A rare disease will claim 600 lives if we do nothing A rare disease will claim 600 lives if we do nothing. We must choose between the following two programs: Program A: 400 people will die with certainty Program B: 1/3 chance that no one will die 2/3 chance that all 600 will die Which program would you choose?

Definition of Economics Economics is the study of how society allocates scarce resources in order to satisfy virtually unlimited wants.

“society” Economics is a Social Science The scientific method Observation Invent a hypothesis (Theory) Use theory to make predictions Test with observation and experiments Repeat

Ockham’s Razor Keep theories simple. With competing theories use the least complicated.

“allocate” Scarcity → Choices The Scarcity Principle (Also called the No-Free-Lunch Principle) Although we have boundless needs and wants, the resources available to us are limited. So having more of one good thing usually means having less of another. There is usually opportunity cost.

Rationality The Rationality Assumption: People have goals and try to fulfill them as best they can. The Cost-Benefit Principle An individual (or a firm, or a society) should take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs.

Cost-benefit analysis Should I do activity x? C(x) = the costs of doing x (I incur these only if I decide to do x.) B(x) = the benefits of doing x (I enjoy these only if I decide to do x.) If B(x) > C(x), do x; otherwise don't. (Positive net benefits!)

Should there be 12 separate sections of Econ 101, with 25 students each?

Or should there be only one section, with 300 students?

Students learn more effectively in smaller classes. But smaller classes are also more expensive.

Should we make the econ class larger? Benefit of making the class size larger = the reduction in cost per student = B(x) Cost of making the class size bigger = the amount people would be willing to pay to avoid the reduced quality of instruction = C(x)

Some relevant costs: Faculty salary: $60,000 per course Per student faculty salary cost: 1 section: $60,000/300 = $200 12 sections: $60,000/25 = $2400

Benefit of increasing class size from 25 students to 300 students = ($2400 - $200) = $2200 = B(x) If you were currently in a class with 25 students, how much would you be willing to pay to avoid switching to one with 300 students? C(x) If C(x) < $2200, then it makes sense to offer the larger class.

People often make bad decisions because they fail to compare the relevant costs and benefits.

Economic Analysis Normative economics How we should behave what should be value judgment Positive economics How we behave what is If this then that– value free

Can cost-benefit analysis help you make better decisions? You are about to buy a $20 alarm clock at the campus store when a friend tells you that K-mart has the same alarm clock on sale for $10. Do you drive down to K-mart?

You are about to buy a $2510 laptop computer from the campus store when a friend tells you that K-mart has the same computer on sale for $2500. Do you drive down to K-mart?

Should you drive down to K-mart? B(x) = benefit of driving down to K-mart = $10 in both cases C(x) = cost of driving down to K-mart = the same amount in both cases. So your answer should be the same in both cases.

A rare disease will claim 600 lives if we do nothing A rare disease will claim 600 lives if we do nothing. We must choose between the following two programs: Program C: save 200 lives with certainty Program D: save 600 lives with probability 1/3, save zero lives with probability 2/3 Which program would you choose?

You have just arrived at the theater to buy your ticket and discover that you have lost a $20 bill from your wallet. Do you buy a ticket and see the play anyway?

You have just arrived at the theater and discover that you have lost the $20 ticket you purchased earlier that day. Do you buy another ticket and see the play anyway?

In both cases, you are $20 poorer than before. In both cases, the benefit of seeing the play, as measured by what you are willing to pay, may therefore be slightly smaller, but this benefit is the same in both cases. In both cases, the additional cost you must incur to see the play is exactly $20.

Normative VS Positive Economics Cost-Benefit principle is normative. People don’t always behave this way but it is quite useful for understanding behavior. Incentive Principle – An economic agent is more likely to take action if its benefits rise and less likely if its cost rise– incentives matter. This is a positive economics principle.