Econ101: A Starter

What is economics? It's all about choice and choosing. Things are scarce. So we make choices. Economics¹ is a way to explain why some guy chooses a banana over an orange, given the money in his pocket.² That's all. Never mind the long and boring definitions in the textbooks. When somebody wakes you up in the middle of the night and ask what economics is, just remember one word: CHOICE.

What is the implication of scarcity and the act of choosing? Tradeoff. When our guy chooses the banana, he gives up the opportunity of having the orange. We say, the opportunity cost of his having the banana is his foregoing the orange.³

How does he choose? By comparing the benefit and cost of the action.⁴ What does it tell us when we see the guy ends up eating the banana? It tells us that for that guy at that time, the benefits of eating banana exceeds the costs.

When "the guy ends up eating the banana", he is revealing his preference. That is, without telling us anything, we have an information about his preference. This is called revealed preference (RP). Or, it can be that he just tells us that he prefers banana over orange. This is stated preference (SP). We tend to believe RP more than SP. Whenever what you do contradicts what you say, we believe the former.

But why do we rely our analysis on what people do? Because we assume people are rational. That is, people do whatever best for him at any given time. Is the assumption alright? Think about a person playing billiard. Is it alright to assume he is rational? That is, is it safe to assume that what he would do is consistent with the physics dictum that "the angle of incidence equals the angle of reflection"? We think it is safe. But there are crazy people, no? Yes, but there are definitely more non-crazy people out there then the crazy ones. So we're fine.

Should the guy eat the banana? We don't know. What we do know, by way of inference, is the guy prefers banana to orange. And as a rational person, he eats the banana. So, when you offer him to choose between the two, he would take the banana. This is a positive approach to economics, as opposed to normative approach. Positive approach is all about "what is" or "if X then Y". Normative approach is a matter of "what should be". We are more confident in positive approach. In fact, we try not to do normative approach. And we encourage you not to believe economic analysis with too many "should"s in it.

Stay tuned.

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¹ In this Econ101 series, all economics keywords/phrases will be highlighted like this.
² From now on, we will be using masculine pronouns. Blame the convention.
³ This is a brutal simplification. The guy can choose to have half banana and half orange. Or the story might as well be: choosing between sweet orange and sour orange, the latter being cheaper for an obvious reason. But don't worry about this complication now. Opportunity cost is central to economics, so we will devote another whole posting for it sometime later.
⁴ You might say, "Well, no, I don't do that". Trust us, you do -- in one way or another.

Econ 101