day?

 If you are willing to pay $20 for the first cup of coffee from the café a day,
and $15 for the second, $9 for the third, and $0 so on.
 Now, the price of a cup of coffee is $14.
 How many cups of coffee do you want to buy?
 Note: we regard the willingness to pay as the benefit that the cup of coffee
brings.

 Total approach:
 Economic Surplus (ES) = Total benefit (TB) – Total cost (TC)
 For 1 cup: TB(1) = 20, TC(1) = 14. ES(1) = 6.
 For 2 cups: TB(2) = 20 + 15 = 35, TC(2) = 14 x 2 = 28. ES(2) = 7.
 For 3 cups: TB(3) = 35 + 9 = 44, TC(3) = 14 x 3 = 42. ES(3) = 2.
 For 4 cups: TB(4) = 44, TC(4) = 14 x 4 = 56. ES(4) = -12.
 To maximize surplus, one should choose to buy
 2 cups.
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 How many cups of coffee you are willing to buy from the café a day?

 If you are willing to pay $20 for the first cup of coffee from the café a day,
and $15 for the second, $9 for the third, and $0 so on.
 Now, the price of a cup of coffee is $14.
 How many cups of coffee do you want to buy?
 Note: we regard the willingness to pay as the benefit that the cup of coffee
brings.

 Marginal approach:
 First, it is generally assumed in Economics that the marginal benefit
decreases with quantity consumed. Why does it make sense?
(Law of diminishing returns)
 We should compare marginal benefit and marginal cost cup by cup.
 For 1st cup: MB(1) = 20 > MC(1) = 14. => Buy 1st cup.
 For 2nd cup: MB(2) = 15 > MC(2) = 14. => Buy 2nd cup.
 For 3rd cup: MB(3) = 9 < MC(3) = 14. => Not to buy 3rd cup. We stop here.
 Therefore, one should buy 2 cups.
 The two approaches are consistent. 21
 If you have dinner with your best friends this coming Sunday afternoon:
 Enjoy the benefit with an equivalent monetary value of $440.
 Pay $200 for the dinner.
 Pay a transportation cost of $30.
 Not able to work 3 hours for a part-time job in selling masks, with a
wage of $75 per hour.

 How large is the opportunity cost (economic cost) of going to the dinner?
 A. $225
 B. $230
 C. $455
 D. $895

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 If you have dinner with your best friends this coming Sunday afternoon:
 Enjoy the benefit with an equivalent monetary value of $440.
 Pay $200 for the dinner.
 Pay a transportation cost of $30.
 Not able to work 3 hours for a part-time job in selling masks, with a
wage of $75 per hour.

 How large is the opportunity cost (economic cost) of going to the dinner?
 Explicit cost (directly pay from your own money, which is the money
you have given up saving) = $200 + $30 = $230.
 Implicit cost (income you have given up getting) = $75 x 3 = $225.
 Both are benefits from choosing the best alternative (part-time job).
 Total cost = $230 + $225 = $455.

 Then should you go to the dinner?

 Benefit = $440.
 Economic Surplus = $440 - $455 = -$15 (Benefit < Cost)
 Therefore, you would not attend the dinner. 23
 If you have dinner with your best friends this coming Sunday afternoon:
 Enjoy the benefit with an equivalent monetary value of $440.
 Pay $200 for the dinner.
 Pay a transportation cost of $30.
 Not able to work 3 hours for a part-time job in selling masks, with a
wage of $75 per hour.

 Further questions for thought:

 How would your decision changes if the wage is only $60 for the part-time
job?
 It would decrease the implicit cost and thus the opportunity cost.

 If you now knows that a friend whom you really want to meet can join the
dinner, does it affect the opportunity cost of going to the dinner?
 No. Why?
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 Mistake 1: Failure to include implicit costs

 If you have a box of surgical masks at home, do you have a cost of using
a mask from it now?

 Yes, you have given up the chance to sell it for money.

You have given up the chance to use it at a later day.
(Should we include the benefits of both then?)

 Similarly, those who have learned the primitive definition of

opportunity cost in Economics may mistakenly think that explicit cost is
not opportunity cost.

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 Mistake 2: Measuring costs and benefits as proportion rather than
in absolute dollar amount.

 Example: You have a discount coupon which can be used for either
one of the following but not both:
 Enjoy 5% discount for buying a notebook computer selling at
$10,000. (saving $500)
 Enjoy 10% discount for buying a laser printer selling at $2,000.
(saving $200)
 In which way should you use it, if you would buy both anyway?

 To avoid the mistake, you should use the coupon to buy the
notebook computer since you can enjoy more economic surplus.
 You can use the $300 you saved in extra to buy something you want!!

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 Mistake 3: Failure to ignore sunk costs.

 Sunk costs are costs that have been paid and cannot be recovered
no matter what is done at or after this moment.

 Because sunk costs must be borne whatever you choose right now,
they are irrelevant to the current decision of whether to take a
certain action.

 Sunk costs are generally not included as economic / opportunity

costs.

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 You bought a house at the cost of $11 million in the beginning of
2020.
 The current (Sept 2021) price of the house is $10 million.
 You expect (100% sure) that the price of the house will be $11.5
million at the end of 2022.

 Should you sell the house now or wait until the end of 2022?

 A. Must sell now because the price now is below the buying price.
 B. Must not sell now because the price now is below the buying
price.
 C. Must not sell now since you can sell it at a higher price at the
end of 2022.
 D. Sell now if you can use the $10m proceed to get more than
$11.5m at the end of 2022.
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 You bought a house at the cost of $11 million in the beginning of 2020.
 The current (Sept 2021) price of the house is $10 million.
 You expect (100% sure) that the price of the house will be $11.5 million at
the end of 2022.

 Should you sell the house now or wait until the end of 2021?

 Notice that the sunk cost of $11 million (or the loss of $1 million for
selling the house now) is irrelevant to your decision making.
 Instead, you should consider the future opportunities.
 If you sell the house now, you have given up the chance to sell the house
at the end of 2022.
 If you sell now, you can get $10m now. If the usage of this $10m is worth
more than $11.5m at the end of 2022, you should sell it now. Otherwise,
you may wait till the end of 2022.
 For example, if you can get 20% return at the end of 2022 from investing
the $10 million now (say buying stocks, or invest in a project), then you
should sell the house now. 29
 The way of thinking in terms of cost-benefit analysis can be
applied to a wide range of issues in real life.

 Use the insights from economics to help make sense of

observations from everyday life.

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 In this topic, you have learned:
 What is Economics?
 Opportunity Cost
 Production Possibility Frontier (PPF)
 Microeconomics and Macroeconomics
 Three basic questions
 The economic way of thinking: cost-benefit analysis
 Explicit cost vs implicit cost
 Sunk Cost

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