Three Key Economic Ideas: Study with Video Lessons, Practice Problems & Examples

In economics, individuals and firms are assumed to be rational, striving to maximize their outcomes with available resources. They respond to economic incentives, exploiting opportunities to improve their situations, such as choosing cheaper alternatives when prices rise. Decision-making often involves marginal analysis, where the key principle is that marginal benefit equals marginal cost. This concept helps determine optimal consumption levels, illustrated through examples like pizza consumption, where satisfaction and costs vary with each additional unit consumed.

People Are Rational

So let's go ahead and define some key ideas or what we can think of as assumptions for this course. The first one here is that people are rational. In this class, when we define rational, we're thinking individuals and firms are attempting to do their best. Right? They're trying to do their best with what they have. And our best, it's not always perfect, but we do the best with what we have. So the idea here is, like, we're not intentionally trying to make ourselves worse off. Right? We're not intentionally self-destructive, we'll say. Not intentionally self-destructive. Alright? That's the idea of being rational here. So when you take an exam, right, you're going to go into the exam, you're going to study for the exam, you're going to use CLUTCH, and, you know, if there's something on the exam that you don't know, you're going to do your best guess. Right? You're going to try your best to get it right. You're not just going to go in there and just start bubbling at random and see what happens. Right? Then why would you even be in the course? And another example, how about a factory? A manager of a factory. Right? He's going to he doesn't have unlimited money. He doesn't he's not going to be wasting resources. Right? He's not going to be just throwing stuff away. He's going to be trying to maximize his output and minimizing his inputs. Right? You know, minimizing inputs or minimizing waste. All these things just to do his best.

Economic Incentives

Next, we have the idea that people respond to economic incentives. Right? So incentives. It's people taking advantage of opportunities to make themselves better off. So a lot of times in these classes, they use the word exploit. Right? They exploit opportunities to make themselves better off. I saw this really funny example. It was about getting an oil change in New York City. So in NYC, parking for the day when you go, you know, downtown to go to your job, you could be spending for an all-day parking upwards of $40, $50. I don't know. Someone from New York could probably tell us better, but parking in New York is no joke. So what people started doing was realizing that they could go to a mechanic and just get an oil change, and the oil change ran them let's say $25, $30 and they ended up being able to leave their car at the mechanic all day. So people started just going to the mechanic and getting an oil change, and it's cheaper literally than just parking for the day. It's crazy. And another example, something very simple. What about apples? You know, when the prices of apples go up, people stop buying apples. They start buying oranges or they buy something else. Right? They're going to exploit opportunities to make themselves better off. Oh, apples are going to be more expensive. The price goes up. Well, I'll take my business elsewhere. The quantity of apples, it's going to go down there. People aren't going to be buying apples anymore. They're going to buy something else. So they're going to take advantage of that opportunity.

