The economy is an abstraction that refers to the sum of all our individual production and consumption activities.

The economy is us, as consumers, as producers, as traders, and as decision makers in a multitude of other activities.

Peter’s Definition◦ Economics is the study of how society allocates

scarce resources to the production, exchange, and consumption of goods.

Book’s Definition◦ Economics is the study of how to allocate scarce

resources among competing uses.

Unsurprisingly, they are very similar. We will discuss the core concepts of these definitions.

Scarcity has two characteristics.◦We have unlimited wants but are limited

by finite resources.

As a result, no one, person or country, can have it all.

If you can’t have it all, then you have to make choices, the core of economics.

Economists build models of these behaviors in order to explain some facet of the economy.

In building an economic model, economists make assumptions about how humans make decisions or choices.

First, people are self interested, meaning each individual defines their own costs and benefits of their decisions.

Choices are made rationally, in that people making a choice, weigh these costs and benefits

Opportunity cost is defined as the next best alternative forgone, or given up, when making a choice.

It is what is given up in order to get something else.

All choices involve an opportunity cost.

When making a choice, people weigh the costs and benefits of that choice. If the benefit of a particular alternative is greater than its opportunity cost (the benefit from the next best alternative) then people will chose it as opposed to the next best one.

If this is better than that then I will chose this and forego that, all else being equal.

The term marginal means incremental, or the next unit of whatever is being discussed.

For example, Marginal Opportunity Cost (marginal cost) is the cost of foregoing one more unit of the next best alternative.

Marginal Benefit is the benefit derived from choosing one more unit of the preferred good.

The more we chose something the additional benefit we derive usually decreases. Think about eating your favorite food. At first, it is really good, but as you eat more and more, the additional benefit decreases.

The same concept applies to marginal opportunity costs, but in the opposite direction. As you forgo more and more of a good, the benefit you forgo, i.e., the marginal opportunity cost, rises.

Suppose we want to measure how much pizza we want to eat, but as we eat more pizza we have to give up chicken wings.

As we eat more pizza, the marginal benefit of eating pizza declines. The first slice is better than the second, which is better than the third, and so on.

The fewer chicken wings we eat (the more we forgo) the benefit of chicken wings rises. This is supposedly the opportunity cost of eating pizza in this example

Costs &

Benefits Marginal Cost

Marginal Benefit

Eating Pizza

We measure the marginal benefits and marginal costs of eating pizza as the vertical height of the respective curves.

The amount of pizza we eat increases as we move to the right. Consequently, the less chicken wings we eat.

The marginal benefit of eating pizza declines. The marginal benefit curve slopes downward.

The marginal cost of eating pizza (the benefit of the chicken wings we forgo) is increasing. The marginal cost curve slopes upward.

Should we eat the ith unit of pizza?

Marginal

Benefit ith unit

Marginal Cost

Marginal Benefit

Eating Pizza

Marginal

Cost ith unit

ith unit

Marginal Profit is the difference between Marginal Cost and Marginal Benefit.

Since the Marginal Benefit of the ith unit is greater than its cost, therefore we would profit from eating the ith unit of pizza.

Maximizing profit is the goal of the economic decision maker.

Maximal profit is the ideal point for an economic decision maker. We will continue to eat more pizza as long as we profit from it. That is, as long as marginal benefit is greater or equal to marginal cost, we will give up chicken wings for more pizza.

Total Profit is the summation of all marginal profit. The total profit from eating pizza is the profit from the first slice, plus the profit from the second slice, plus the profit from the third slice, and so on. over an area.

Total profit is the area between marginal benefit and the marginal cost curves, where marginal benefit is at least as high as the marginal cost curve.

Optimal

Amount

Marginal Benefit = Marginal Cost

Marginal Cost

Marginal Benefit

Eating Pizza

Where the two curves cross, they have the same height, or marginal benefit equals marginal costs.

At this point we have captured all possible profit, measured as the purple triangle. In essence, we have maximized profit.

Marginal profit at this point is equal to zero. We have traded off chicken wings for more pizza up to this point. It is now no longer profitable to forgo chicken wings in favor of pizza. We have eaten the optimal amount of pizza.

Most economic models make the assumption of rational decision making as described above.

This means, economic theories are based on self interested optimal decision making.

People’s behavior is assumed not to be random or arbitrary, but follows this pattern.

This gives economic models their explanatory power in describing economic phenomena.

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Economics is broadly defined as the study of the resources of

The two characteristics of Scarcity are wants and

resources. This forces us to

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To study human behavior, economists construct an

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A) The Money spent on the purchase

B) All other goods you could have purchased with that money

C) Your first alternative choice in spending the money

D) The interest the money would have received had it remained in the bank

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Marginal Opportunity Cost is the cost of forgoing alternative.

unit of the next best one

Marginal Profit is the difference between and

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When making an economic choice, the best possible choice occurs where marginal benefit

marginal cost.

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When studying economic decisions, an

subject.

economist will always assume on behalf of the

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