Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Thinking Like an Economist

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Costs Matter  Economists count costs  Someone must pay them  Scarcity is a fact of life  Never enough time,money, energy….  Economics is the study of how people make choices under conditions of scarcity and of the results of those choices for society

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Scarcity Principle  Because of scarcity  Tradeoffs are widespread  Having more of one good usually means having less of another  AKA the “No free lunch Principle”

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Everyone Faces Scarcity  Even Bill Gates faces scarcity  Should he pick up a $100 bill on the ground?  Someone once estimated that his time was so valuable picking up a $100 bill wouldn’t be worth his while  But, he only has 24 hours a day and a limited amount of energy  If he spends his time building his business empire, then he cannot use that time doing other things

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Cost-Benefit Principle  Take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs  Measuring the costs and benefits is often difficult  One may have to use assumptions

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide People Are Rational  Economists assume that people are rational--that they try to fulfill their goals as best they can

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Reservation Prices  The highest price one would be willing to pay for any good or service  It is equal to the benefit received from the good or service

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Economic Surplus  The benefit of taking an action minus its cost  Economic Surplus = Benefit - Cost  Rational decision makers take all actions that yield a positive economic surplus

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Opportunity Cost  Opportunity Cost: The value of the next-best alternative that must be forgone in order to undertake an activity  Decisions depend upon opportunity costs  It is not the combined value of all other forgone activities, just the next best one

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Example 1.1 Ironing Shirt  Suppose you have a dinner date and you need to choose between ironing a shirt (which will take 20 minutes) or doing other things  Do you iron your shirt?  A cost-benefit analysis says only if the benefits outweigh the costs

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Benefit of an Ironed Shirt  The benefit is estimated by the  Highest price you would be willing and able to pay to have it ironed  This is your reservation price for having an ironed shirt  Suppose the benefit of having an ironed shirt is $2.25

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Cost of an Ironed Shirt  The cost is estimated by the  Lowest price you would pay to avoid ironing your shirt  This is your reservation price for ironing the shirt  Suppose the cost of ironing the shirt is $2.00

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Solution to Example 1.1  The benefit of having an ironed shirt ($2.25) is greater than the cost of not having an ironed shirt ($2.00) [i.e., your economic surplus is $0.25]  You should iron your shirt  Suppose that the value of your alternatives change  Perhaps you have a test tomorrow and need the 20 minutes to study. In this case, your opportunity costs have changed and you may decided against ironing the shirt

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Role of Models  An “abstract model” is a simplified description capturing essential elements of a situation  It allows logical analysis  It includes only the major forces at work and will ignore many details  I.E., the cost-benefit principle is an abstract model of how an idealized individual would choose among competing alternatives

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Imperfect Decision Makers  Rational people will apply the cost- benefit principle using their intuition  However, people can make mistakes when weighing the costs and benefits  People often make inconsistent choices

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Example 1.6 Lost Theater Ticket  A theater tickets cost $10  You have at least $20 and want to see a play  Would you buy a theater ticket after losing a $10 bill?  Would you buy a second theater ticket after losing the first?

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Example 1.6 Lost Theater Ticket  Many people say that they would purchase the ticket after losing the $10 but would not purchase a second ticket after losing the first  This is inconsistent behavior since the financial loss is equivalent  The choice of whether to see the play depends upon whether seeing the play is worth spending $10

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Marginals  Marginal Benefit  The increase in total benefit that results from carrying out one additional unit of the activity  Marginal Cost  The increase in total cost that results from carrying out one additional unit of the activity

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig. 1.1 The Marginal Cost and Benefit of Additional RAM

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Optimal Level  If the marginal benefit is greater than marginal cost  Increase output  If the marginal benefit is less than the marginal cost  Decrease output  Optimal output is where marginal benefit equals marginal cost  MB = MC

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Micro and Macro  Microeconomics studies  Choices of individuals  Behavior of specific markets  Prices and quantities  Macroeconomics studies  Performance of national economies  Government policies to change performance  Unemployment rate and the price level

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Always Tradeoffs  The scope of macro and micro are different  However, both are trying to predict behavior that is based on scarcity  Clear thinking about economic problems will always account for tradeoffs--having more of one good thing usually means having less of another

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Philosophy of This Text  Focuses on deeply covering the core ideas of economics rather than covering many topics superficially  Encourages active learning--one must do economics in order to learn it  Uses examples, exercises, and applications  Encourages thinking critically when considering the problems  Encourages discussing interesting insights with friends

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Economic Naturalism  Using your insights from economics to make sense of observations from everyday life  Learning economic principles enables us to see the ordinary details of life in a new light  E.G., Look for differences in costs and benefits

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig. 1.2 Falling RAM Prices Increase the Optimal Amount of Memory

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig. 1.3 An Increase in the Marginal Benefit of RAM Increases the Optimal Amount of Memory