Thinking Like an Economist Chapter 1 ©McGraw-Hill Education. All rights reserved.

Learning Objectives Explain and apply the Scarcity Principle Explain and apply the Cost-Benefit Principle Discuss three important pitfalls that occur when applying the Cost-Benefit Principle inconsistently Explain and apply the Incentive Principle ©McGraw-Hill Education. All rights reserved.

Economics: Studying Choice In a World of Scarcity The Scarcity Principle Boundless wants cannot be satisfied with limited resources. Therefore, having more of one thing usually means having less of another. Because of scarcity we must make choices. Chapter 1: Thinking Like an Economist

Economics: Studying Choice In a World of Scarcity Wants vs. Resources Scarcity Choices Chapter 1: Thinking Like an Economist

The Scarcity Principle Economics: The study of how people make choices under scarcity and the results of these choices for society. The Scarcity Principle: People have unlimited wants and limited resources. Having more of one good means having less of another. Also called No Free-Lunch Principle ©McGraw-Hill Education. All rights reserved.

The Scarcity Principle: Examples Scarcity is involved in Global warming Political elections Career choices Buying bottled water ©McGraw-Hill Education. All rights reserved.

The Scarcity Principle: Examples Scarcity: Time is a valuable asset, too Should Bill Gates pick up a $100 bill while hurrying to a business meeting? Should a famous divorce lawyer write his own will? ©McGraw-Hill Education. All rights reserved.

The Cost-Benefit Principle Take an action if and only if the extra benefits are at least as great as the extra costs Costs and benefits are not just money Marginal Benefits Marginal Costs ©McGraw-Hill Education. All rights reserved.

Economics: Studying Choice In a World of Scarcity The study of how people make choices under conditions of scarcity and of the results of those choices for society. 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 Chapter 1: Thinking Like an Economist

Applying the Cost – Benefit Principle Assume people are rational A rational person has well defined goals and tries to fulfill those goals as best as she or he can Would you walk to town to save $10 on an item? Benefits are clear Costs are harder to define Hypothetical auction Would you walk to town if someone paid you $9? If you would walk to town for less than $10, you gain from buying the item in town ©McGraw-Hill Education. All rights reserved.

Cost – Benefit Principle Examples You clip grocery coupons but Bill and Melinda Gates do not You speed on the way to work but not on the way to school At the ball park, you pay extra to buy a soda from the hawkers in the stands You skip your regular dental check-up ©McGraw-Hill Education. All rights reserved.

Applying The Cost-Benefit Principle Rational Person Someone with well-defined goals who tries to fulfill those goals as best he or she can Constrained optimization Maximize benefit (minimize cost) within your means Chapter 1: Thinking Like an Economist

Applying The Cost-Benefit Principle Should you walk downtown to save $10 on a $25 computer game? The benefit of going downtown = $10 The cost of going downtown is the dollar value of everything you give up to go downtown Chapter 1: Thinking Like an Economist

Applying The Cost-Benefit Principle Should you walk downtown to save $10 on a $25 computer game? Estimating the cost How much could someone have to pay to walk downtown? If you would walk downtown for $9, the trip’s cost is $9. The benefit ($10) exceeds the cost of ($9) of buying the game downtown Chapter 1: Thinking Like an Economist

Economic Surplus The economic surplus of an action is equal to its benefit minus its costs Economic Surplus Total Benefits Total Costs ©McGraw-Hill Education. All rights reserved.

Applying The Cost-Benefit Principle Opportunity Cost The value of the next-best alternative that must be forgone to undertake an activity Example: How much is the total cost of your undergrad education? Explicit costs Implicit costs (opportunity cost) Chapter 1: Thinking Like an Economist

Applying The Cost-Benefit Principle Assume The benefit of buying the game downtown is $10 The cost of making the trip is $12 Questions What is your economic surplus from buying the game downtown? Where should you buy the game? Chapter 1: Thinking Like an Economist

Applying The Cost-Benefit Principle The Role of Economic Models Economic models are abstract constructs (simplified descriptions) that allow us to analyze situations in a logical way Other examples of abstract models A computer model of climate change A road map Chapter 1: Thinking Like an Economist

Opportunity Cost Opportunity cost is the value of what must be foregone in order to undertake an activity Consider explicit and implicit costs Examples: Give up an hour of babysitting to go to the movies Give up watching TV to walk to town Caution: NOT the combined value of all possible activities Opportunity cost considers only your best alternative ©McGraw-Hill Education. All rights reserved.

Economic Models Simplifying assumptions Which aspects of the decision are absolutely essential? Which aspects are irrelevant? Abstract representation of key relationships The Cost-Benefit Principle is a model If costs of an action increase, the action is less likely If benefits of an action increase, the action is more likely ©McGraw-Hill Education. All rights reserved.

Economic Models Assumptions (Hypotheses) Theory Model Testing your model

Three Decision Pitfalls Economic analysis predicts likely behavior Three general cases of mistakes Measuring costs and benefits as proportions instead of absolute amounts Ignoring implicit costs Failure to think at the margin ©McGraw-Hill Education. All rights reserved.

Pitfall #1 Action Marginal Costs Marginal Benefits Measuring costs and benefits as proportions instead of absolute amount Would you walk to town to save $10 on a $25 item? Would you walk to town to save $10 on a $2,500 item? ©McGraw-Hill Education. All rights reserved.