Marginal Analysis

So let's move on to the last key economic idea here. To make the best decisions, we use marginal analysis. So that sounds like a kind of a funky term, but in economics, marginal just means extra or additional. Right? Like the idea of one more. Right? What is one more? How is it going to change our current situation? Like what happens if we produce 1 more unit? What happens if I eat one more slice of pizza, things like that. So I hope you notice this big green box because I was trying to catch your eye with it. And inside, we've got a key formula that we're going to use throughout the entire class. I'm going to introduce you to it now. It's the idea that marginal benefit equals marginal cost. Okay. We're going to define those terms in a second, but I just wanted to point out how important this is for the class. It's going to help us in all sorts of calculations and it's going to be a key point on a lot of graphs. We're going to use it when we're defining allocative efficiency. Right now I'll have an example for you with optimum consumption, like how much we should consume, right, the optimum amount consume, or finding the profit maximizing point in different business structures. How do we make the most profit? All of these are related to the marginal benefit equaling the marginal cost, and I promise it's going to come up quite a bit in this course. So let's define those terms. And even before we get to the graph here and you're like woah woah woah woah woah woah woah woah woah woah Brian, I haven't seen a graph since high school, man. I don't know what you're about to do, but it's scaring me. I feel your pain and we're going to have a graphing review at the end of this section. That's going to kind of be a refresher for you. It's not going to go so deep, but it is going to help you have the tools ready to do really well in this course. So when we get to the graph, I'm going to use blue for our marginal benefit, and let's go ahead and define marginal benefit right now. When we think of marginal benefit, it's remember marginal is additional. Right? So it's kind of like the additional satisfaction that we get from something. It's really hard, you know, it's a subjective kind of thing, it's pretty qualitative. It's not so easy to just define how much happiness, you know, does going to the movies bring me. Oh, it brings me 10 happiness. Right? It's not so easy. But in this class, you know, they they kinda quantify it in that sense, and, most of the time, it's just going to be given to you. You can't really be expected to know how to define these benefits in number terms. Right? So we're going to kinda call marginal benefit here. We'll say it's the additional satisfaction. Right? Additional satisfaction that you're getting from one more of something. Right? And in our example, we're going to be talking about pizza. So So it's the additional satisfaction from eating one more slice of pizza. Right, and for cost we're going to be using red. And I guess I'll take this moment to point out that in this class we are going to be using a lot of colors especially when it comes to graphs, and I really suggest that you do the same thing. Even on the exams, I would suggest bringing a couple of different color pens. It just makes it so much easier, to keep your work separate and just keep track of everything. I really suggest using at least 2 colors, maybe even 3 when you're when you're taking this class. So we're going to use red for marginal cost and this is basically well, it's the additional cost. Right? I'm using cost again, but it doesn't have to be a monetary cost. Right? It could be a cost, an emotional cost, a psychological cost, could even be like a time cost, right? The time you spend doing something is part of the cost. So I'm just going to put additional cost here. It's a little easier to understand than marginal benefit. And let's go ahead and dive into the graph. Okay. I'm not going to use so many numbers here. We're just going to gonna use the graph as a tool. So let's start with our marginal benefit, and let's think about eating slices of pepperoni pizza. Right. The goal here is to find out what is the optimum amount of pizza that I should eat. So, you know, it's almost lunchtime here and man that first slice of pizza is sounding really good right now. I'm pretty hungry, and I think that if I were to eat a slice of pizza right now, probably bring me quite a bit of happiness. I'm just going to put it way up here. No numbers, right? We're just saying that there's a lot of happiness with that first slice of pizza. And the second slice, yeah, you know, still sounds delicious, still sounds cheesy, and oh, yeah. That sounds good, but that first bite that I got from that first slice of pizza, I'm not getting it back again, right? I'm still eating delicious pizza but that first slice was extra delicious. So it's still bringing me quite a bit of happiness but not as much as that first slice. The third slice, I'm still hungry, still feeling pretty good. I'm going to eat another slice of pizza and I'm still going to feel pretty good about it. By that fourth slice, well, now I'm getting full. But, I was still hungry so, you know, still bringing me happiness so it seems okay. How about once I get to that fifth slice of pizza? Now, you know, I'm starting to, like, question myself. I don't know if I should be eating this much pizza at once, but, you know, if I did it anyway, I'd probably still get some benefit from it. Maybe, you know, even if it's like, I'm not going to starve today, right, or tomorrow I guess if I eat 5 slices of pizza. And by the sixth pizza, you know, I'm I'm not getting much happiness out of it at all. It's just a lot of pizza at this point. So now let's talk about the marginal delicious, we're just going to talk about like emotional benefits and emotional costs here, right? Psychological or like you know nutritional costs, nothing nothing monetary. So that first slice of pizza, I'm really hungry. There's not a high cost here. I'm I'm hungry. I want the pizza, so there's not really much cost. How about that second slice? Well I'm not as hungry anymore and now I might start thinking about my health, right? The third slice, it's starting to come up. The fourth slice. Now I'm not even hungry anymore. Right? I ate that that fourth slice of pizza, and now I feel satiated. That fifth slice of pizza, it's going to come at a cost. Right? Now I'm bloated. Right? I can't even, like, get up after lunch. I'm going to need a 30 minute break. Probably, you know, it's a little much. And that sixth piece, the slice of pizza now I'm just, you know, I'm, I just got a stomachache now. It just wasn't worth it. Right? So the idea I think you might see at this fourth slice of pizza, they're kinda overlapping here, but the idea I think you'll see what's going to be happening here. Why don't we go ahead and connect our lines? So here, we're going to have what's called the marginal benefit line. Right? And let's draw our marginal cost line this way. And you can see that the marginal cost is increasing the more pizza I eat. Okay? So what do we find here? I think it's pretty obvious on the graph that there's one point that seems to stand out right here in the middle, and that is when our marginal benefit equals our marginal cost. And just like we defined right up here, marginal benefit equals marginal cost at our optimum consumption. Right? So here at 4 slices of pizza, that is how much pizza I should eat and I'll be most satisfied. So let's think about some different situations. What if I had only eaten three slices of pizza? What would have happened? Right. Let's say I'm at this point right here, I ate three slices of pizza. Well, you can see that the marginal benefit at three slices of pizza, if I were to eat one more, I'd be bringing in you know still some happiness, right? I'm still hungry and the marginal cost is still down here. It's less than the marginal benefit. So the idea is I should keep eating pizza because the marginal benefit is greater than the marginal cost of that next slice of pizza. So when I have three slices of pizza, I should have another one. But what if I'm here at 5 slices of pizza? Right, that fifth slice of pizza, now the marginal cost is greater than the marginal benefit. I'm not even hungry anymore, I'm starting to question myself right like why am I eating so much pizza, and I find that that's too much pizza. So for me, right here, we're going to find that four slices of pizza is the correct amount, and, you what you could think is like, you know, maybe for you, four isn't the right amount.

