Boundless EconomicsPrinciples of Economics
Individual Decision Making
Scarcity Leads to Tradeoffs and ChoiceWhen scarce resources are used, actors are forced to make choices that have anopportunity cost.
Learning ObjectivesGive examples of economic trade-offs.
Key TakeawaysKey PointsScarce resources diminish as they are used and almost all resources are scarce.In order to use a scarce resource, you are inherently using the resource for onepurpose and not an alternative.The cost of using a resource is called the opportunity cost: the value of the nextbest alternative that you could be using the resource for instead.
Key TermsScarce: Insufficient to meet demand.Opportunity cost: The value of the best alternative forgone.
A fundamental concept in economics is that of scarcity. In contrast to itscolloquial usage, scarcity in economics connotes not that something is nearlyimpossible to find, but simply that it is not unlimited. For example, the number ofavailable hours in a day is a scarce resource: there is a finite amount of time
available to you to do work, hang out with friends, and relax. Most resources arescarce in most situations.
Since resources tend to be scarce, anyone that uses the resource has to make adecision about how to use it. Suppose, for example, that you are a drinkmanufacturer. To produce a beverage, you have to use some scarce resources: theplastic for the bottle, the workers' time, a machine to fill the bottles, etc. If youchoose to make one bottle of water, you have chosen to not make a bottle ofsoda. Your scarce resources force you to make a choice and a trade-off producingone product or another.
Tradeoffs: Since resources are scarce for a drinkmanufacturer, it must make a tradeoff betweenproducing bottles of water and bottles of soda.
Like producers, consumers also have to make choices. Often, consumers mustchoose between current consumption ("I want to buy an ice cream") and futureconsumption ("I should rather save my money so I can buy an ice creamtomorrow"). Since consumers' resources such as time, attention, and money are
limited, they must choose how to best allocate them by making tradeoffs.
The concept of trade-offs due to scarcity is formalized by the concept ofopportunity cost. The opportunity cost of a choice is the value of the bestalternative forgone. In other words, if you can only produce bottles of soda andwater, the opportunity cost of producing a bottle of water is the value ofproducing a bottle of soda. Similarly, there is an opportunity cost in everything:the opportunity cost of you reading this is what you could be doing with yourtime instead (say, watching a movie). When scarce resources are used (and justabout everything is a scarce resource), people and firms are forced to makechoices that have an opportunity cost.
Individuals Face Opportunity CostsIndividuals face opportunity costs when they choose one course of action overanother.
Learning ObjectivesDistinguish between explicit costs and opportunity costs
Key TakeawaysKey PointsThe opportunity cost is the value of the next best alternative foregone.Every decision necessarily means giving up other options, which all have a value.The opportunity cost is the value one could have derived from using the sameresources another way, though this is not always easily quantifiable.
Key TermsOpportunity Costs: The value of the best alternative forgone, in a situation inwhich a choice needs to be made between several mutually exclusive alternativesgiven limited resources.
When individuals make decisions, they are necessarily deciding between takingone course of action over another. In doing so, they are choosing both what todo and, by extension, what not to do. The value of the next best choice forgone iscalled the opportunity cost. In other words, the opportunity cost of a course ofaction is the value the of the option that the individual chose not to take.
Individuals face opportunity costs in both economic and non-economic decisions.One of the easiest way to imagine an individual's opportunity costs is to imaginea student who decides to study. By choosing to study, the student is implicitlychoosing to not go to a party, hang out with friends, or catch up on some much-needed sleep. In this example, the opportunity cost is not easily expressed indollars and cents, but is just as real.
Opportunity Cost: By choosing to go to spend time and money on thingslike classes and computers, you are necessarily choosing not to spend it onsomething else, like going on vacation. This is an opportunity cost.
Rational individuals will try to minimize their opportunity costs. By doing so,individuals are maximizing the amount that they can get out of their resources(time, money, effort, etc.). This makes sense: individuals should seek to get themost and give up the least.
As economic actors, individuals face opportunity costs as well. For example,suppose you decide to purchase a new computer. You could have chosen tospend your money on books or rent or a spring break trip; whichever one ofthose options is most valuable to you (beside purchasing a new computer) is theopportunity cost.
Such logic applies for every economic decision: purchasing one good means thatan individual has chosen to spend resources one way instead of another.Opportunity costs are an important consideration for economists and businesspeople, but are faced by individuals even when they are not making classicallyeconomic decisions.
Individuals Make Decisions at the MarginsIndividuals will choose the option that yields the greatest net marginal benefit.
Learning ObjectivesApply the concepts of marginal analysis and utility to decision-making
Key TakeawaysKey PointsThe marginal cost or benefit is the amount that a decision will change the totalcost or benefit from where it is currently.Individuals will make choice that maximizes the net marginal benefit (marginalbenefit – marginal cost).While total or average cost and benefit are important, provided enoughresources, individuals will look only at the net marginal benefit.
Key Termsmarginal benefit: The additional benefit from taking a course of action.marginal cost: The additional cost from taking a course of action.
When individuals make decisions, they do so by looking at the additional costand benefit of the decision. The cost or benefit of the single decision is called themarginal cost or the marginal benefit. This is different from the total or average:net marginal benefit (marginal benefit minus marginal cost) is the amount thattotal benefit will change due to the single decision. For example, if the cost ofmaking 9 pieces of pizza is $90 and the cost of making 10 pieces is $110, themarginal cost of producing the tenth piece of pizza is $20. In theory, individualswill only choose an option if marginal benefit exceeds marginal cost.
