Think like an economist

Economics is about viewing the world as a place where humans face scarcity. People face constraints, which means that they must make choices in the face of tradeoffs. Choices are shaped by the costs and benefits of the various alternatives---and those costs and benefits can change over time.

Principles

People respond to incentives (stick and carrot)
There is no free lunch (by choosing something you dismiss others -> opportunity cost)
There are always at least 2 sides to every interaction.
There are usually unanticipated and unintentional consequences therefore no one is in complete control

Concepts

Thinking like an economist means being aware of the incentives you face and, perhaps more importantly, the incentives those around you face. It means anticipating what's strategically rational for them, and how that will affect your options. It means focusing on the margin, on trade-offs, and on adjustments to find the optimal balance. The question is always how much? And of which?

Rationality (people will choose strategically rather than randomly)
Clarify the objective
Identify all possible alternative paths to achieve the objective.
Evaluate carefully the payoffs from each of those alternatives.
Select the option with the highest payoff
marginal analysis
The change in a starting total value from a slight increase or > decrease in an activity. If a bus company provides service between > 2 cities, the marginal cost is the addition to cost of taking on 1 > more passenger. The marginal revenue is the increase in revenue > from selling the final ticket.
optimization
Figuring out the best attainable allocation given a set of > constraints.
E.g. limited resources to chose between food and shelter. The > optimal solution is to find the balance between food and shelter > that will make the marginal value of each of them equal; hence the > name "equimarginal principle."

Rational choices can lead all of us involved to better. They don't have to. That failing is most likely to take place:

When our decisions and our strategies are interdependent
When my best strategy depends on your choice
When your best strategy depends on mine.
If we don't need each other's consent
if we don't communicate and we don't negotiate
if some kind of an enforceable agreement isn't possible

We may end up rationally choosing paths that harm us both.

Economic efficiency

Rationality refers to the process by which individuals reach choices; efficiency is a measure that we use to judge the social consequences of those many choices. Economists define efficiency as people being made better off. What determines whether you're better off? You do; it's a measure of how you feel.

How to measure efficiency?

At the beginning of the 20^th^ century, economists gave up to find a way to objectively measure when society is better off. They figured they could not find a strong, objective measure of social welfare, so they settled for a very weak one instead. They adopted a principle from the sociologist Vilfredo Pareto, who said that the only unambiguous standard of a social gain is this:

If we take a number of people, and something makes any one of them better off by their own judgment without making anyone else worse off, that is an unambiguous social improvement.

We call such a situation in which no one can be made better off without harming another a Pareto optimum. The allocation of resources is efficient but not necessarily fair.

Value to any person is the marginal contribution to that person's welfare, and it can be quite different in different circumstances or for different people. The value of a glass of water when I'm sitting at home next to a free-flowing tap versus when I'm crawling across a broiling desert is quite different.

Economic efficiency is the exhaustion of all possible unambiguous increases in self-defined welfare. We know that individual rationality will promote it, as long as the incentives driving each decider reflect the costs and benefits that result from decisions.

Each harm must be accurately compensated
each gain must be appropriately priced
rights must be clearly defined
information must be complete and true
promises must be kept.

But this, of course, is not the world in which we live.

We may not understand the true consequences of our actions
we may voluntarily choose ones that make us worse off
people may lie about their intentions or break their promises
rights may be ambiguous.

It is when the incentives that guide choices fail to be accurate or comprehensive that individual rational choices can make the decider, or someone else, worse off.

Thinking like an economist has its greatest value in these instances---by understanding the harms that these imperfections cause and formulating strategies to overcome them.

Incentives and Optimal Choice

The rules and rights surrounding any interaction define the incentives that relevant individuals face. Altering, clarifying, or redesigning rights will also redefine optimal strategies for players.

In thinking like an economist, you should always ask yourself the following questions:

Are the rules and rights in this situation creating any prisoner's dilemma incentives--- incentives that cause individuals to adopt rational strategies that ultimately harm us all?
Could the rules or rights be redesigned or renegotiated to induce individuals to reach better decisions?
Are there real consequences to a choice that are somehow not being paid for, that are not accounted for, in the incentives facing this decider?
How are the false incentives distorting the outcome?
Are there mechanisms we can employ to be sure that the consequences are going to be effectively priced?
Are there free rider problems here that are preventing our cooperation that would make many of us better off?

