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Professor Economics' Lessons

Costs

Definition of accounting cost: An actual monetary outlay

Definition of opportunity cost (Courtesy of The Economist): The economic benefits you go without because you bought or did something and can no longer buy or do something else

Definition of economic cost: Accounting costs plus opportunity costs

Example:
Sally goes to see a two-hour movie at the theater. The ticket costs her $8. If Sally hadn't gone to see the movies, she would have relaxed at home, an activity that Sally values at $5 per hour.
Sally's accounting cost is $8
Her opportunity cost is $5 per hour x two hours = $10
Her economic cost is $8 + $10 = $18

Follow-up question: How much enjoyment does Sally need to get from the movie in order to justify forgoing relaxing at home?
Answer: The value of enjoying the movie needs to be at least $18. Otherwise, she should have stayed home. This is because, by staying at home, she would have avoided the $8 ticket fee, and she would have incurred $10 worth of enjoyment from relaxing.

Final note: Every activity has an opportunity cost, even if you thoroughly enjoy the activity. The money, time, energy, etc. you invest into one activity could always be spent on a myriad of other alternatives. The difficulty, however, comes in trying to compare the value of the activity you do to the opportunities forgone.

Demand

There are many things that affect the demand for a good or service, such as:
Availability of substitutes: Products that serve as alternates to the desired product
Availability of complements: Products that are sold in combination with the desired product
Future expectations: If consumers expect the product to be cheaper in the future, they will hold off purchasing today, and vice versa.
Tastes and preferences: The demand for a product changes as consumers' tastes change, a process that can be facilitated by factors such as age, news announcements, friends' consumption choices, etc.

You will notice that price is not included in that list. Price affects the quantity demanded, but it does not affect the demand curve. That is because the demand curve already takes the price into account.

Applications:
As an example, the product we will consider is soda.

Substitutes for soda would include water, juice, milk, alcohol, energy drinks, and anything else that quenches thirst. So, all other things equal, if the price of milk raises relative to the price of soda, demand for soda will increase. If the price of energy drinks decreases relative to the price of soda, demand for soda will decrease.

Complements for soda are goods that make the consumption of soda more enjoyable. These might include potato chips, for example. If the price of potato chips goes up, demand for soda will go down. If the price of potato chips falls, the demand for soda will rise.

Let's say it is announced on the news that price for aluminum, an important component for creating soda cans, is increasing. Because of this, consumers expect that prices will rise in the near future. A rational consumer of soda, then, would purchase soda today, in order to avoid the future high prices, causing demand to rise.

Finally, let's say it is announced by respected medical professionals that drinking caffeine - an ingredient found in soda - causes cancer. Consumer preferences would likely change to reflect this news, prompting a decrease in demand for soda.

Final note: Many of the things that affect demand also affect supply. I encourage you to apply what you have learned to consider how these things would affect supply.

Becoming a self-educated consumer

Professor Economics encourages everyone to develop an understanding of how the economy works. There are many books that apply economics in ways that understandable, and even enjoyable, to read by the average individual. My favorite choices are detailed below.

Freakonomics and SuperFreakonomics by Steven Levitt and Stephen Dubner. These books apply the economic way of thinking to topics as varied as drug dealers, prostitutes, sumo wrestlers, global warming, and parenting.

The Economic Naturalist: Why Economics Explains Almost Everything by Robert Frank. This book finds economic explanations for common things, such as airplane peanuts, salaries, and school uniforms. It also further explains concepts such as opportunity cost, market signals, self-interest, discount pricing, and supply and demand.

Thinking Strategically by Avinash Dixit and Barry Nalebuff. This book applies the exciting subject of game theory and teaches readers how to use concepts of incentives, cooperation, bargaining, and judging rivals in real-life situations.

Happy reading!

Words to Know