Basic economic concepts

Why do we write this blog? As Jocelyn mentioned in her latest post one reason is to break down the barriers between academic economics and everyone who might be interested in economics but scared away because of the jargon and the maths. But at the same time, we are rational, self-interested economist students (little economics joke) so we couldn't possibly do something just for the public's benefit. This post (and probably some of my future posts, too) will demonstrate how we can do both at the same time.

Let me explain. Just like everyone else, I am thinking (panicking) about what to do after third year and one route I am looking at is a research economist role at the Institute for Fiscal studies. They are an applied microeconomics (yes, please no more macroeconomics) institute that does economic research with a policy focus. The place sounds like an absolute dream to me so I want to do well in the applications. In the process, they will test our understanding of basic economic principles. So, today I will revisit some of these "basic" principles (this is the self-interest part). At the same time, I think it could be useful to explain some of the jargon and work through some of the basic theory economists use to explain the world. So, let's start.

Courtesy of Freeeconhelp.com I will discuss some of what they identify as the fundamental principles of economics.

Rationality
The economist's best friend is the rational agent. But who is she*? The idea of rationality is based on preferences. Preferences must be complete and transitive (hello jargon!) to be rational. Completeness means that if I look at all the fruit at Lidl I have a preference over which fruit I prefer to the other, e.g. apples are better than oranges, and oranges are better than bananas, and so on. Completeness just means that I have an opinion on all of this. This could also mean that I am indifferent between apples and pears, for example, it just means that given the choice between an apple and a pear I'm happy to have either. Transitivity means that my choices are logical. For example, if I like apples better than oranges, and oranges are better than bananas, then that implies that I also like apples better than bananas. If both of these things hold then my preferences are considered rational. This concept can then be applied to larger scales, from what type of food I buy, to how I behave in day to day life. One thing that is absolutely crucial to understand is that the rational agent is just a theory. There are many, many cases where people don't behave perfectly rational and yes economists do know this. However, there are different degrees to which economists are willing to digress from this theory. Assuming people are rational agents enables economists to scale up this behavior and then make predictions about how people will behave. But what are these predictions worth if people don't even behave this way? But if we can't make any predicitons it makes it harder to say which programs governments should spend their money on or how high taxes on certain goods should be. The rational agent is definitely a balancing act. The main takeaway should be that economists have an "ideal" model of how people behave (the rational agent) which simplifies their analysis but that this model is flawed and these flaws should be taken into account when making predictions.

Costs and Opportunity Costs
This is actually a fun one. We all know normal costs, the price tag on that Lidl banana or the concert tickets we've been waiting to buy forever. These costs are pretty straight forward and are called "monetary" (because of money) costs. But economists also look at different types of costs - opportunity costs. The opportunity cost is the cost of the options forgone. For example, if I skip work to go to a concert, not only do I have to pay for the concert tickets, there is also the indirect cost of my forgone wages (assuming I am paid by the hour). Or, if I go on a night out with my friends instead of studying, I incur the costs of the drinks but there is also the cost of the lost studying time (although this is harder to measure - this could be measured in lost marks?). That's the basic concept of opportunity cost. A quick side note on costs here: There are many costs that are neither direct monetary costs nor can they straight-up opportunity costs. The most prominent example of this are environmental costs. What is the cost of building a parking lot on a green space? This doesn't have a straight price tag. Environmental valuation tries to approximate these costs by looking at the benefits and happiness people derived from going to the park or the benefit of the air quality provided from the green space. This is a good example where economic theory falls short and it's important to think beyond economic models to have a wholesome assessment of the situation.

Marginal Analysis
This plays a very important role in economics. Economists usually analyze things at the margin. What does that mean? The straight forward answer is that it's the next possible unit. So marginal utility (read: happiness) would mean how much happier I'd be from eating one more brownie. Marginal cost would be how much more it costs a firm to produce one more unit. For costs, the marginal costs could be quite low. For example, if you start a pencil-making business, in the beginning, you have to spend quite a bit of money to buy machines and rent a place (assume you're the only worker there) for example. But once all the equipment is bought it doesn't cost you anything to produce the next pencil. So the marginal cost from producing the fifth pencil after the first four is basically zero. This simplification again can help economists make inferences over people's behavior.



*Footnote: Yes, my rational agent is a she. But whenever I have read about the rational agent it was pretty much always a he. Why? Because the majority (pretty much all) of economists who came up with these theories were men, so all their examples are men. Recently, people have called attention to the fact that most examples in economics textbooks are men and that maybe we should change that. The result? My math econ lecturer priding himself on being politically incorrect because he used a male name in his example. Congrats K. you absolutely do not get the point.

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