Key Economic Concepts

1. Opportunity Cost

• Economic cost of a decision or action =

direct cost + opportunity cost

• Opportunity cost = what else would you have done if you did not take that action or make that decision?

Opportunity Cost of being in this classroom

Example: LIUC Degree

With degree• - € 6,000• - € 6,000• - € 6,000• € 25,000• € 27,000• € 28,000• € 30,000• € 32,000

Without degree• € 15,000• € 16,000• € 17,000• € 18,000• € 19,000• € 20,000• € 21,000• € 22,000

Direct cost Opportunity cost

€ 18,000 € 48,000

Economic Cost = € 66,000 !

Economic Cost of LIUC Degree(with discounting)

Direct Cost: 6000 + 6000/(1.05) + 6000/(1.05)2 = € 17,156

Opportunity Cost: 15,000 + 16,000/1.05 + 17,000/(1.05)2 = € 45,658

Economic Cost: € 62,814

Economic Decision- Making

• A decision or action is worth pursuing if: economic benefit from it > economic cost (direct cost + opportunity cost) of undertaking it.

Whether to Pursue LIUC Degree

With WithoutYear Degree Degree Discount Rate 5%

1 (6,000) 15,000 2 (6,000) 16,000 3 (6,000) 17,000 4 25,000 18,000 5 27,000 19,000 6 29,000 20,000 7 31,000 21,000 8 33,000 22,000 9 35,000 23,000

10 37,000 24,000

NPV 136,666€ 147,478€

10 year analysis

Whether to Pursue LIUC DegreeWith Without

Year Degree Degree Discount Rate 5%1 (6,000) 15,000 2 (6,000) 16,000 3 (6,000) 17,000 4 25,000 18,000 5 27,000 19,000 6 29,000 20,000 7 31,000 21,000 8 33,000 22,000 9 35,000 23,000

10 37,000 24,000 11 39,000 25,000 12 41,000 26,000 13 43,000 27,000 14 45,000 28,000 15 47,000 29,000 16 49,000 30,000 17 51,000 31,000 18 53,000 32,000 19 55,000 33,000 20 57,000 34,000

NPV 360,408€ 285,422€

20 year analysis

2. Incentives

• Economic agents respond to incentives

Penalties Rewards

Example: Incentives to reduce pollution

• Gasoline tax

• Emissions limits

• Driving regulations

• Fuel mileage standards

• Investment tax credit

• Tax exemptions

• Tradable permits

• Funding for researchand development

Example: Incentives to improve worker efficiency

• Pay for performance

• Promotions/demotions

• Benefits

• Equity in the firm

Example: Incentives to improve firm efficiency

• In market economies: Firm efficiency firm profits stock price managers’ salaries

• In regulated markets:Price = cost of production insufficient incentives for efficiency.

Solutions: (1) Regulatory oversight, private/public partnership(2) Price-caps(3) Industry standards

3. Marginal Analysis

• Economic decisions are made at the margin, by comparing:

The additionalvalue from thedecision

The additionalcost of thedecision

Employment• P = price of good

• MPL = marginal product of labor = additional output (in units) from an

additional worker/day

• WL = wage (in $) of additional worker/day

• Then, firm should hire an additional worker if:(MPL * P) > WLMarginal product of labor (in $) > wage

Example: How many workers do you hire?

Number of Workers

Number of Skateboards

Produced

1 12

2 21

3 29

4 36

5 42

Price/skateboard = $30

Wage/worker/day = $200

MPL 12

9

8

7

6

MPL * P $360

$270

$240

$210

$180

Production

• Let P = price

• Q = quantity

• C(Q) = cost of producing Q

• R(Q) = revenue from Q = P*Q

• Then, a firm should produce an additional unit if:

Marginal revenue MR(Q) > marginal cost MC(Q)

Example: Do you produce an additional kilo of pastries?

Cost: C(Q) = 500 + 10QWhere:500 = fixed cost10Q = variable costQ measured in kilosC(Q) measured in $

Market price: P = $20/kilo

MC(1 Kilo of pastries) = $10

MR(1 Kilo of pastries) = $20

Answer: Yes

Consumption

• U(x) = utility from consuming x units

• P = price of good

• Then a consumer should consume an additional unit x if:

Marginal utility MU(x) > price

Example: Do you eat another slice of pizza?

Price = $2/sliceMarginal utility (slice) = ?

Eat additional slice if:MU (add. slice) > $2

Economists Tyler Cowen and Alex Taborrok video clip on Incentives.

http://mruniversity.com/courses/principles-economics-microeconomics?utm_source=Email&utm_medium=MRUannouncement&utm_campaign=MRUNewsletter