Code EM_M3L1: Lesson 1 of Ten (10) Economic Principles

Analyze How People Make Decisions

Principle 1: People Face Trade-Offs.

You have likely heard the old saying, “There is no such thing as a free lunch.” There is much to this
old adage and it’s one we often forget when making decisions. To get more of something we like we
almost always have to give up something else we like. In life, in whatever form, there will always be
trade-offs.
Scarcity Leads to Tradeoffs and Choice. When scarce resources are used, individuals are forced to
make choices that have an opportunity cost. The concept of trade-offs due to scarcity is formalized by
the concept of opportunity cost. The opportunity cost of a choice is the value of the best alternative
forgone. In layman’s term: it is the cost of losing an opportunity to earn better or be better-off (de
Jesus, 2001). In other words, if you can only produce bottles of soda and water, the opportunity cost of
producing a bottle of water is the value of producing a bottle of soda. Similarly, there is an opportunity
cost in everything: the opportunity cost of you reading this is what you could be doing with your time
instead (say, watching a movie). When scarce resources are used (and just about everything is a scarce
resource), people and firms are forced to make choices that have an opportunity cost. Economics is all
about scarcity and it is not at all unusual. Everyone around us, rich or poor, is faced with the same
economic problem - resources are scarce relative to unlimited wants and needs. What does this imply?
Man cannot have everything. Not all of man's needs can be satisfied. There is shortage of goods. This is
the concept of scarcity. This has given birth to the study of Economics.

Principle 2: The Cost of Something Is What You Give Up to Get It.

Because of trade-offs, people face decisions between the costs and benefits of one course of
action and the costs and benefits of another course. Individuals face opportunity costs when they
choose one course of action over another. Everyday endeavors entail opportunity cost! The tardiness of
attending classes will cost one to miss lectures, for instance. One has to critically analyze choices that
will have the least sacrifice and the greatest benefit.

Principle 3: Rational People Think at the Margin.

For the sake of simplicity, economists normally assume that people are rational. While this causes
many problems, there is an undercurrent of truth to the fact that people systematically and purposefully
“do the best they can to achieve their objectives, given opportunities.” There are two parts to
rationality. The first is that your understanding of the world is correct. Second you maximize the use of
your resources toward your goals. “Economics is the painful elaboration of the obvious” – Anonymous.
This quote might seem quite relevant in whatever we do because if we decide to proceed to the chosen
course of action, it simply means that the benefits outweigh the costs. While sometimes economics can
seem obvious, it is important to first understand how a rational consumer should behave before seeing
how we fail to meet that standard. For example, if you have decided to go clubbing, how many drinks do
you buy? This is a decision where we use marginal analysis. Marginal analysis is the process of breaking
down a decision into a series of ‘yes or no’ decisions. More formally, it is an examination of the
additional benefits of an activity compared to the additional costs incurred by that same activity. To
make a decision using marginal analysis (even with the simple situation of going to the club), we need to
know the willingness to pay for each level of the activity. As mentioned, this is also known as the
marginal benefit from an action.
Principle 4: People Respond to Incentives.
Incentives induce people to act. If you use a rational approach to decision making that involves
trade-offs and comparing costs and benefits, you respond to incentives. Charlie Munger once said:
“Never, ever, think about something else when you should be thinking about the power of incentives.”
People respond predictably to positive and negative incentives:
• Both positive and negative incentives affect people’s choices and behavior.
• Changes in incentives cause people to change their behavior in predictable ways.
• Incentives can be monetary or non-monetary.
• Acting as consumers, producers, workers, savers, investors, and citizens, people respond to incentives
in order to allocate their scarce resources in ways that provide the highest possible returns to them.
Incentives are the rewards or punishments that shape people’s choices.
• Incentives can be either monetary or non-monetary.
• When opportunity costs change, incentives change, and people’s choices and behavior change.
• Changes in incentives cause people to change their behavior in predictable ways. (Principles of
Microeconomics: Marginal Analysis https://pressbooks.bccampus.ca/uvicecon103/chapter/1-3-
marginal-analysis/)
(Source: Condensed from the notes of Dr. Matt Macalaguing, 2020)