1-1 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 1 - All Chapter 1: Thinking Like an Economist 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

1-2 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-3 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-4 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Economic Surplus Benefit of an action minus its costs Economic Surplus Total Benefits Total Costs

1-5 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-6 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-7 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-8 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-9 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-10 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-11 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO - 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

1-12 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-13 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-14 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

1-15 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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