WEEK 1: Core Principles of Economics
Three Core Principles:
1. Efficiency
2. Welfare
3. Transaction
Core Principle 1: Efficiency
● The concept of efficiency is the center of economics.
● Efficiency is:
○ Costs & benefits (in strict terms)
○ Maximizing net benefits (i.e. the difference between benefits and costs)
■ You want to achieve the highest possible benefits and lowest possible costs.
● Costs effectiveness (costs only):
○ A (smaller) sub-concept (of efficiency)
○ Balance between costs and benefits is however important.
● Transaction costs:
○ Essentially production costs: information costs, bargaining costs, monitoring costs,
enforcement costs.
Core Principle 2: Welfare
● A concept that is both subjective and indifferent.
○ Subjective: similar phenomenon increases welfare for some, decreases for others.
○ Indifferent: we do not judge people’s desires.
● Welfare collides with scarcity:
○ Limited means = you have to make decisions under scarcity.
○ Economics aims to increase welfare under this condition in order to make as many people
as happy as possible.
Core Principle 3: Transaction
● Transaction = transfer of property rights
● A transaction is a simultaneous economic and legal exchange
○ Physical transfer of good/service
○ Economic transfer of money
○ Legal transfer of property rights
Measuring costs-benefits:
● Lesson 1: Don’t forget opportunity costs:
○ Opportunity cost = the value of the next best alternative that must be forgone in order to
undertake an activity.
● Lesson 2: Ignore sunk costs:
○ Sunk costs = those costs that will be incurred whether or not an action is taken.
, ● Lesson 3: Relevant costs & benefits are marginal:
○ The level of an activity should be increased only if marginal net benefit is positive.
○ i.e. when marginal benefit exceeds marginal costs.
How to achieve optimum allocation of production factors?
● Not optimum: Central planning
○ Central agency decides (top-down):
■ Production targets (what/how much)
■ Planning of how to achieve the targets (how)
■ Distribution of goods & services (for whom)
○ However this approach is inefficient as if the government decides on the above → leads
to information asymmetry.
■ E.g. former soviet union, 20th century China, North Korea
● Optimum allocation: Markets (Bottom up)
○ Individuals and firms interact (bottom-up) within regulatory framework.
Market Failures:
Why do we need government regulation in markets?
● Due to market failures such as:
○ Imperfect competition:
■ When only 1 or 2 or 3 companies are on the market.
○ External effects:
■ Referring to damage done to others e.g. environmental pollution.
○ Public goods:
■ Collective goods which are valued by consumers but nonetheless not provided by
the market because consumers have the tendency to free-ride on the provision of
the goods by others.
○ Information asymmetries:
■ If consumers are not able to grasp, fully understand the characteristics of a
product + risks/dangers
Regulatory failures:
● When regulation perfect - but government failure:
○ Asymmetric information:
■ Where the government has to set the rules but does so in a way that ends up in a
situation where consumers are not satisfied.
○ Lobbying (or rent-seeking):
■ Companies lobbying for certain rules that are good for them but not good for
consumers.
○ Short (4 year) time horizon:
■ Focus of politicians is to get re-elected thus may not lead to regulation that is
efficient in the long term.
○ Budget maximization
, ■ Governments seeking higher budgets for themselves.
○ Corruption
■ Inefficient regulation
Perfect competition:
● Many suppliers and consumers:
○ As a result of which an individual supplier is not able to influence the market price.
● Homogeneous goods:
○ Consumers can go to many suppliers that supply the same goods of the same quantity,
same look, same feel etc.
● No transaction costs:
○ Perfectly transparent:
■ Accessible, You know where to go, which suppliers.
○ (Property) rights defined
○ Free entry and exit
■ New suppliers may enter the market without any barriers and suppliers may also
leave the market without any barriers.
● However - in reality, perfect competition is never realized.
Learned Hand Rule - Standard duty of care:
● Optimal prevention is where MB (marginal benefits) = MC (marginal costs)
○ Burden of precautionary measure: B
○ Cost of possible accident: p x L
● Learned Hand Rule: defendant negligent & liable if B < p x L (i.e. cost of possible accident is
higher than burden of precautionary measure).
Calculations/formulas:
Demand & Supply Curve:
● Demand = consumers
● Demand curve = willingness to pay (WTP)
● Supply = producers
● Supply curve = willingness to supply (STP)
, Q1a) What is the marginal benefit for the 2nd plectrum?
Answer: 6 euros
Q1b) When MR = MC
2x0 = 0, MB = 0
2x1=2, MC = 2, MB = 8
2x2=4, MC =2, MB = 6
2x3=6, MC =2, MB = 4
2x4=8, ,MC = 2, MB = 2
2x5=10, MC =2 MB = 1
Quantity Cost per plectrum Marginal cost Marginal revenue
(benefit)
0 2x0 = 0 0 0
1 2x1=2 2 8
2 2x2=4 2 6
3 2x3=6 2 4
4 2x4=8 2 2
5 2x5=10 2 1
So he should buy 4 plectrums because that is the point at which MR = MC.
At 5 plectrums marginal cost = 2 and benefit = 1 so MR < MC → not optimal.
