Thinking like an economist

Economics is the study of how people, businesses and governments make choices when resources are scarce. Every day, a student decides whether to spend an evening studying or working a shift, a coffee shop decides how many baristas to schedule, and a government decides whether to spend more on health care or on roads. None of these choices can give everyone everything they want, because time, money, land, workers, machines and raw materials are limited. Economics offers a way of thinking about such choices that is surprisingly powerful. This course covers microeconomics, the study of individual decision makers and markets: households, firms, industries and the prices that connect them. Its companion course, ECON-102, covers macroeconomics: national output, unemployment, inflation, money, interest rates and government budgets. BUS-101 lesson 5 introduced markets and the business cycle from a manager's point of view; here we build the tools economists use to analyze them.

Scarcity and choice

Scarcity means that our wants exceed the resources available to satisfy them. It is not the same as poverty. A billionaire still faces scarcity, because she has only 24 hours in a day and cannot be in two places at once. A rich country still faces scarcity, because land used for a new hospital cannot also be used for housing. Because resources are scarce, every society must answer three basic questions: what goods and services to produce, how to produce them, and for whom. Different economic systems answer these questions in different ways. In a market economy, most of the answers emerge from the decisions of millions of buyers and sellers interacting through prices. In a command economy, a central authority makes most of the decisions. Canada and the United States, like almost all real economies, are mixed economies: markets coordinate most production, but governments provide some goods directly, regulate many markets, redistribute income and set the legal rules within which markets work.

Economists group productive resources into four factors of production. Land includes all natural resources: farmland, forests, minerals, water and the radio spectrum. Labor is the time and effort of people, including their skills, which economists call human capital. Capital is the stock of produced goods used to make other goods, such as machines, buildings, software and trucks; note that in economics capital means physical and intangible productive assets, not money. Entrepreneurship is the initiative to combine the other factors, take risks and innovate. Each factor earns an income: land earns rent, labor earns wages, capital earns interest, and entrepreneurs earn profit.

Opportunity cost

Because choosing one thing means giving up another, every choice has a cost. The opportunity cost of an action is the value of the best alternative forgone. If you spend Saturday afternoon at a hockey game rather than working a four-hour shift at $18 an hour, the opportunity cost includes not only the ticket price but also the $72 in wages you did not earn, or, if you would not have worked, whatever else you would most have liked to do with the time. Opportunity cost is the most important cost concept in economics, and it is often different from the accounting cost recorded on a receipt.

Consider the cost of a university degree. The obvious costs are tuition, books and fees. But room and board are not really a cost of attending, because you would need to eat and live somewhere anyway, unless studying forces you to pay more than you otherwise would. The largest cost for many students is the income they give up by studying rather than working full time. This explains why the opportunity cost of education is higher for people with high-paying alternatives. A professional athlete who could earn millions by turning professional at 19 faces a far larger opportunity cost of attending university than most students do, which is one reason why many such athletes delay or skip university.

Thinking at the margin

Economists stress that most decisions are not all-or-nothing. A business does not decide whether to produce anything at all; it decides whether to produce a little more or a little less. A student does not decide whether to study or never study; she decides whether to study one more hour tonight. The word marginal means additional or incremental. Marginal benefit is the extra benefit from one more unit of an activity, and marginal cost is the extra cost. A rational decision maker continues an activity as long as the marginal benefit exceeds the marginal cost and stops where they are equal.

Marginal thinking resolves puzzles. Why is water, which is essential to life, so cheap, while diamonds, which are not, are so expensive? This is the diamond–water paradox that puzzled Adam Smith. The answer is that prices reflect marginal value, not total value. The total benefit of water is enormous, but water is so plentiful that the benefit of one more liter is tiny. Diamonds are scarce, so the marginal diamond is highly valued. Similarly, an airline that has already scheduled a flight may sell a last-minute seat for far less than the average cost per seat, because the marginal cost of one more passenger on a plane that is flying anyway is only a snack and a little fuel.

A closely related idea is that sunk costs should not affect decisions. A sunk cost is a cost that has already been incurred and cannot be recovered. If you paid $60 for a concert ticket and then feel sick on the night, the $60 is gone whether or not you attend; the decision should depend only on whether going will make you better off than staying home. Firms make the same error when they keep pouring money into a failing project because they have already spent so much, a pattern BUS-130 discussed as escalation of commitment.

# Marginal benefit and marginal cost of hours of study before an exam
# Marks gained from each extra hour fall; the value of the next best use of time rises.
marks_gained = [9, 7, 5, 4, 3, 2, 1]          # extra marks from hour 1, 2, ...
value_per_mark = 6.0                          # $ value a student places on one extra mark
cost_of_hour = [12, 14, 18, 22, 26, 30, 35]   # value of the next best use of each hour, $
best = 0
for h, (m, c) in enumerate(zip(marks_gained, cost_of_hour), start=1):
    mb = m * value_per_mark
    decision = "study" if mb >= c else "stop"
    if decision == "study":
        best = h
    print(f"hour {h}: MB = ${mb:5.1f}  MC = ${c:4.1f}  -> {decision}")
print("best number of hours:", best)

hour 1: MB = $ 54.0  MC = $12.0  -> study
hour 2: MB = $ 42.0  MC = $14.0  -> study
hour 3: MB = $ 30.0  MC = $18.0  -> study
hour 4: MB = $ 24.0  MC = $22.0  -> study
hour 5: MB = $ 18.0  MC = $26.0  -> stop
hour 6: MB = $ 12.0  MC = $30.0  -> stop
hour 7: MB = $  6.0  MC = $35.0  -> stop
best number of hours: 4

The output shows the logic of the margin. The first hour brings marks worth $54 and costs only $12 of forgone alternatives, so it is clearly worth it. By the fourth hour, the extra marks are worth $24 against a cost of $22, still just worth it. The fifth hour brings $18 of benefit at a cost of $26, so the student should stop after four hours. Note that the decision does not depend on the total benefit of studying, only on the comparison at the margin.

