AF1605 Introduction to Economics

Topic 1: The Scope of Economic Analysis

Lecturer: Chau Tak Wai

School of Accounting and Finance

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

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v Wants and needs are unlimited.

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

v We are facing the problem of scarcity.

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

v Economics defined:
v 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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v 1. It is about resources allocation.
v What?
v How?
v For Whom?

v 2. It is about choices.
v Economics assumes that people are rational when they make choices.
v Rational choice approach is the basis of economic thinking. This can help us
understand human decisions in a much broader range of issues.
v Economics is everywhere.

v 3. It is mainly about market mechanism.

v The most popular and successful resource allocation mechanism so far.
v Other streams of economics about other forms of allocation mechanisms.

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v Every economy has to answer the following economic questions:

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

services … ? What is the output level of each product or service?
v How to produce: What is the method of production for each product?
How to make use of workers and machines to produce the goods?
v For whom the produce: Who can enjoy the outputs? This is the
problem of distribution.

v In the command economy, these economic decisions are made by the

government (centralized).
v 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.
v In reality, there is a mix of two.
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v With limited resources, when we choose to satisfy certain wants, at the
same time, we have to give up the opportunity to satisfy other wants.

v Opportunity cost arises. There are always trade-offs by giving up

something.
v “There is no such thing as free lunch” (Milton Friedman)
v Definition: The opportunity cost of an action is the value (benefit) of the
next-best alternative that must be given up in order to undertake that
action. (The benefit from the highest-valued option forgone.)

v A few key points:

v 1. Opportunity cost measures the benefits given up from certain
option(s) being given up. (but which option?)
v 2. We assume that given the fixed time/resources, we have a list of things
that we can do, but we can only do ONE of them.
v 3. We simply choose the first one, and if you do not do the first one, you
just do the next-best one. This is why only the next-best one matters. 6
Example

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

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v The core idea of economics:

v Unlimited Wants + Limited Resources

v Problem of scarcity

v Have to make choices

v Opportunity cost arises

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

v PPF shows the combination of goods and services that can just be
produced with the existing resources and technology.
v Any points above the PPF are not feasible.

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

v In order to produce more bikes with a fixed amount of resources and
technology, we have to reduce the production of smartphones.
v To produce more bikes, we have to give up producing some
smartphones.
v To produce more smartphones, we have to give up producing some
bikes.

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v Downward sloping
v 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.
v 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.

v Concave to origin (bending away from the origin)

v When more of one good is produced, the resulting reduction in the
other good will generally become larger and larger.
v Increasing opportunity cost.
v 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.

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v PPF can illustrate the following three important concepts
corresponding to the core ideas

v Scarcity: We cannot attain production points outside the PPF

due to insufficient resources given the technology.

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

v Opportunity cost: have to give up producing an amount of one

good in order to produce more of another good.

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

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

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

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

v The Cost-Benefit principle:

v People make decisions to maximize economic surplus.
v 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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v How many cups of coffee you are willing to buy from the café a day?

v 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.
v Now, the price of a cup of coffee is $14.
v How many cups of coffee do you want to buy?

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

v 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.
v Now, the price of a cup of coffee is $14.
v How many cups of coffee do you want to buy?

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

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

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

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

v Then should you go to the dinner?

v Benefit = $440.
v Economic Surplus = $440 - $455 = -$15 (Benefit < Cost)
v Therefore, you would not attend the dinner. 22
v If you have dinner with your best friends this coming Sunday afternoon:
v Enjoy the benefit with an equivalent monetary value of $440.
v Pay $200 for the dinner.
v Pay a transportation cost of $30.
v Not able to work 3 hours for a part-time job in selling masks, with a
wage of $75 per hour.

v Further questions for thought:

v How would your decision changes if the wage is $60 for the part-time job?

v Now, with the risk of getting a deadly infectious disease, how does it affect
the benefit, cost and surplus of having a dinner with your best friends?

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v Mistake 1: Failure to include implicit costs

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

v 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?)

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

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

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

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v Mistake 3: Failure to ignore sunk costs.

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

v 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.

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v You bought a house at the cost of $1.1 million in the beginning of
2019.
v The current (Sept 2020) price of the house is $1 million.
v You expect (100% sure) that the price of the house will be $1.15
million at the end of 2021.

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

v A. Must sell now because the price now is below the buying price.
v B. Must not sell now because the price now is below the buying
price.
v C. Must not sell now since you can sell it at a higher price at the
end of 2021.
v D. Sell now if you can use the $1m proceed to get more than
$1.15m at the end of 2021.
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v You bought a house at the cost of $1.1 million in the beginning of 2019.
v The current (Sept 2020) price of the house is $1 million.
v You expect (100% sure) that the price of the house will be $1.15 million at
the end of 2021.

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

v Notice that the sunk cost of $1.1 million (or the loss of $0.1 million for
selling the house now) is irrelevant to your decision making.
v Instead, you should consider the future opportunities.
v If you sell the house now, you have given up the chance to sell the house
at the end of 2021.
v If you sell now, you can get $1m now. If the usage of this $1m is worth
more than $1.15m at the end of 2021, you should sell it now. Otherwise,
you may wait till the end of 2021.
v For example, if you can get more than $1.15 million at the end of 2021
from investing the $1 million now (say buying stocks, or invest in a
project), then you should sell the house now. 28
v The way of thinking in terms of cost-benefit analysis can be
applied to a wide range of issues in real life.

v Use the insights from economics to help make sense of

observations from everyday life.

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

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