Three Core Principles:
1. Efficiency
2. Welfare
3. Transaction
Core Principle 1: Efficiency
● The concept of efficiency is the center of economics.
● Efficiency is:
○ Costs & benefits (in strict terms)
○ Maximizing net benefits (i.e. the difference between benefits and costs)
■ You want to achieve the highest possible benefits and lowest possible costs.
● Costs effectiveness (costs only):
○ A (smaller) sub-concept (of efficiency)
○ Balance between costs and benefits is however important.
● Transaction costs:
○ Essentially production costs: information costs, bargaining costs, monitoring costs,
enforcement costs.
Core Principle 2: Welfare
● A concept that is both subjective and indifferent.
○ Subjective: similar phenomenon increases welfare for some, decreases for others.
○ Indifferent: we do not judge people’s desires.
● Welfare collides with scarcity:
○ Limited means = you have to make decisions under scarcity.
○ Economics aims to increase welfare under this condition in order to make as many people
as happy as possible.
Core Principle 3: Transaction
● Transaction = transfer of property rights
● A transaction is a simultaneous economic and legal exchange
○ Physical transfer of good/service
○ Economic transfer of money
○ Legal transfer of property rights
Measuring costs-benefits:
● Lesson 1: Don’t forget opportunity costs:
○ Opportunity cost = the value of the next best alternative that must be forgone in order to
undertake an activity.
● Lesson 2: Ignore sunk costs:
○ Sunk costs = those costs that will be incurred whether or not an action is taken.
, ● Lesson 3: Relevant costs & benefits are marginal:
○ The level of an activity should be increased only if marginal net benefit is positive.
○ i.e. when marginal benefit exceeds marginal costs.
How to achieve optimum allocation of production factors?
● Not optimum: Central planning
○ Central agency decides (top-down):
■ Production targets (what/how much)
■ Planning of how to achieve the targets (how)
■ Distribution of goods & services (for whom)
○ However this approach is inefficient as if the government decides on the above → leads
to information asymmetry.
■ E.g. former soviet union, 20th century China, North Korea
● Optimum allocation: Markets (Bottom up)
○ Individuals and firms interact (bottom-up) within regulatory framework.
Market Failures:
Why do we need government regulation in markets?
● Due to market failures such as:
○ Imperfect competition:
■ When only 1 or 2 or 3 companies are on the market.
○ External effects:
■ Referring to damage done to others e.g. environmental pollution.
○ Public goods:
■ Collective goods which are valued by consumers but nonetheless not provided by
the market because consumers have the tendency to free-ride on the provision of
the goods by others.
○ Information asymmetries:
■ If consumers are not able to grasp, fully understand the characteristics of a
product + risks/dangers
Regulatory failures:
● When regulation perfect - but government failure:
○ Asymmetric information:
■ Where the government has to set the rules but does so in a way that ends up in a
situation where consumers are not satisfied.
○ Lobbying (or rent-seeking):
■ Companies lobbying for certain rules that are good for them but not good for
consumers.
○ Short (4 year) time horizon:
■ Focus of politicians is to get re-elected thus may not lead to regulation that is
efficient in the long term.
○ Budget maximization
, ■ Governments seeking higher budgets for themselves.
○ Corruption
■ Inefficient regulation
Perfect competition:
● Many suppliers and consumers:
○ As a result of which an individual supplier is not able to influence the market price.
● Homogeneous goods:
○ Consumers can go to many suppliers that supply the same goods of the same quantity,
same look, same feel etc.
● No transaction costs:
○ Perfectly transparent:
■ Accessible, You know where to go, which suppliers.
○ (Property) rights defined
○ Free entry and exit
■ New suppliers may enter the market without any barriers and suppliers may also
leave the market without any barriers.
● However - in reality, perfect competition is never realized.
Learned Hand Rule - Standard duty of care:
● Optimal prevention is where MB (marginal benefits) = MC (marginal costs)
○ Burden of precautionary measure: B
○ Cost of possible accident: p x L
● Learned Hand Rule: defendant negligent & liable if B < p x L (i.e. cost of possible accident is
higher than burden of precautionary measure).
Calculations/formulas:
Demand & Supply Curve:
● Demand = consumers
● Demand curve = willingness to pay (WTP)
● Supply = producers
● Supply curve = willingness to supply (STP)
, Q1a) What is the marginal benefit for the 2nd plectrum?
Answer: 6 euros
Q1b) When MR = MC
2x0 = 0, MB = 0
2x1=2, MC = 2, MB = 8
2x2=4, MC =2, MB = 6
2x3=6, MC =2, MB = 4
2x4=8, ,MC = 2, MB = 2
2x5=10, MC =2 MB = 1
Quantity Cost per plectrum Marginal cost Marginal revenue
(benefit)
0 2x0 = 0 0 0
1 2x1=2 2 8
2 2x2=4 2 6
3 2x3=6 2 4
4 2x4=8 2 2
5 2x5=10 2 1
So he should buy 4 plectrums because that is the point at which MR = MC.
At 5 plectrums marginal cost = 2 and benefit = 1 so MR < MC → not optimal.
