Chapter 1: The Scope and Method of Economics

Chapter 1 Objectives: Upon completion of this chapter, you should understand and be able to answer these key questions: 1. Why study economics? 2. What are opportunity costs and how do they differ from sunk costs? 3. What does it mean to say that there’s “no free lunch?” 4. What’s the difference between positive and normative questions? 5. What are some logical pitfalls that often get in the way of clear thinking about important questions?

To Learn a Way of Thinking Probably the most important reason for studying economics is to learn a way of thinking. A good way to introduce economics is to review three of its most fundamental concepts: opportunity cost, marginalism, and efficient markets. If your study of economics is successful, you will use these concepts every day in making decisions. You will be a: Better problem solver More critical thinker More informed voter More successful person Source: Case & Fair, Principles of Microeconomics

While there is no doubt that luck, both good and bad, plays a role in determining the success of firms, we believe that success is often no accident. We believe that we can better understand why firms succeed or fail when we analyze decision making in terms of consistent principles of market economics and strategic action. Besanko, et. al Economics of Strategy (2 nd )

Key Concepts (*  elaborated on in lecture) 1. Cartesian coordinate system and graphs* 2. Criteria for evaluating economic results a. Economic growthc.Equity b. Efficiencyd.Stability 3. Criteria for evaluating economic choices (or making decisions or solving problems) a. Opportunity cost* b. ‘Marginalism’ and sunk costs* c. Efficient markets*

Key Concepts (cont’d) 4. Economics* 5. Errors or cautions in logic or reasoning* a. Post hoc b. Fallacy of composition c. Ceteris paribus d. Correlation vs. causality 6. Macroeconomics vs. microeconomics* 7. Models, theories, and variables 8. Normative vs. positive economics 9. Negative vs. positive slopes*

Economics is a social science that studies how people, either individually or collectively, make choices to use scarce resources. Q.Explain further or define each of the underlined words above.

People  consumers, workers, gov’t officials Choices  consumption, production, exchange, policies Scarce  limited Resources  natural (e.g. land, water) capital (man-made bldgs & equip) labor managerial skills financial (i.e. money) time A.

Accounting Costs Out-of-pocket costs or costs as an accountant would define them. Sometimes referred to as explicit costs.

Opportunity Costs The best alternative that we forgo, or give up, when we make a choice or a decision. These are noncash or implicit costs.

Economic Costs Costs that include both explicit costs and the full opportunity costs (implicit costs) of all inputs.

Sunk Costs Costs that cannot be avoided, regardless of what is done in the future, because they have already been incurred.

Total Fixed Costs Costs that do not depend on the quantity of output produced. These must be paid even if output is zero.

Total variable costs Costs that vary with the level of output.

Total Cost The total economic cost of all the inputs used.

Opportunity Cost Examples of 1. A student skipping Dr. Deiter’s Econ class? 2. Going to college versus entering the work place? 3. An investor waiting a year to sell some property versus selling now? 4. A business firm buys some new machinery?

Thought of the Day “There is no such thing as a ‘free’ lunch.” - Milton Friedman

Evaluating Choices Economists are noted for evaluating choices or alternatives by identifying and quantifying the associated benefits and costs. Economists are also noted for emphasizing marginal (or incremental or additional) benefits and costs in choosing among alternatives.

Marginal Analysis Marginal => additional, incremental changes Often involves analyzing how changes in one variable will change/impact another variable Two components of analysis: 1. Direction of change(s) and 2. Magnitude of change(s)

Joe lives in Houston and is traveling to Kansas City on business. What is the ‘marginal’ cost to Joe of visiting his grandmother who lives in Des Moines by extending his trip one more day? Marginal Analysis Example #1

Marginal Analysis Example #2 Why does an airline sometimes set aside a few seats to be sold at big discounts through pricline.com or other Web sites?

Sue has been asked by her boss to attend a business meeting 125 miles away by either renting a car for $50 (fuel costs not included) or by driving a company-owned car. Her boss has asked her to choose the cheapest form of transportation for the company. Identify marginal and sunk costs of driving the company car. Marginal Analysis Example #3

Q.What is the favorite bumper sticker of most economists? A.Economists Do It ‘Marginally’

Examples of Marginal Analysis Questions Typically of Interest to Firm Managers (TR = total revenue, TC = total cost) What will happen to: 1. Our TR if we sell 1 more unit of product? 2. Our TC if we sell 1 more unit of product? 3. Our profit if we sell 1 more unit of product? 4. Our production if we hire 1 more unit of labor? 5. Our TC if we hire 1 more unit of labor? 6. Our TR if our main competitor lowers the price of their product by $1?

“Good” Economic Decisions  Marginal benefits > marginal costs Examples of marginal benefits:  profit  revenue  cost  safety  risk Marginal costs = opposite of above examples

‘Efficient’ markets (or situations) implies unequal ‘costs’ or ‘profits’ associated with alternatives are eliminated as people respond to incentives (e.g. profit, risk, time savings, price, money, etc.) Examples: Drive-through lanes at a bank Local gas station making ‘excessive’ profits Business firm producing a product out of two plants

Cautions in analyzing variable relationships Caution #1. Ceteris paribus  hold all relevant explanatory variables EXCEPT one constant e.g. # miles driven depends on price of gasoline, ceteris paribus

Caution #2. Post hoc fallacy  falsely assuming a first event caused second event e.g. price of gasoline decrease caused the stock market to decrease Cautions in analyzing variable relationships

Caution #3. Correlation does not imply causality e.g. the number of cars and number of crimes in cities are positively correlated; thus, cars cause crimes Cautions in analyzing variable relationships

Caution #4. Fallacy of composition  what is good for one is not necessarily good for all e.g. one person vs. everybody standing up to get a better view at a sporting event Cautions in analyzing variable relationships

Equation of a straight line where: y=vertical axis variable x=horizontal axis variable  Y=b + mx where b = vertical-axis intercept (value of y when x = 0) m = slope = Δy/Δx =

The slope (m) of a line has two components: 1. Sign >0  y and x  (or  ) together  positive correlation 2. Number (or magnitude) which shows amount y is expected to change for each 1 unit change in x

‘Slope’ and Marginal Analysis The ‘marginal’ or incremental change in Y as a result of a 1 unit change in X is given by the ‘slope’ at that point of the line or curve connecting paired observations of Y and X. e.g. ΔY/ΔX = +6/+3 = +2/+1 = +1/+.5  A +1 unit ΔX results in a +2 unit ΔY or => a +1 unit ΔY results in a +.5 unit ΔX Note: the ‘ratio’ of the changes is 2 to 1

Given any 2 points, one can calculate the actual equation of a straight line: Step #1) Step #2)

“Economics is the most quantitative of the social sciences.” - Karl Case & Ray Fair Prin. Of Microeconomics, 7 th ed.