Question

The fundamental principles on individual decision making are that 1) people face trade-offs among alternative goals, and 2) that the cost of any action is measured in terms of forgone opportunities, 3) that rational people make decisions by comparing marginal costs and marginal benefits and 4) that people change their behavior in response to the incentives they face. Talk about each one of these concepts and make sure to support your analysis with examples.

Answer 1

1. People face trade-offs

• “There is no such thing as a free lunch ” To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading one goal for another.
• Examples include how students spend their time, how a family decides to spend its income, how the government spends revenue, and how regulations may protect the environment at a cost to firm owners.
• A special example of a trade-off is the trade-off between efficiency and equality.
  • Definition of efficiency: the property of society getting the maximum benefits from its scarce resources.
  • Definition of equality: the property of distributing economic prosperity fairly among the members of society.
  • For example, tax paid by wealthy people and then distributed to poor may improve equality but lower the incentive for hard work and therefore reduce the level of output produced by our resources.
  • This implies that the cost of this increased equality is a reduction in the efficient use of our resources.
• Another Example is “guns and butter”: The more we spend on national defense(guns) to protect our borders, the less we can spend on consumer goods (butter) to raise our standard of living at home.
• Recognizing that trade-offs exist does not indicate what decisions should or will be made.

2. Significance of opportunity cost in decision making

• Because people face tradeoffs, making decisions requires comparing the costs and benefits of alternative courses of action.
• The cost of
  • …going to college for a year is not just the tuition, books, and fees, but also the foregone wages.
  • …seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater
• This is called opportunity cost of resource
• Definition of opportunity cost: whatever must be given up in order to obtain some item. or last best alternative forgone
• When making any decision, decision makers should consider the opportunity costs of each possible.

3. Rational people think at the margin

• Economists generally assume that people are rational.
  • Definition of rational: systematically and purposefully doing the best you can to achieve your objectives.
  • Consumers want to purchase the bundle of goods and services that allow them the greatest level of satisfaction given their incomes and the prices they face.
  • Firms want to produce the level of output that maximizes the profits.
• Many decisions in life involve incremental decisions: Should I remain in school this semester? Should I take another course this semester? Should I study an additional hour for tomorrow’s exam?
• Rational people often make decisions by comparing marginal benefits and marginal costs.
• If the additional satisfaction obtained by an addition in the units of a commodity is equal to the price a consumer is willing to pay for that commodity, he achieves maximum satisfaction, which is the main goal of every rational consumer.
  • Example: Suppose that flying a 200-seat plane across the country costs the airline $1,000,000, which means that the average cost of each seat is $5000. Suppose that the plane is minutes away from departure and a passenger is willing to pay $3000 for a seat. Should the airline sell the seat for $3000? In this case, the marginal cost of an additional passenger is very small.
  • Another example: Why is water so cheap while diamonds are expensive? Because water is plentiful, the marginal benefit of an additional cup is small. Because diamonds are rare, the marginal benefit of an extra diamond is high.

4. People respond to incentives

• Incentive is something that induces a person to act [by offering rewards to people who change their behavior].
• Because rational people make decisions by comparing costs and benefits, they respond to incentives.
• Incentives may possess a negative or a positive intention. It may be in a positive or a negative way.

For example,by offering a raise in the salary of whosoever works harder can induce people to work hard which is a positive incentive. Whereas putting a tax on a good,say fuel, can induce people to consume it less which is a negative incentive.