Economics As A Collection Of Analytical Tools

Economics as a collection of analytical tools - concepts of rationality, opportunity cost, comparative advantage and the margin

Economics is been described as a set of analytical tools outlined to tackle different problems (Gowland and Paterson, 1993). Bill Gerrard asserts that the concept of rationality is the core of modern economics. His work “The Economics of Rationality” contains a lot of critical perspectives on the interpretation of rationality in economics.

Here the idea of rationality is connected with normative notions about what choices in general will improve a welfare of a person. Newell offered the following principle of rationality: “If an agent has knowledge that one of its actions will lead to one of its goals, then the agent will select that action.” (Newell, 1982, p. 87) B. Venkatesh says that “rationality in economics is to do with greed! People are called rational if they desire to improve their economic well-being. That is, they want more wealth, and they want it sooner than later. Thus, if you are offered Rs 1 lakh, and you refuse it, you may be deemed irrational by the economists”. (Venkatesh, 1990, p.2)

Count the following decision problem. A consumer must choose between 2 actions, videlicet, A and B. She/he acquires 10 dollars from action A and 5 dollars from action B. On the supposition that the consumer prefers more money to less one, he is rational if he chooses action A; a consumer choosing action B is irrational. In the context of this mere example, the rationality concept is trivial, partly because there is no ambiguity in the decision problem (i.e., the set of probable actions and the payback from each action are clear with certainty). Nevertheless, in the context of examples with uncertainty, the concept of rationality is by no means trivial. For instance, consider the following modification to the decision problem stated earlier. If the consumer selects action B, then a fair coin is tossed, and if he is lucky and heads turned up then the consumer gets 15 dollars, and if tails turned up then he gets 5 dollars. In this much more complicated decision problem, it is not clear whether it is as yet rational for the person to choose action A.

Opportunity cost is an economical term that means the cost of something in terms of an opportunity foreseen and the benefits that could be obtained from that opportunity, or also understood as the most valuable foreseen alternative. The opportunity cost concept is used in CBA to adjust a dollar value on the inputs necessary to execute policies. The opportunity cost of using an input to execute the policy is its value in the best alternative usage. It assesses the value of what people should forgo to use the input for the policy fulfillment.

For instance, if a city wants to construct a hospital on available land it owns, the opportunity cost is another possibility that might have been used with the land and funds for construction instead. Having built the hospital, the city has lost the opportunity to construct a sports centre on that place, or the opportunity to sell that piece of land to decrease the city’s debts, and so forth. Simply said, the opportunity cost of spending a Friday night having fun could be the sum of money you could have made if you had spent that time in labor.

Opportunity cost is not determined in monetary terms, but in terms of anything that constitutes value for the person or persons carrying out the assessment. The use of the opportunity cost concept seeks for the latent cost of each and every separate economic decision. Incompetence in the economic concept of opportunity cost has induced general economic mistakes, like “the broken window fallacy” reported by Frederic Bastiat. According to Frederic Bastiat, it is not possible to have everything promoted at the expense of everything else. This calls up his well-known definition describing the state, “the great fictitious entity by which everyone seeks to live at the expense of everyone else” (Bastiat, 1975, p.144). A. Smith says “If among a nation of hunters, for instance, it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer. It is natural that what is usually the produce of two days or two hours labour, should be worth double of what is usually the produce of one day’s or one hour’s labour.” (Smith, 2003, p.65). P.H. Wicksteed concludes “The only sense, then, in which cost of production can affect the value of one thing, is the sense in which it is itself the value of another thing. Thus, what has been variously termed “utility”, “ophelimity”, or “desiredness”, is the sole and ultimate determinant of all exchange values” (Wicksteed, 1910, p.391).

In economics, the comparative advantage theory illustrates why it can be advantageous for two given states to trade, even if one of them is able to produce each kind of item cheaper than the other. What really matters is not the absolute cost of production, but the ratio between how easily the two countries can produce various kinds of items. Robert Torrens described it first in 1815 in an article on the corn trade. He made the conclusion that it was advantageous to England to trade different goods with Poland in exchange for corn, even if it might be possible to have the corn produced in England much more cheaper.

Still, it is usually ascribed to David Ricardo who described it clearly in 1817 in his book using an example with Portugal and England. In Portugal it is feasible to produce both cloth and wine with less work involved than it takes in England. However, the relative expenses on manufacturing the two goods differs in the two countries. In England it is very difficult to produce wine, and only reasonably difficult to produce cloth. In Portugal both goods are easy to produce. Thus, whereas it is much cheaper to produce cloth in Portugal than England, for Portugal it is still more inexpensive to produce surplus wine, and trade it for English cloth. Conversely, England gains benefits from this trading activity because its cost for producing cloth remained the same but it can now get wine for the cost close to that of cloth. “That it is logically true need not be argued before a mathematician” says Paul Samuelson (Samuelson, 1997, p.72).

