McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 1 Thinking Like an Economist

1-2LO 1 - All Learning Objectives: Understand 1.The Scarcity Principle: having more of any good thing necessarily requires having less of something else 2.The Cost-Benefit Principle: an action should be taken if and only if its benefit is at least as great as its costs 3.The Incentive Principle: examine people's incentives to predict their behavior 4.Three pitfalls in reasoning 1.Measuring costs and benefits as proportions instead of as dollar amounts 2.Ignoring implicit costs 3.Failing to weigh costs and benefits at the margin

1-3LO The Scarcity Principle Economics: The study of choices and results under scarcity The Scarcity Principle: Unlimited wants and limited resources means having more of one good means having less of another. Also called No Free-Lunch Principle

1-4LO The Scarcity Principle: Examples Scarcity is involved in Global warming Political elections Career choices Buying bottled water

1-5LO 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

1-6LO Cost – Benefit Example  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

1-7LO 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

1-8LO Economic Surplus  Benefit of an action minus its costs Economic Surplus Total Benefits Total Costs

1-9LO Opportunity Cost  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

1-10LO 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

1-11LO 1 – 4, 5, 6 Three Decision Pitfalls  Economic analysis predicts likely behavior  Three general cases of mistakes 1.Measuring costs and benefits as proportions instead of absolute amounts 2.Ignoring implicit costs 3.Failure to think at the margin

1-12LO Pitfall #1  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? Action Marginal Costs Marginal Benefits

1-13LO 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

1-14LO Pitfall #3  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

1-15LO - 6 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

1-16LO - 6 Marginal Analysis: NASA Space Shuttle # of Launches Total Cost ($B) 0$0 1$3 2$7 3$12 4$20 5$32  If the marginal benefit is $6 billion per launch, how many launches should NASA make? Average Cost ($B/launch) $0 $3 $3.5 $4 $5 $6.4 Marginal Cost ($B) $3 $4 $5 $8 $12

1-17LO 1 - All Normative and Positive Economics  Normative economic statements say how people should behave  Gas prices are too high  Building a space base on the moon will cost too much  Positive economic statements predict 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

1-18LO 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

1-19LO 1 - All 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

1-20LO 1 - All 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

1-21LO 1 - All 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/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 1 Appendix Working with Equations, Graphs, and Tables

1-23LO 1 - All Definitions  Equation  Variable  Dependent variable  Independent variable  Parameter (constant)  Slope  Intercept

1-24LO - 5 From Words to an Equation  Identify the variables  Calculate the parameters  Slope  Intercept  Write the equation  Example: Phone bill is $5 per month plus 10 cents per minute B = T

1-25LO 1 - All B = T  Draw and label axes  Horizontal is independent variable  Vertical is dependent variable  To graph,  Plot the intercept  Plot one other point  Connect the points From Equation to Graph T B 5 6 A C D

1-26LO 1 - All From Graph to Equation  Identify variables  Independent  Dependent  Identify parameters  Intercept  Slope  Write the equation B = T

1-27LO 1 - All Changes in the Intercept  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

1-28LO 1 - All Changes in the Slope  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

1-29LO 1 - All From Table to Graph  Identify variables  Independent  Dependent  Label axes  Plot points  Connect points Time (minutes/month) Bill ($/month) $10.50$11.00$11.50$12.00

1-30LO 1 - All From Table to Equation  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 T 12 = f (40) = f + 2 f = 12 – 2 = 10 B = T Time (minutes/month) Bill ($/month) $10.50$11.00$11.50$12.00

1-31LO 1 - All 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?

1-32LO - 5  Plan 1B = T  Plan 2B = T  Plan 1 has higher per minute price while Plan 2 has a higher monthly fee  Find B and T for point A Simultaneous Equations

1-33LO  Find B when T = 500 B = T B = (500) B = $30 OR B = T B = (500) B = $30 Simultaneous Equations  Plan 1B = T  Plan 2B = T  Subtract Plan 2 equation from Plan 1 and solve for T B = T – B = – 20 – 0.02 T 0 = – T T = 500