Week 1: Basic principles of economics and markets
Chapter 1: Thinking like an Economist
Economics: Studying in a World of Scarcity
Economics is the study of how people make choices under conditions of scarcity, and the
effects of those choices on society. In other words, the study looks at how people manage
their limited and insufficient resources (scarcity) in order to achieve their goals.
Although people have boundless needs and wants, all resources are limited. This
phenomenon is referred to as the scarcity principle (or the ‘no-free-lunch’ principle).
Consequently, this means that having more of one good results in having less of another
good. People are confronted with a trade-off. That is why the scarcity principle is also called
the ‘no-free-lunch’ principle, meaning that a lunch is never actually free, as someone always
pays for it.
The cost-benefit principle states that one should only take action when the benefits are at
least as high as the costs of the activity (the higher the benefits, the better off you are). If the
costs are higher than the benefits, one does not take action. The major difficulty is to come up
with accurate measures for the costs and benefits, since they can be intangible.
Applying the cost-benefit principle,
The study of economics assumes rationality of individuals. A rational person is a person
who acts in line with the cost-benefit principle. To illustrate the concept, let's take the
example of a book you must buy for university. You found it in the city center for 25 euros,
but the exact same book is on the internet for 35 euros (free home-delivery). The city center
is a 30-minute walk away, so the question is, where should you buy the book? The
Cost-Benefit Principle states that the book should be bought from the city center if the
benefit of buying it is exactly or exceeds 10 euros. Thus, as a rational person, you must decide
if you value the time you will lose at 10 euros.
Economic surplus
An economic surplus occurs when the difference between benefits and costs is positive. In
other words, the benefits outweigh the costs. Your goal is to choose the action that maximizes
the economic surplus. This means taking all actions that yield a positive total economic
surplus, which is just another way of restating the Cost-Benefit Principle.
Example:
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑠𝑢𝑟𝑝𝑙𝑢𝑠 𝑜𝑓 𝑡𝑎𝑘𝑖𝑛𝑔 𝑎𝑛 𝑎𝑐𝑡𝑖𝑜𝑛 = 𝑏𝑒𝑛𝑒𝑓𝑖𝑡 − 𝑐𝑜𝑠𝑡
Opportunity cost
The opportunity cost of an activity is equal to the value of the next best (so not every!)
,alternative or opportunity that must be foregone for your chosen opportunity. It is the value
of the activity you sacrifice for another one. The options are mutually exclusive due to limited
resources, this means that one can only select a single option.
Example:
Four Decision Pitfalls
When applying the principles that were just discussed, several pitfalls can occur:
● Pitfall 1: The mistake to measure costs and benefits as proportions rather than as
absolute money amounts. For instance, many people would agree that saving 10 euros
on a computer game is more valuable than saving the same amount on a laptop. This
faulty reasoning can lead to problems with the cost-benefit analysis or measurement
of the opportunity costs of an activity.
● Pitfall 2: The mistake to ignore opportunity costs. People sometimes overlook the
implicit value of activities that fail to happen. However, the value of foregone
opportunities (= opportunity costs) must be included in the cost-benefit analysis as
costs. If they are ignored, the difference between benefits and costs is misstated.
● Pitfall 3: The failure to ignore sunk costs. Sunk costs are costs that are beyond
recovery at the moment of the decision (for example, you have already paid them).
Since those costs occur anyway, they are not relevant for the cost-benefit analysis any
more and should be ignored. One only needs to include those costs that we can avoid
by taking the chosen action.
● Pitfall 4: The failure to understand the average-marginal distinction. Generally,
‘marginal’ always refers to one additional unit, whereas the ‘average’ deals with
the entirety. Thus, the marginal benefit means the increase in benefit when one more
unit is added. Accordingly, the marginal cost refers to the increase in cost when one
additional unit is carried out. Note that cost-benefit analyses should always be based
on marginal benefits and costs.
Example A:
, Example B (Production capacity):
The ‘not-all-costs-and-benefits-matter-equally’ principle encompasses the aforementioned
pitfalls and states that some costs and benefits matter in decisions (e.g. opportunity costs and
marginal costs / benefits), whereas others do not (e.g. sunk costs and average costs /
benefits).
Micro and Macroeconomics
It is important to be familiar with the terminology of economics when dealing with the field.
Economics can be distinguished into micro and macroeconomics. Microeconomics is the
study of individual choices under scarcity and its implications for the behaviour of prices and
quantities in individual markets. Macroeconomics is the study of the performance of
national economies and the policies that governments use to try to improve that
performance. Hence, it includes broader economic issues compared to microeconomics, like
understanding the unemployment rate. Economic naturalism refers to applying
knowledge about economics in daily life.
Finally, one has to pay attention to the difference between positive and normative
statements. Positive statements are economic conclusions that are independent of the
economist’s ethical value system. In contrast, normative statements reflect the underlying
values of the economists. This can happen explicitly or unconsciously.
Appendix A (Algebra)
This appendix A elaborates on two ways of deriving equations.
Deriving an equation of a straight line from its graph
The basic equation for a straight line is γ = α * 𝑥 + 𝑏, whereas α is the slope and 𝑏 is the
y-intercept (where the line crosses the vertical axis). The slope is an indication of how steep
or flat the line is.
Deriving an equation of a straight line from given points
, If two points P (𝑋𝑃 | 𝑌𝑃) and Q (𝑋𝑄 | 𝑌𝑄) are given and the equation of a straight line is to be
calculated, a different approach has to be used. Namely, in order to calculate the slope, the
following formula is used:
Example:
Appendix B (Calculus)
Differentiation is useful in economics; for example, when the slope of a curve at a certain
value is wanted. Generally, differentiation is conducted with respect to x, which is why the
𝑑𝑌
first derivative of y(x) is either expressed as y’(x) or 𝑑𝑋.
3 2
For appendix B the basic equation is 𝑦 = 𝑎 * 𝑥 + 𝑏 * 𝑥 + 𝑐 * 𝑥 + 𝑑.
In order to find the first derivative, the coefficient of each x (here: a, b, c, d) needs to be
3, 2, 1, 0
multiplied by the power of x (here: ), respectively. After that, each exponent has to be
2
reduced by 1. Thus, the equation of the first derivative is 𝑦' = 3𝑎 * 𝑥 + 2𝑏 * 𝑥 + 𝑐.
2 0 −1
Note that this equals 𝑦' = 3𝑎 * 𝑥 + 2𝑏 * 𝑥 + 1 * 𝑐 * 𝑎 .
Examples:
The product chain rule
Sometimes, you will need to calculate the product of two functions 𝑦 = 𝑓(𝑥) and 𝑦 = 𝑔(𝑥).
This type of calculation requires using the product chain rule:
