Overview
This lecture covers key economic decision-making principles, focusing on marginal analysis, sunk costs, incentives, and the law of unintended consequences.
The Buy or Not Decision
- Buy an item if your willingness to pay is at least as large as the explicit (monetary) cost.
- Willingness to pay includes both the item's value to you and the implicit cost (value of the next best alternative).
The "How Many" Decision & Marginal Analysis
- The decision of how many units to buy depends on comparing marginal benefit (added benefit from one more unit) to marginal cost (added cost of one more unit).
- Marginal benefit is the change in total benefit from an extra unit; marginal cost is the change in total cost.
- Rule: Keep doing activity as long as marginal benefit is at least as large as marginal cost.
- Net benefit is total benefit minus total cost; maximizing net benefit is optimal.
Buying Multiple Units Example
- Two people may value two cups of coffee equally in total, but buy different amounts if their marginal benefits differ.
- The "how many" decision is uncertain without knowing marginal willingness to pay for each unit.
Pitfall: Decreasing Marginal Cost (Quantity Discounts)
- When discounts apply after a threshold, blindly applying the marginal rule may lead to suboptimal choices.
- Always check total net benefit when marginal costs decrease due to discounts.
Sunk Costs & Decision-Making
- Sunk costs are costs already incurred and unrecoverable; they should not affect future decisions.
- The sunk cost fallacy is considering these costs when deciding to continue or stop an activity.
Incentives & Unintended Consequences
- People respond to incentives: increasing benefits or decreasing costs increases activity, and vice versa.
- Consider both explicit (monetary) and implicit (non-monetary/opportunity) costs.
- Law of unintended consequences: policies may have effects contrary to their intentions due to changes in behavior.
Review of Economic Models
- Economics studies how agents allocate scarce resources; microeconomics focuses on individual/firm markets, macroeconomics on the whole economy.
- Economic models use the principle: keep doing something as long as marginal benefit equals marginal cost.
Key Terms & Definitions
- Explicit cost — the monetary payment required for a good or service.
- Implicit cost — the value of the next best alternative foregone.
- Marginal benefit — the additional benefit from one more unit of activity.
- Marginal cost — the additional cost from one more unit of activity.
- Sunk cost — a past cost that cannot be recovered and should not influence current decisions.
- Net benefit — total benefit minus total cost.
- Law of unintended consequences — unexpected outcomes caused by policy or incentive changes.
Action Items / Next Steps
- Review marginal analysis examples, especially with quantity discounts.
- Practice distinguishing sunk costs from relevant future costs.
- Remember: for most economic questions, the answer is "marginal benefit equals marginal cost."