In finance, a margin is the money or collateral that a holder of a position in securities or in exchange-traded derivatives needs to relate to cover future negative movements in the value of the position. Marginal concepts in economics refer to the result of producing or consuming one more of a certain good, i.e. at the border, or margin, of the total whether consumed or produced.

For instance, marginal cost refers to the cost of production of one more item of some good. Generally, this will be lower than the average cost, for the average cost includes fixed costs. Marginal benefit is the additional profit acquired from one additional item of a good. Margin is money borrowed that is used to buy securities. This practice is called ‘buying on margin’. The initial margin and maintenance margin are two types of margin for frowers who want to trade and are not registered with the Winnipeg Commodity Exchange. The first deposit that ought to be made with a broker when a position in the futures market is taken is the initial margin. Maintenance margin is the minimal amount to remain in the account after all losses are subtracted from the initial margin. The WCE determines the minimal level of initial and maintenance margin. Separate brokerage houses may demand more than the minimal initial margin. In case the producer’s account gets to the maintenance level, the broker will issue a margin call asking the grower deposit more money in the account.

This is a concept which must be comprehended before starting ones business. When the producer, for instance, holds a short position, and the market goes up the producer will have a signal to provide more margin money. If the price rises, the producer has a more costly contract, and he is required to cover that grown value. A margin call can be important, depending on the contract size. The producer must be ready to cover it or have a line of credit to cover it. Here’s an appropriate example “suppose the maintenance margin on a 100 ton lot of canola is $1,000 (or $10/mt) and the initial margin is $1,350 or $13.50 ton. The grower would have to deposit $1,350 initially. The grower then sells a January futures for $345/mt. If the price for a January futures increases, the grower is in a paper loss position until the grower buys the contract back and the grower would be called to deposit more margin” (Canola Council of Canada, 2005).

References

(1) Bastiat, Frédéric. (1975) “Selected Essays in Political Economy” Foundation for Economic Education.

(2) Canola Council of Canada (2005). “Growing Canola. Margin Money”. Retrieved October 17, 2005, from http://www.canola-council.org/mktgmechmargin.aspx.

(3) Newell, A. (1982). “The knowledge level” Artificial Intelligence, 18, pp. 87-127.

(4) Samuelson, Paul A. (1997) “Economics: The Original 1948 Edition” McGraw-Hill\Irwin.

(5) Smith, A., Krueger, A. B. (2003) “The Wealth of Nations” Bantam Classics.

(6) Venkatesh, B Athreya. (1990) “Barriers broken: Production relations and agrarian change in Tamil Nadu” London: Sage Publications.

(7) Wicksteed, P.H. (1910) “The Common Sense of Political Economy” 1933 edition, London, Routledge and Kegan Paul.

Bibliography

(1) Bastiat, Frederic. (2001) “Economic Fallacies” FL, Simon Publications.

(2) Bastiat, Frédéric. (1975) “Selected Essays in Political Economy” Foundation for Economic Education.

(3) Canola Council of Canada (2005). “Growing Canola. Margin Money”. Retrieved October 17, 2005, from http://www.canola-council.org/mktgmechmargin.aspx.

(4) Gerrard, Bill. (1993) “The Economics of Rationality” London, Routledge.

(1) Gowland, D. and Paterson A. (1993) “Taxation. In: Microeconomic Analysis”, Ch. 15. New York, Harvester Wheatseaf.

(5) Newell, A. (1982). “The knowledge level” Artificial Intelligence, 18, pp. 87-127.

(6) Ricardo, David. (1996) “Principles of Political Economy and Taxation (Great Minds)” NY, Prometheus Books.

(7) Samuelson, Paul A. (1997) “Economics: The Original 1948 Edition” McGraw-Hill\Irwin.

(8) Smith, A., Krueger, A. B. (2003) “The Wealth of Nations” Bantam Classics.

(9) Torrens, Robert and Giancarlo de Vivo. (1998) “Collected Works” UK, Thoemmes Continuum.

(10) Venkatesh, B Athreya. (1990) “Barriers broken: Production relations and agrarian change in Tamil Nadu” London: Sage Publications.

(11) Wicksteed, P.H. (1910) “The Common Sense of Political Economy” 1933 edition, London, Routledge and Kegan Paul.

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