Understand the Basics of Economic Theory

Understand the Basics of Economic Theory

In this lesson, you’re expected to learn:
– the role of assumptions and how to think like an economist
– Mankiw’s Ten Principles of Economics
– the concept of utility

Think like an Economist

“The rest of my life begins now. What happened in the past is irrelevant.”

The economic way of thinking involves thinking analytically and objectively.

Economics trains you to:
• Think in terms of alternatives.
• Evaluate the cost of individual and social choices.
• Examine and understand how certain events and issues are related.

The Role of Assumptions

• Economists make assumptions in order to make the world easier to understand.
• The art in scientific thinking is deciding which assumptions to make.
• Economists use different assumptions to answer different questions.

1) Rationality

They build complex models on the assumption that humans are fundamentally rational in their behavior. People will choose strategically rather than randomly.

In our world of scarcity, evaluating alternatives is all about valuing the opportunity costs. Rationality says that you should always choose the option with the highest net payoff; to knowingly choose anything worse would be irrational.

The presumption of rationality helps us with the prediction and description of behavior.

2) Marginal Analysis

Economists tend to look carefully at sequences of small changes made on the margin, because most of the choices we make in life are not all-or-nothing decisions; most of them involve marginal trade-offs.

A little more of one thing inevitably means a little less of another.

3) Optimization

This means figuring out the best attainable allocation of resources given a set of constraints.

The optimal solution is to find the balance between two resources (for example, food and shelter) that will make the marginal value of each of them equal.

4) Time Frame

In economics, another assumption is that an economy behaves differently depending on the length of time it has to react to certain stimuli.

• Short Run: a period during which only some factors or variables can be changed.
• Long Run: a period of time in which all factors of production and costs are variable.

It does not refer to a specific duration of time but rather is unique to the firm, industry or economic variable being studied.

5) Ceteris Paribus

In economics, the assumption of ceteris paribus, a Latin phrase that means “all other things being unchanged or constant”, is important in determining causation.

It is used to rule out the possibility of ‘other’ factors changing, i.e. the specific causal relation between two variables is focused.

Thinking like an economist means being aware of the incentives you face and, perhaps more importantly, the incentives those around you face.

It means anticipating what’s strategically rational for them, and how that will affect your options. It means focusing on the margin, on trade-offs, and on adjustments to find the optimal balance.

[Optional] Do you think like an economist?
Mankiw’s Ten Principles of Economics

Below are the ten principles of economics according to Harvard professor, Gregory Mankiw:

1) People face tradeoffs.
2) The cost of something is what you give up to get it.
3) Rational people think at the margin.
4) People respond to incentives.
5) Trade can make everyone better off.
6) Markets are usually a good way to organize economic activity.
7) Governments can sometimes improve market outcomes.
8) A country’s standard of living depends on its ability to produce goods and services.
9) Prices rise when the government prints too much money.
10) Society faces a short-run tradeoff between inflation and unemployment.

1) People face tradeoffs

Making decisions requires trading off one thing against another.

2) The cost of something is what you give up to get it

Making a decision requires comparing the costs and benefits of alternative courses of action.

The cost of one option is not how much it will cost in dollar terms, but rather the value of your next best alternative.

3) Rational people think at the margin

People make decisions by comparing the marginal benefit with the marginal cost.

For example, you might buy a cup of coffee in the morning because it helps you start the day, but you probably won’t buy a second cup because this gives you no added benefit (and costs another $3).

The cost-benefit principle says that you should take an action if, and only if, the extra benefit from taking the action is greater than the extra cost.
4) People respond to incentives

Since people make decisions by comparing costs and benefits, their behaviour may change accordingly.

5) Trade can make everyone better off

Trade allows people to specialize in what they do best. By trading, each person can then buy a variety of goods or services at a lower price.

6) Markets are usually a good way to organize economic activity

Individuals and firms that operate in a market economy respond to prices and thereby act as if guided by an “invisible hand” which leads the market to allocate resources efficiently.

7) Governments can sometimes improve market outcomes

Sometimes a market may fail to allocate resources efficiently, and government regulation can be used to improve the outcome.

Market failures can occur due to the existence of public goods, monopolies and externalities.

8) A country’s standard of living depends on its ability to produce goods and services

A country whose workers produce a large number of goods and services per unit of time will enjoy a high standard of living.

9) Prices rise when the government prints too much money

Printing money causes inflation. When a government prints money, the quantity of money increases and each unit of money therefore becomes less valuable. As a result, more money is required to buy goods and services.

10) Society faces a short-run tradeoff between inflation and unemployment

Reducing inflation often causes a temporary rise in unemployment. This tradeoff is the key to understanding the short-run effects of changes in taxes, government spending and monetary policy.

[Optional] Principles of Economics by Gregory Mankiw

Utility is the power of a commodity to satisfy human wants. It is the satisfaction, actual or expected, derived from the consumption of a commodity.

Obviously no two persons assign identical utilities to a given good – thus, there is no standard unit in which utility can be measured. (Economists use Utils to measure utility)

Utility is an idea that people get a certain level of satisfaction or happiness from consuming goods and services.

Marginal Utility is the benefit from consuming an additional unit of a good.

Law of Diminishing Marginal Utility

This law states that as we consume more and more units of a commodity, the utility derived from each successive unit goes on decreasing.

The law of diminishing marginal utility is comprehensively explained by economist Alfred Marshall. According to his definition of the law of diminishing marginal utility, the following happens:

“During the course of consumption, as more and more units of a commodity are used, every successive unit gives utility with a diminishing rate, provided other things remaining the same; although, the total utility increases.”

Let’s use an example to better understand Marshall’s theory.

Assume that a person consumes 6 apples one after another. The first apple gives him 20 utils (units for measuring utility). When he consumes the second and third apple, the marginal utility of each additional apple will be less. This is because with an increase in the consumption of apples, his desire to consume more apples falls.

The total utility obtained from the first apple is 20 utils, which keeps on increasing until we reach the saturation point* at the 5th apple. Meanwhile, marginal utility diminishes with every additional apple consumed. When we consume the 6th apple, we have gone over the limit. Hence, the marginal utility is negative and the total utility falls (disutility).

The schedule below explains that with each additional unit consumed the marginal utility increases at a diminishing rate. After the saturation point though, the utility starts to fall.

[Optional] Diminishing Marginal Utility
Watch this 4-minute video to learn more.
Link to the video: https://www.youtube.com/watch?v=d0AouX33WMk



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