Externalities

One kind of inaccuracy that is important to economists is externalities, which occur any time we take an action that creates a benefit for somebody else or imposes a cost on somebody else with no payment made.

When externalities exist, rational individual decisions can lead to inefficient outcomes in 2 distinct ways:

False incentives may cause us to make decisions that cause significant harm to other people,
we may fail to consider choices that would cause benefit.

Commons

A commons is something that we all use collectively and no one is directly responsible for.

The presumption is that we'll all use the commons responsibly, but the incentives for each user of a commons work against that hope.

If other people pay the costs, I get protected without doing a thing; I can be what economists call a free rider. There are 2 practical ways to try to overcome the free rider problem:

There are strong economic forces incentivizing us to use the atmosphere as a free-for-all dump for greenhouse gases.

compulsory participation (e.g., taxation)
and linking the public good to a desirable private good (e.g., getting people to pay voluntarily).

Expected value

It is the average outcome that would result from repeating the same decision multiple times.

Take the probability (1 divided by the number of total possible outcomes.) of each possible outcome
multiply that by the value of the outcome
add all of these values together
It is up to us to estimate carefully both the probabilities and the payouts from various outcomes.
Do not be misled by other people's interpretation of risk, which will not necessarily mesh with yours
Our knowledge of probabilities can be systematically distorted.
When there's a lot of group interaction, the people making decisions feed off each other.
Rationally ignorant people (i.e., all of us) are susceptible to information cascades that can lead us wildly astray. If all or many members in a group are uninformed of actual facts but form opinions based on the number of others who assert something to be true.

Knowing the expected value helps you make a rational decision.

Time value/preference of money

People almost always prefer to have good things happen sooner and bad things happen later. Economists refer to this as pure time preference.

discounted present value and future value

At 5% p.a interest 105 is the one year future-value of 100 today.

At 5% p.a. interest 100 is the present value equivalent of 105 in a year.

Behavioral Economics

Not considering people as 100% rational but taking into account our personal preferences and biases.

Doesn't rationality dictate that you should choose to receive money over not receiving any? Not necessarily; rationality refers to the process of reaching decisions, not to the objectives and motivations. The evidence here is showing us that for many people, fairness has a real value, and unfairness has a real cost. Therefore, rationality requires that their behavior respond to that.

We adopt subjective anchor points that set parameters for our decisions
We remain attached to past decisions even when they no longer make sense
We revalue things simply because we possess them.

Loss aversion:

There's no rational reason why the value we place on \$1 won versus \$1 lost should be much different, but experimentally we find that a loss hurts about twice as much as a gain helps.

tragedy of the commons: When enough people use a common resource, there is an incentive for each to overuse the resource because they personally receive all the bene¿ ts from overuse while the costs imposed by overuse are shared by all; of course, if everyone follows this logic, then the common resource is depleted and even ruined for all.

framing: When a certain outcome can be described in different ways---and how it is described affects how people respond.

loss aversion: When people have a greater preference for avoiding losses of a certain size than they do for achieving gains of the same size.

reference point: When people make decisions based on how the outcome relates to their internal sense of what is appropriate or fair.

Herd behaviour

Information cascade: Part of the information that people use in making decisions is to look at the decisions made by others, and as a result, it is possible that a misguided decision can spread.

For stock analysts there are modest gains from doing better than the group, but there is a real chance of getting ¿ red if one does much worse than the group.

Under a repressive government, many citizens will hide their private reactions and, instead, will go with the crowd in professing support for the government. However, if circumstances disrupt this information cascade, and many citizens begin revealing their private information at once, the result can be an overthrow of a repressive government.

In political campaigns, every candidate wants to create a sense that the herd is moving their way so that people will disregard their own private preferences and go with the herd, which has a chance of winning.

We should also be aware of the possibility that the information cascade has headed off in an incorrect direction. Therefore, you should value the entrepreneurs and dissenters who question conventional wisdom, and nourish a germ of skepticism for yourself.