In economics, marginal means

• A. Additional
• B. Extra
• C. One more
• D. All of the above

Here’s what students ask on this topic:

What does it mean for individuals and firms to be rational in economics?

In economics, rationality means that individuals and firms strive to maximize their outcomes with the resources they have. This involves making decisions that they believe will best improve their situation. For example, a student will study for an exam to achieve the best possible grade, and a factory manager will aim to maximize output while minimizing waste. Rational behavior assumes that people do not intentionally make decisions that will make them worse off. Instead, they use the information and resources available to them to make the best possible choices, even if those choices are not perfect.

How do people respond to economic incentives?

People respond to economic incentives by exploiting opportunities to make themselves better off. For instance, if the price of apples increases, consumers might switch to buying oranges or other fruits. This behavior is driven by the desire to maximize utility or satisfaction. Another example is in New York City, where people might opt for an oil change at a mechanic to avoid high parking fees, thus saving money. Economic incentives guide individuals and firms to make decisions that align with their best interests, often leading to changes in consumption patterns and resource allocation.

What is marginal analysis in economics?

Marginal analysis in economics involves examining the additional benefits and costs of a decision. The key principle is that optimal decisions are made when the marginal benefit (MB) equals the marginal cost (MC). For example, if you are deciding how many slices of pizza to eat, you would continue eating until the additional satisfaction (marginal benefit) from one more slice equals the additional cost (marginal cost), which could include feeling too full or unhealthy. This concept helps determine the optimal level of consumption or production, ensuring resources are used efficiently.

How is the concept of marginal benefit and marginal cost used to determine optimal consumption?

The concept of marginal benefit (MB) and marginal cost (MC) is used to determine optimal consumption by comparing the additional satisfaction gained from consuming one more unit of a good (MB) with the additional cost incurred (MC). The optimal consumption level is reached when MB equals MC. For example, if you are eating pizza, you would continue eating until the satisfaction from the next slice (MB) is equal to the cost, such as feeling too full (MC). This ensures that you maximize your total satisfaction without incurring unnecessary costs.

Can you provide an example of how marginal analysis is applied in real-life decision-making?

Sure! Consider a student deciding how many hours to study for an exam. The student will use marginal analysis to determine the optimal number of study hours. Initially, each additional hour of study (marginal benefit) significantly improves the student's understanding and potential exam score. However, as the student continues to study, the additional benefit from each extra hour decreases, while the marginal cost, such as fatigue and lost leisure time, increases. The student will find the optimal study time when the marginal benefit of one more hour of study equals the marginal cost, ensuring efficient use of their time and resources.