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Chapter 1. Economics: the Study of Opportunity Cost. Definition of Economics. According to Guell : Economics : the study of the allocation and use of scarce resources to satisfy unlimited human wants Opportunity Cost The forgone alternative of the choice made Or

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chapter 1

Chapter 1

Economics: the Study of Opportunity Cost

definition of economics
Definition of Economics

According to Guell:

  • Economics: the study of the allocation and use of scarce resources to satisfy unlimited human wants
  • Opportunity Cost
    • The forgone alternative of the choice made


    • What you would have done had you not done what you did.
opportunity costs
Opportunity Costs
  • Point of both of these is that if you want to get more of one thing you typically have to give up something of another

We see these things all the time:

  • In order to buy food I need to give up money
  • In order to get money I have to give up some free time and work more
  • If I want to eat more potato chips I have to spend less on bananas
  • I spend time in school today to make money in the future

The opportunity cost can be different over time

When you study you give up time when you could be doing something else.

The opportunity cost of your time probably is different:

On a Monday Evening

On a Saturday Night

During the Super Bowl

On thanksgiving

On the day you get married

production possibilities frontier
Production Possibilities Frontier
  • We are going to start with a simple model to learn how economists formalize these things
  • This is called a production possibilities frontier
  • Just a fancy way of describing the the way in which we are limited in what we can get
production possibilities frontier1
Production Possibilities Frontier

Imagine you are in charge of a small tribe on an island.

You have 2 workers and you want to allocate them between two different tasks: Hunting or Fishing

You know how good the workers are at each skill:


How do you assign them?

There are 4 different possibilities that would lead to the following outcomes:

fish and deer
Fish and Deer




now suppose we add a few more people
Now suppose we add a Few More People

This gives us quite a few more options

with a lot of people
With a Lot of People

Now it is going to look something like this:

We are going to end up somewhere

on the red line

Attainable (and efficient)

Not Attainable


Attainable (but not efficient)


what will i choose
What will I Choose?

I know that I will be somewhere on the red line

But where?

It depends how much I like venison as opposed to seafood

There is a tradeoff between fish and deer:

The more deer I get the fewer fish I can get

Economics is fundamentally about making these kinds of tradeoffs

increasing opportunity costs
Increasing Opportunity Costs

When things are bowed out like this there are increasing opportunity costs

Suppose the PPF looks like what is on the next slide

Think about the opportunity cost of a Deer when

  • I have no Deer
  • I already have 4 Deer

Increasing Opportunity Cost

If I already have 4 Deer,

the opportunity cost of another is

5 fish


If I have no Deer, the

opportunity cost of a deer is

1 fish


homogeneous workers
Homogeneous Workers

Now suppose all workers are the same

ppf with workers same
PPF with Workers Same

Here the opportunity cost is constant

The opportunity cost of 2 more deer is

20 fish regardless of how many deer I already have



budget constraint
Budget constraint

This is also very similar to another really important concept: the budget constraint

  • Suppose you have $100 to spend on Deer and Fish
  • The price of a fish is $1.00
  • The price of a deer is $10.00
  • This will look exactly the same
the big picture
The Big Picture

Circular Flow Model: A model that shows the interactions of all economic actors

  • Markets are where the interactions take place (rectangles)
  • Actors are the entities interacting (ovals)
markets in a circular flow diagram
Markets in a Circular Flow Diagram
  • Market: Any mechanism by which buyers and sellers negotiate an exchange
  • Factor Market: A mechanism by which buyers and sellers of labor and financial capital negotiate an exchange.
  • Goods and Services Market: A mechanism by which buyers and sellers of goods and services negotiate an exchange.
  • Foreign Exchange Market:A mechanism by which buyers and sellers of the currencies of various countries negotiate an exchange.
actors in a circular flow diagram
Actors in a Circular Flow Diagram
  • Households
  • Firms
  • Government
thinking economically marginal analysis
Thinking Economically: Marginal Analysis
  • Optimization Assumption: an assumption that suggests that the person in question is trying to maximize some objective
  • We usually assume people are maximizing utility or happiness
  • Firms maximize profits
marginal costs and benefits
Marginal Costs and Benefits
  • Marginal Benefit: the increase in the benefit that results from an action
  • Marginal Cost: the increase in the cost that results from an action

Generally we do things until the marginal cost=marginal benefit

  • If the marginal cost of fish I give up is greater than the marginal benefit I get from more deer, then I have too many deer
  • If the marginal cost of fish is less than the marginal benefit then I want more deer
positive and normative analysis
Positive and Normative Analysis
  • Positive Analysis: a form of analysis that seeks to understand the way things are and why they are that way
  • Normative Analysis: a form of analysis that seeks to understand the ways things should be
economic incentives
Economic Incentives
  • Incentive: something that influences the decisions we make


  • Hourly wage influences how many hours you work
  • My grade scale influences how hard you study
  • Price of gas influences how much gas you buy
  • Taxes on pineapples influence how many pineapples you eat
  • Paying teachers based on students test scores influences how they teach
unintended consequences
Unintended Consequences

Thinking about policy the most important thing economics has to offer is that policies often affect incentives and these incentives can have unintended consequences


  • Taxes
  • Teacher Cheating
  • Welfare(and other social programs)
  • Insurance
  • Safety Regulations
correlation and causation
Correlation and Causation

If I was still teaching econometrics I would make a really big deal of this

Often what we learn in economics depends on data and how we think about data is important

Causation just means that one thing causes another


Correlation means that they are related in the data (tend to move together)

Things that are positively correlated:


Wife’s Education/Husband’s education

GDP/Food Consumption

Things that are negatively correlated:

Unemployment/GDP Growth

Family Income/Family Size

Things that are not correlated have no relationship

Temperature here/weight of Vice President

Result of first die/result of second die


Just because two things are correlated does not mean that one causes the other

  • Possibilities:
    • A causes B
    • A causes B and B causes A at the same time
    • Z causes both A and B
  • These are not mutually exclusive
  • This is not a minor problem-it makes empirical work in economics very difficult
  • As we will see in this course theory is not enough-we need to combine models with evidence to really say anything strong about policy