Pitfall #2 Ignoring implicit costs Consider your alternatives The value of a Frequent Flyer coupon depends on its next best use Expiration date Do you have time for another trip? Cost of the next best trip Explicit Costs Implicit Costs Opportunity Cost ©McGraw-Hill Education. All rights reserved.

Pitfall #3 Marginal Benefits Marginal Costs Failure to think at the margin Sunk costs cannot be recovered Examples: Eating at an all-you-can-eat restaurant Attend a second year of law school Marginal Benefits Marginal Costs ©McGraw-Hill Education. All rights reserved.

Pitfall #4 Pitfall 4: Failure To Understand the Average-Marginal Distinction Marginal Benefit The increase in total benefit that results from carrying out one additional unit of an activity Chapter 1: Thinking Like an Economist

Pitfall #4 Pitfall 4: Failure To Understand the Average-Marginal Distinction Marginal Cost The increase in total cost that results from carrying out one additional unit of an activity Chapter 1: Thinking Like an Economist

Pitfall #4 Pitfall 4: Failure To Understand the Average-Marginal Distinction Average Cost The total cost of undertaking q units of an activity divided by q Chapter 1: Thinking Like an Economist

Pitfall #4 Pitfall 4: Failure To Understand the Average-Marginal Distinction Average Benefit The total benefit of undertaking n units of an activity divided by n Chapter 1: Thinking Like an Economist

Average and Marginal Quantities (1) Average quantity falls if marginal quantity is smaller than average Average quantity increases if marginal quantity is larger than average Average Marginal q A(q) M(q)

Average and Marginal Quantities (2) Total Average Marginal 1 100 .. 2 180 90 80 3 210 70 30 4 220 55 10 5 230 46 6 300 50 7 420 60 120 8 640

Pitfall 4: Failure To Understand the Average-Marginal Distinction Example Should NASA expand the space shuttle program from four launches per year to five? Benefits $24 billion (average of $6 billion/launch) Costs $20 billion (average of $5 billion/launch) Chapter 1: Thinking Like an Economist

Assume: Average Benefit = Marginal Benefit = $6 billion Pitfall #4 Total Cost Average Cost # of Launches ($ billion) ($ billion/launch) Marginal Cost 0 0 0 0 1 3 3 3 2 7 3.5 4 3 12 4 5 4 20 5 8 5 32 6.4 12 Assume: Average Benefit = Marginal Benefit = $6 billion What is the optimal number of launches? Chapter 1: Thinking Like an Economist

Marginal Analysis Ideas Marginal cost is the increase in total cost from one additional unit of an activity Average cost is total cost divided by the number of units Marginal benefit is the increase in total benefit from one additional unit of an activity Average benefit is total benefit divided by the number of units ©McGraw-Hill Education. All rights reserved.

Marginal Analysis: NASA Space Shuttle # of Launches Total Cost ($B) $0 1 $3 2 $7 3 $12 4 $20 5 $32 Marginal Cost ($B) $3 $4 $5 $8 $12 Average Cost ($B/launch) $0 $3 $3.5 $4 $5 $6.4 If the marginal benefit is $6 billion per launch, how many launches should NASA make? ©McGraw-Hill Education. All rights reserved.

Marginal Benefit Marginal benefit is the increase in total benefit from one additional unit of an activity ©McGraw-Hill Education. All rights reserved.

Average Benefit Average benefit is total benefit divided by the number of units ©McGraw-Hill Education. All rights reserved.

Marginal Analysis Marginal cost is the increase in total cost from one additional unit of an activity ©McGraw-Hill Education. All rights reserved.

Marginal Analysis Average cost is total cost divided by the number of units ©McGraw-Hill Education. All rights reserved.

Normative and Positive Economics Normative economic principle says how people should behave Gas prices are too high Building a space base on the moon will cost too much Positive economic principle predicts how people will behave The average price of gasoline in May 2010 was higher than in May 2009 Building a space base on the moon will cost more than the shuttle program ©McGraw-Hill Education. All rights reserved.

Incentives are central to people's choices Incentive Principle Incentives are central to people's choices Benefits Actions are more likely to be taken if their benefits rise Costs Actions are less likely to be taken if their costs rise ©McGraw-Hill Education. All rights reserved.

Microeconomics and Macroeconomics Microeconomics studies choice and its implications for price and quantity in individual markets Sugar Carpets House cleaning services Microeconomics considers topics such as Costs of production Demand for a product Exchange rates Macroeconomics studies the performance of national economies and the policies that governments use to try to improve that performance Inflation Unemployment Growth Macroeconomics considers Monetary policy Deficits Tax policy ©McGraw-Hill Education. All rights reserved.

Economics Is Choosing Focus in this course is on a short list of powerful ideas Explain many economic issues Predict decisions made in a variety of circumstances Core Principles are the foundation for solving economic problems ©McGraw-Hill Education. All rights reserved.

Economics Is Everywhere There are many things that economics can help to explain Economic Naturalist topics Why is expensive software bundled with PCs? Why can't you buy a car without heaters Drive-up ATMs with Braille ©McGraw-Hill Education. All rights reserved.

©McGraw-Hill Education. All rights reserved.