Economics is the study of choice under scarcity. Typically consumers want more goods and services than they can afford to buy. Similarly, businesses face constraints in relation to the funds and resources they have access to. Governments and countries also face the same type of problem: a government might want to tackle a large number of social problems but only have limited resources to draw on. Economics is about understanding how a party (that is, a consumer, a business, a country and so on) deals with the fact that when they use their resources to pursue one option, they cannot use those resources to do something else. And so, a consumer may have to choose between a new pair of shoes or a textbook, a firm may have to choose between developing a new product or launching a marketing campaign, and a government may have to choose between improving education or targeting crime.
To help understand these issues, economics has developed a set of analytical tools. This book provides an introduction to these tools. They can be used to help understand economic problems wherever they arise, be it businesses understanding the markets they compete in, or governments trying to develop social policy, or families trying to manage their households. These tools are not meant to capture everything that is occurring in any given situation. Rather, they are designed to simplify (or to model) complicated and potentially messy real-world issues into a tractable form that can provide valuable insights.
Given that resources are limited, the key questions that an economy needs to ‘decide’ are: (a) what to produce; (b) how to produce it; and (c) who should get what is made. In modern economies, the answers to these questions are largely determined by the market – that is, through the interaction of sellers and buyers.1
Sometimes, however, the government also helps determine the
answer to these questions by regulating or intervening in the market. Consequently, our focus in this microeconomics text will be on the behaviour of individuals (consumers, firms, and governments) and their interaction in markets.
This chapter provides a few key concepts that underpin the analysis in the rest of the book, as well as economic analysis in general.
1.2 Scarcity and opportunity cost
As noted above, it is usually the case that resources are limited, so that not all wants can be met. We call this situation scarcity.
Scarcity also means that individuals, businesses and societies face trade-offs; by choosing one thing, a person must give up or miss out on something else. For example, if a consumer uses their money to buy product X
, they cannot then use that same money to buy another product.2
We use the concept of opportunity cost to capture this trade-off; the opportunity cost
of any choice is the value of the next best forgone alternative. In the example above, if the consumer buys product X
, and the next best thing they could have done is buy product Y
, the opportunity cost of buying X
is forgoing Y
Individuals also face opportunity costs in terms of their time – that is, if a person spends his time doing one thing, he cannot also spend that time doing something else.
Example. Suppose Elizabeth prefers to spend her Saturday afternoon walking. The next best thing that she could have done is to sleep, and her third best choice is to go swimming. Therefore, if Elizabeth goes for a walk, the opportunity cost of going for a walk is not sleeping, as this is her best foregone opportunity. The option of swimming is not relevant here because it is not the next best opportunity.
Opportunity costs include both explicit costs and implicit costs. Explicit costs are costs that involve direct payment (or, in other words, would be considered as costs by an accountant). Implicit costs are opportunities that are forgone that do not involve an explicit cost.3
Example. Suppose Stephen decides to go to university, and his next best option is to work at a construction site and earn $80k over the year. The explicit costs are those that Stephen must directly pay to go to university, such as student fees, the cost of textbooks, and so on. The implicit costs are the opportunities that Stephen must forgo – in this case that is working at the construction site and earning $80K.
It is important to note that opportunity cost only includes costs that could change if a different decision were made. Opportunity cost does not include sunk (or unrecoverable) costs. Sunk costs
are costs that have been incurred and cannot be recovered no matter what. For example, if Katrien spends the weekend reading an accounting textbook, no matter what she does (such as whether or not she decides to continue
studying accounting), she cannot get that time back. Similarly, if a business spent $100K on an advertising campaign last year, regardless of what they decide to do this year, that money (and effort) cannot be recovered.
1.3 Marginal analysis
Typically, we assume that economic agents are rational and act to maximize the benefit they receive from any economic transactions.4
For example, consumers seek to maximize their benefits from consumption and firms seek to maximize their profits from production. One way that economic agents can solve this maximization problem is by considering the additional benefit or additional cost of any action. This sort of analysis is referred to as marginal analysis
and it is a recurring theme both in this book and economics generally.
For instance, consider a consumer faced with the decision of whether to buy one more unit of a particular good. That consumer might consider the extra benefit he derives from buying that extra unit; this is referred to as the marginal benefit of that extra unit of the good. The consumer will also consider the additional cost of buying one more unit; this is referred to as the marginal cost of purchasing another unit, which is typically the price of the good. In making their final decision, the consumer will weigh the marginal benefit against the marginal cost of buying that extra unit. For example, if a consumer is considering buying another cup of coffee, and the marginal benefit is $5 and the marginal cost is $3, the consumer will be better off buying the extra coffee.
Each of the marginal terms noted above, and many others, will be discussed at length throughout the book. What is crucial to note is that the term ‘marginal’ simply means additional or extra. That is, we are interested in what happens if we increase something (such as the number of coffees bought) by a small amount.
1.4 Ceteris paribus
The notion of ceteris paribus is also an important foundation of economic analysis. As noted, because the real world is complicated and messy, it is necessary to simplify real-world situations into tractable economic models, in order to better analyse them. Thus, in order to determine the impact of a particular event, economists tend to examine the impact of one change at a time, holding everything else constant. This is called ceteris paribus, which roughly means ‘other things equal’.
For instance, suppose we are interested in how a change in price will affect the quantity demanded of a good. In reality, demand for a good can be affected by a number of other factors, such as changes in the tastes or income of consumers, or the availability or price of substitute goods. Therefore, in order to isolate the effect of price upon quantity demanded, we need to hold everything else constant. This is not to deny that in the real world multiple changes can occur at a time – they often do. Rather, to fully understand the relationship between price and demand, it is essential to isolate that
relationship from other events that might also be occurring. For example, a firm might be interested in the effect of advertising on demand for its product. To understand the impact of advertising, it is crucial to remove other factors that could affect demand, otherwise advertising could be attributed too much (or too little) influence, whi...