Marginal and Total Utility: Marginal utility is the amount that a certain action willchange total utility. Individuals use net marginal utility to make decisions.Let's take an example. Suppose you are buying a car and have three choices:
Car A, which costs $10,000Car B, which costs $12,000Car C, which costs $15,000
The prices represent the marginal costs of each car; purchasing the car will addthe cost of the car to your total costs. Also suppose Car A provides you $15,000worth of utility, Car B provides $15,000, and Car C provides $25,000. Thoseutilities, in dollar terms, are the marginal benefit of each car.
In order to make the decision, you look at the marginal cost and marginal benefitof each car. By subtracting the cost from the benefit, Car A offers $5,000 ofmarginal benefit, Car B offers $3,000, and Car C offers $10,000. Obviously, Car C isthe best choice because, at the margins, it offers the most benefit to you.
Note that you are concerned not with your total or average cost and benefit(assuming no resource or other external restrictions), but with the marginal costand benefit. As a decision maker, you want to know how much the decision willchange your current state, so you look at the margins, not the overall picture.That is not to say that things like the total cost are unimportant, but that,assuming there are enough resources, individuals will look at the marginalchange each option will provide to his/her life or to the firm and chose the onewith the greatest net marginal benefit.
Marginal Benefits and Costs for PollutionThe tools of marginal analysis can illustrate the marginal costs and the marginalbenefits of reducing pollution. When the quantity of environmental protection islow (quantityQ a
) and pollution is extensive, there are cheap and easy ways to reduce pollution,and the marginal benefits of doing so are quite high. At
, it makes sense to allocate more resources to fight pollution.
However, as environmental protection increases, the cheap and easy ways ofreducing pollution decrease, and pollution can only be reduced with costlymethods. In other words, the largest marginal benefits are achieved first, followedby decreasing marginal benefits. As the quantity of environmental protectionincreases to
, the gap between marginal benefits and marginal costs decreases. At point
the marginal costs will exceed the marginal benefits. At this level ofenvironmental protection, society is not allocating resources efficiently, becausetoo many resources are being given up to reduce pollution.
Q a
Q b
Q c
,
Marginal Costs and Marginal Benefits of EnvironmentalProtection: Reducing pollution is costly—resources must besacrificed. The marginal costs of reducing pollution are generallyincreasing, because the least expensive and easiest reductions canbe made first, leaving the more expensive methods for later. Themarginal benefits of reducing pollution are generally declining,because the steps that provide the greatest benefit can be takenfirst, and steps that provide less benefit can wait until later.Individuals Respond to IncentivesIncentives are ways to encourage or discourage certain behaviors or choices.
Learning ObjectivesPredict how pay incentives will influence a person's work performance
Key TakeawaysKey PointsPrice is one of the main incentives studied in economics. Price incentivizesproducers to supply a certain amount, and consumers to purchase a certainamount.Economics is mainly concerned with studying remunerative incentives (those thatconcern material reward).Individuals, firms, and governments all change incentives in hopes ofencouraging desired outcomes.
Key Termsincentive: Something that motivates an individual to perform an action.Incentive Structure: The cumulative set of promised rewards and/orpunishments that encourage actors to make a set of decisions.
An incentive is something that motivates an individual to perform an action. Thestudy of incentive structures is central to the study of all economic activities (both
in terms of individual decision-making and in terms of cooperation andcompetition within a larger institutional structure).
Perhaps the most notable incentive in economics is price. Price acts as a signal tosuppliers to produce and to consumers to buy. For example, a sale is nothingmore than a store providing an incentive to potential customers to buy. Thelowering of the price makes the purchase a better idea for some customers; thesale seeks to persuade individuals to change their actions (namely, to buy theproduct).
Sales are Incentives: Sales are incentives forconsumers to buy, because firms know consumers
generally respond to lower prices by purchasingmore.Similarly, the increase in price acts as an incentive to suppliers to produce moreof a good. If suppliers think they can sell their products for more, they will beinclined to produce more. The price acts, therefore, as an incentive to customersto buy and suppliers to produce.
Types of IncentivesIncentives come in many other forms, however. Broadly, most incentives can begrouped into one of four categories:
Remunerative incentives: The incentive comes in the form of some sort ofmaterial reward – especially money – in exchange for acting in a particular way.Wages, prices, and bribery are all examples of remunerative incentives. This is thetype of incentive that is typically associated with economics.Moral incentives: This occurs when a certain choice is widely regarded as theright thing to do, or as particularly admirable, or where the failure to act in acertain way is condemned as indecent. Societies and cultures are two mainsources of moral incentives.Coercive incentives: The incentive is a promise of some sort of punishment if thewrong decision is made. For example, the promise of imprisonment is a coerciveincentive for people to not steal.Natural Incentives: Things such as curiosity, mental or physical exercise,admiration, fear, anger, pain, joy, the pursuit of truth, and a sense of control ofpeople or oneself can cause individuals to make certain decisions.
Economics is mainly concerned with remunerative incentives, though whendiscussing government regulations, coercive incentives often come into play. Bymanipulating incentives, individuals (as well as businesses and governments)hope to encourage some behaviors and discourage others.
Incentives and Performance
Companies leverage incentives-based strategies to drive performance andoptimize employee decision-making and behaviors through meaningful rewardsystems. While there are both advantages and drawbacks to this type ofapproach, remunerative (financial) incentives are highly attractive options foremployers in a variety of industries and businesses. Providing incentives such asvariable income, where an individual can obtain more personal rewards forsuccessfully creating a product or making a sale, often drives up production forhighly motivated employees.
An example of this would be a manufacturing facility making widgets. The floormanager shifts the wage system from an hourly wage perspective to a straightpiece rate system. The more widgets a worker creates, the higher his or herprospective income will be. Under this incentive system less productive workersmay stay the same, but highly productive workers will respond by increasing theirproduction.
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