The Economic Problem

The economic problem is the problem of how to make a choice in a world of scarcity.

Choices and tradeoffs

Consider the following example:

In general, the higher the degree, the higher the salaries.

How Individuals Make Choices Based on Their Budget Constraint

• Budget constraint - all possible consumption combinations of goods that someone can afford, given the prices of goods, when all income is spent; the boundary of the opportunity set.
• Opportunity set - all possible combinations of consumption that someone can afford given the prices of goods and the individual’s income (all income does not need to be spent).
• Given the price of the two goods and a budget amount, a budget constraint can be illustrated graphically.
• With a limited amount of income to spend on things, consumers must choose what they need and want.

The Budget Constraint: Alphonso’s Consumption Choice

• Each point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to Alphonso’s budget of $20.
• The slope of the budget constraint is determined by the relative price of burgers and bus tickets.
• Giving up one burger means gaining four bus tickets.
• The opportunity set - every point on (or inside) the constraint which shows a combination of burgers and bus tickets that Alphonso can afford.
• Any point outside the constraint is not affordable, because it would cost more money than Alphonso has in his budget.

The Budget Constraint

The idea: expenditure cannot exceed the budget \[p_x x + p_y y \leq W\quad \Rightarrow\quad y = \frac{W}{p_x}-\frac{p_x}{p_y}x\]

The Concept of Opportunity Cost

• Opportunity cost indicates what people must give up to obtain what they desire.
  • The cost of one item is the lost opportunity to do or consume something else.
  • The opportunity cost is the value of the next best alternative.
  • A fundamental principle of economics is that every choice has an opportunity cost.
• For Alphonso, the opportunity cost of a burger is the four bus tickets he would have to give up.

Identifying Opportunity Cost

• The price as measured in dollars may not accurately capture the true opportunity cost, such as when costs of time are involved.
  • Example: Attending college
    • The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses.
    • Additionally, during the hours you are attending class and studying, it is impossible to work at a paying job.
    • So, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.

Opportunity Cost Examples

• What are the opportunity costs of…
  • Buying vs. leasing a car
  • Investing in different ways (i.e., savings accounts, certificates of deposit, mutual funds, stocks, etc.)
  • Going out to eat vs. preparing food at home
  • Walking or taking public transportation

Marginal Decision-Making and Diminishing Marginal Utility

• Marginal analysis - examining the benefits and costs of choosing a little more or a little less of a good.

• Utility - satisfaction, usefulness, or value one obtains from consuming goods and services.

• Law of diminishing marginal utility - as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines.

  • Example - the first slice of pizza eaten brings more satisfaction than the sixth.

Sunk Costs

• Sunk costs - costs that were incurred in the past and cannot be recovered.

• For people and firms alike, dealing with sunk costs can be frustrating.

  • Example - A firm finds it hard to give up on a new product that is doing poorly because much money was spent in creating and launching the product.

• The lesson of sunk costs is to ignore the past errors and make decisions based on what will happen in the future.

Confronting Objections to the Economic Approach

Objections in understanding the economic approach to decision-making:

1. People, firms, and society do not act in a way that fits the economic way of thinking.
   • However, it is reasonable, as a first approximation, to analyze them with the tools of economic analysis.
   • Will be addressed in a later chapter on consumer choices.

Confronting Objections to the Economic Approach

2. People, firms, and society should not act this way.
   • The economics approach:
     • Portrays people as self-interested, but economics is not a form of moral instruction.
     • Seeks to describe economic behavior as it actually exists.
     • Uses, positive statements, which describe the world as it is. These are factual.
     • Tries to avoid normative statements, which describe how the world should be. These statements are subjective questions of opinion.

Confronting Objections to the Economic Approach

• Invisible hand - concept that individuals’ self-interested behavior can lead to positive social outcomes

  • Identified in Adam Smith’s The Wealth of Nations.

• Consumers will encourage businesses to offer goods and services that meet their needs.

• It is possible that broader social good can emerge from selfish individual actions.

• Self-interest in economics does not imply self-interest in all aspects of life.

Reference

Shapiro, D.; MacDonald, D.; Greenlaw, S. A. (2022). Principles of Economics 3^e. OpenStax.

Chapter 2