Why Economics Matters

Farid Abolhassani M.D.

بسم الله الرحمن الرحيمبسم الله الرحمن الرحيم

Economics: Definition

The study of how individuals and societies

choose to

Allocate scarce productive resources among

competing alternative uses and

Distribute the products from these uses

among the members of a society

Resources

Time and abilities of individuals

Land and natural resources

Capital

Knowledge of production processes

MoneyMoney is not defined by economists as a resource in itself

Scarcity

Scarcity means that:

There are not, and can never

be, enough resources to satisfy

all human wants and needs

The Cost-benefit Approach To Decisions

The major challenge of daily living:Should I do activity x ?

Economists’ answer to this question:Economists’ answer to this question:If B(x) > C(x) Then

Do x

OtherwiseDo not do x

End if

B(B(xx) and C() and C(xx) could always be expressed in ) could always be expressed in monetary termsmonetary terms

Reservation Price: Definition

The minimum amount of money one asks to give up something

Or

The minimum amount of money one is ready to pay to benefit from something

The Role of Economic Theory

Many economists believe that:

Useful insights into our behavior can be

gained by assuming that we act as if

governed by the rules of rational decision

making.

Common Pitfalls in Decision Making

Ignoring implicit costs

Failing to ignore sunk costs

Focusing on only some of the relevant costs

Common Pitfalls in Decision Making

Ignoring implicit costsIgnoring implicit costs

Failing to ignore sunk costsFailing to ignore sunk costs

Focusing on only some of the relevant costsFocusing on only some of the relevant costs

Cost of Activity x

Cost of activity x =

Direct costs + Opportunity cost

Opportunity Cost

The highest valued highest valued alternative

sacrificed in order to choose an option

is called the opportunity (realreal) cost

of that option

The Benefit of Activity x

Benefit of a pleasant activity =

Direct Benefit + Reservation Price

Benefit of an unpleasant activity =

Direct Benefit – Reservation Price

Common Pitfalls in Decision Making

Ignoring implicit costsIgnoring implicit costs

Failing to ignore sunk costsFailing to ignore sunk costs

Focusing on only some of the relevant costsFocusing on only some of the relevant costs

Sunk Cost: Definition

Costs that are beyond

recovery at the moment

a decision is made

Marginal Analysis

1 2 3 40

2000

1000

Number

Tomans / Number

Marginal benefit of pizza

Marginal cost of pizza

- 500

Common Pitfalls in Decision Making

Ignoring implicit costsIgnoring implicit costs

Failing to ignore sunk costsFailing to ignore sunk costs

Focusing on only some of the relevant costsFocusing on only some of the relevant costs

Buick or Toyota

0 4000 8000

100

300

500

Cb

Ct

Cb = 100 + 0.05d

Ct = 300 + 0.025d

distance

Cost

The Invisible Hand

Wholly unaware of the effects of their

actions, self-interested consumers often

act as if driven by what Adam SmithAdam Smith

called an invisible hand to produce the

greatest social good.

Economic Analysis

Evaluating and choosing among

alternative courses of action

through examining both the

costs and consequences of the

alternatives.

Efficiency

Get the mostmost

from

scarcescarce resources

Elements of Efficiency

Do not waste resources

Technical efficiencyTechnical efficiency

Produce each output at least cost

Cost-effectiveness efficiencyCost-effectiveness efficiency

Produce the type and amounts of output which

people value most

Allocative efficiencyAllocative efficiency

Allocative EfficiencyAllocative Efficiency

Social DesirabilitySocial Desirability

They Are Not the Same

Marginal Conditions for Allocative Efficiency

Marginal cost:Marginal cost: The additional cost incurred in producing

the last unit of an output

Marginal benefit:Marginal benefit: The additional benefit obtained by

consuming the last unit of an output

Marginal Benefit = Opportunity cost of resources used

up to create the last unit of output

Allocative Efficiency: Role of Market

Perfect market

Marginal Social Cost = Marginal Social Benefit

Market Failure

The Last Remaining Points

Positive questions and normative

questions

Microeconomics and macroeconomics