People respond to incentives

An incentive is a reward or penalty that motivates behavior. Because people compare marginal benefits and costs, changing those benefits and costs changes behavior. When the price of gasoline rises, people drive less, carpool more and, over time, buy more fuel-efficient vehicles. When a city introduces congestion charges, traffic falls at peak times. When governments subsidize home insulation, more people insulate. Incentives can also have unintended consequences. A famous example is the cobra effect: a colonial government that paid a bounty for dead cobras is said to have found that people began breeding cobras to collect the reward. More practically, a rule that requires vehicles to be more fuel-efficient may lead people to drive more, because each kilometer is now cheaper, offsetting part of the fuel savings. Economists call this the rebound effect.

Economic models and the scientific method

Economists study the world by building models: simplified representations of reality that focus on the features that matter for a particular question. A road map leaves out trees and houses because it is designed to help you navigate; a model of the market for apartments leaves out the color of the walls because it is designed to explain rents. Models rely on assumptions. A common one is ceteris paribus, Latin for other things being equal: when we study how the price of coffee affects the quantity people buy, we hold constant income, the prices of tea and other goods, and tastes. Good models are judged by how well they predict and explain, not by whether every assumption is literally true.

Like other sciences, economics tests its models against data. Economists use statistics from agencies such as Statistics Canada and the US Bureau of Labor Statistics, run laboratory and field experiments, and study natural experiments, situations where a policy change affects some people but not others in a way that mimics random assignment. Correlation is not causation: if neighborhoods with more police have more crime, it is probably because police are sent to high-crime areas, not because police cause crime. Much of modern empirical economics is about finding credible ways to separate cause from correlation.

Positive and normative economics

It helps to distinguish two kinds of statements. Positive statements describe how the world is and can, in principle, be tested with evidence: 'raising the minimum wage to $20 would reduce employment of teenagers by 3 %' is positive, even if it turns out to be wrong. Normative statements describe how the world should be and involve value judgments: 'the government should raise the minimum wage' is normative. Economists often agree on positive questions while disagreeing on normative ones, because they weigh outcomes such as efficiency, fairness and freedom differently. When you read economic commentary, it is useful to ask which parts are claims about facts and which are claims about values.

Graphs in economics

Economists use graphs constantly, so it is worth being comfortable with them. A graph shows the relationship between two variables. When two variables move in the same direction, such as the price of a good and the quantity producers want to sell, the relationship is positive and the line slopes upward. When they move in opposite directions, such as price and the quantity buyers want, the relationship is negative and the line slopes downward. The slope of a straight line is the change in the vertical variable divided by the change in the horizontal variable, the rise over the run.

An important convention: in supply and demand diagrams, economists put price on the vertical axis and quantity on the horizontal axis, even though we usually think of quantity as depending on price. This convention dates back to Alfred Marshall in the 1890s, and it can confuse students who learned in mathematics to put the dependent variable on the vertical axis. Another trap is confusing a movement along a curve with a shift of the whole curve. If the graph shows how quantity demanded depends on price, a change in price moves us along the curve, while a change in anything else that affects demand, such as income, shifts the entire curve. Lesson 3 develops this distinction carefully.

The production possibilities frontier

One of the simplest economic models is the production possibilities frontier (PPF), which shows the combinations of two goods an economy can produce with its available resources and technology. Imagine an economy that produces only health care and housing. If it devotes all its resources to housing, it can build a certain number of homes; if it devotes all to health care, it can provide a certain amount of care; in between are many combinations. The PPF illustrates scarcity (points outside the curve are unattainable), efficiency (points on the curve use resources fully), inefficiency (points inside the curve mean idle or misused resources, such as unemployed workers during a recession) and opportunity cost (moving along the curve means giving up some of one good to get more of the other).

The PPF is usually bowed outward, meaning that the opportunity cost of a good rises as we produce more of it. The reason is that resources are not equally suited to all uses. When the economy first shifts resources from housing to health care, it moves the workers and buildings best suited to health care, say, those with medical training, and gives up relatively little housing. As it continues, it must move construction workers and equipment that are much less useful in hospitals, so each extra unit of health care costs more and more housing. This is called the law of increasing opportunity cost.

The PPF can shift. Economic growth shifts it outward: more workers, more capital, better education or new technology let the economy produce more of both goods. A technology that affects only one good, such as a breakthrough in modular construction, shifts the frontier outward mainly along the housing axis. Natural disasters, wars and the loss of skilled workers can shift it inward. A society that chooses to produce more capital goods today, such as factories and research, rather than consumer goods, sacrifices current consumption but shifts its future PPF further outward. This is one way to see why investment matters for long-run living standards, a theme ECON-102 develops.

Why economists disagree, and why they often agree

The joke that if you laid all economists end to end they would not reach a conclusion is popular, but it overstates disagreement. Surveys of economists, such as the Clark Center's panels at the University of Chicago, find broad agreement on many positive questions: that tariffs usually reduce overall economic welfare, that price controls on rents tend to reduce the quantity and quality of rental housing, and that carbon pricing is a cost-effective way to cut emissions. Disagreement is more common on questions where the evidence is still developing, such as the size of the employment effects of moderate minimum wage increases, and on normative questions about how to weigh efficiency against fairness. Throughout this course, we will try to present the evidence and the main positions fairly and leave the normative judgments to you.