Thinking Like an Economist CHAPTER 1 Thinking Like an Economist OUTLINE 1.Scarcity and Choice 2.The Cost Benefit Approach to Decisions 3.The Role of Economic Theory 4.Positive Questions and Normative Questions 5.Microeconomics and Macroeconomics 1-1

THE FLOW-CHART OFMICROECONOMICS A view of the "forest"_ the course seen as a whole but beware of getting lost is in the "trees" of individual topics ¾ of the course ¼ of the course

The Rational Choice Model It is important to stress at least three very important assumptions of the rational choice model. a. Behavior is not random. b. People have reasonably simple objectives common to most. c. People behave rationally without regard to emotions that detract from rationality. Where these givens are not present, the rational choice models will fail. For example, the risk aversion assumption underlying rational choice theory, uncommon objectives , irrationality are not as rare as we may sometimes think.

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

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

Applying the Cost – Benefit Principle Assume people are rational A rational person has well defined goals and tries to fulfill those goals as best they can Would you walk to town to save $10 on an item? Benefits are clear Costs are harder to define

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

Should there be 32 separate sections of Econ 100B, with 25 students each?--- Trinity University, San Antonio, Texas **Students learn more effectively in smaller classes. **But smaller classes are also more expensive.

Or should there be only one section, with 800 students Or should there be only one section, with 800 students?- University of Texas @Austin: Note 32x25 = 800

Cost-Benefit Analysis (CBA) Should I do activity x? C(x) = the costs of doing x or value of resources one needs to give up to do x. B(x) = the benefits of doing x If B(x) > C(x), do x; otherwise don't. 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 Let the Faculty salary: $60,000 per course Per student faculty salary cost: 1 section: $60,000/800 = $75—large class 32 sections: $60,000/25 = $2400-small class Benefit (to the university) of increasing class size from 25 students to 800 students = ($2400 - $75) = $2,325 = 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 800 students? = C(x) If C(x) < B(x)=$2,325, then it makes sense to offer the larger class.

The Cost-Benefit Principle 1. 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. 2. Critics of the cost-benefit approach often object that people don’t really calculate costs and benefits when deciding what to do 3. People often behave as if they were comparing the relevant costs and benefits

People often make bad decisions because they fail to compare the relevant costs and benefits “The Budweiser “or “Corona “Walk

Example 1.8. How much memory should your computer have? Suppose that random access memory (RAM)can be added to your computer at a cost of $0.50 per megabyte. How many megabytes of memory should you purchase? "Should I do X?" "How much X should I buy?" "Should I buy an additional unit of X?"

Cost-Benefit principle Rule: a. Buy an additional megabyte if the marginal benefit of RAM is at least as great as its marginal cost, i.e. MB ≥MC b. Do not buy an additional megabyte if the marginal benefit of RAM is less than its marginal cost, i.e. MB < MC c. You are indifferent if the marginal benefit of RAM equivalent to its marginal cost, i.e. MB ≈ MC where Marginal benefit (MB)= added benefit from having 1 more unit Marginal cost (MC)= added cost of having 1 more unit

Optimal amount of memory

Power Point Slides: Chapters 1-4 for now http://www.csus.edu/dev/managed/College-of-SSIS/econ/faculty/faculty%20webpages/Professors/dube1.html

Marginal Analysis Ideas Marginal cost is the increase in total cost from one additional unit of an activity (q) MC =∆TC/∆q Average cost is total cost divided by the number of units, AC= TC/q Marginal benefit is the increase in total benefit from one additional unit of an activity MB =∆TB/∆q Average benefit is total benefit divided by the number of units, AB = TB/q

Normative and Positive Economics Positive economic principle predicts how people will behave The average price of gasoline in May 2008 was higher than in May 2007 Building a space base on the moon will cost more than the shuttle program Normative economic principle says how people should behave Gas prices are too high Building a space base on the moon will cost too much

Working with Equations, Graphs, and Tables Definitions Equation Variable Dependent variable Independent variable Parameter (constant) Slope Intercept

From Words to an Equation Identify the variables Calculate the parameters Slope Intercept Write the equation (B) Example: Phone bill is $5 per month plus 10 cents per minute (T =time) B = $5 +$0.10 T

From Equation to Graph B = 5 + 0.10 T Draw and label axes To graph, Horizontal is independent variable =T Vertical is dependent variable =B To graph, Plot the intercept (T=0; B=5) Plot one other point(T=30; B=8) Connect the points (0,5) and (30,8) T B 5 6 A C D 12 8 10 30 70

From Graph to Equation Identify variables Independent (T) Dependent (B) Identify parameters Intercept (=4 if T=0) Slope (4/20=0.2) Thus, we can write the equation as: B = 4 + 0.2 T

Changes in the Intercept (from 4 to 8) An increase in the intercept shifts the curve up Slope is unchanged Caused by an increase in the monthly fee A decrease in the intercept shifts the curve down Slope is unchanged

Changes in the Slope (from 4/20=0.2 to 8/20=0.4) An increase in the slope makes the curve steeper Intercept is unchanged Caused by an increase in the per minute fee A decrease in the slope makes the curve flatter Intercept is unchanged

Time =T (minutes/month) From Table to Graph Time =T (minutes/month) 10 20 30 40 Bill ($/month) =B $10.50 $11.00 $11.50 $12.00 Identify variables Independent Dependent Label axes Plot points Connect points From Graph to Equation: is B= 10 + 0.05T

From Table to Equation Time (minutes/month) 10 20 30 40 Bill ($/month) B= f + bT Time (minutes/month) 10 20 30 40 Bill ($/month) $10.50 $11.00 $11.50 $12.00 Identify independent and dependent variables Calculate slope Slope = (11.5 – 10.5) / (30 – 10) = 1/20 = 0.05 Solve for intercept, f, using any point B = f + 0.05 T; At B =12 and T=40 12 = f + 0.05 (40) = f + 2 f = 12 – 2 = 10 B = 10 + 0.05 T

Simultaneous Equations Two equations, two unknowns Solving the equations gives the values of the variables where the two equations intersect Value of the independent and dependent variables are the same in each equation Example Two billing plans for phone service How many minutes make the two plans cost the same?

Simultaneous Equations Plan 1 B = 10 + 0.04 T Plan 2 B = 20 + 0.02 T Plan 1 has higher per minute price ($0.04) while Plan 2 has a higher monthly fee ($20) Find B and T for point A

Simultaneous Equations Plan 1 B = 10 + 0.04 T Plan 2 B = 20 + 0.02 T Subtract Plan 2 equation from Plan 1 and solve for T B = 10 + 0.04 T – B = – 20 – 0.02 T 0 = – 10 + 0.02 T T = 500 Find B when T = 500 B = 10 + 0.04 T B = 10 + 0.04 (500) B = $30 OR B = 20 + 0.02 T B = 20 + 0.02 (500)