McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist 1.Explain and apply the Scarcity Principle 2.Explain and apply the Cost-Benefit Principle 3.Explain and apply the Incentive Principle 4.Discuss the pitfall of measuring costs and benefits as proportions rather than as absolute dollar amounts 5.Discuss the pitfall of ignoring implicit costs 6.Discuss the pitfall of failing to weigh costs and benefits at the margin

1-2 The Scarcity Principle Economics: The study of how people make choices under scarcity and the results of these choices for society. The Scarcity Principle: People have unlimited wants and limited resources. Having more of one good means having less of another. Also called No Free-Lunch Principle

1-3 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 Economic Surplus The economic surplus of an action is equal to its benefit minus its costs Economic Surplus Total Benefits Total Costs

1-5 Opportunity Cost Opportunity cost is 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 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 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 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 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 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 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 Normative and Positive Economics –Normative economic principle says how people should behave Gas prices are too high Building a space base on the moon will cost too much –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

1-13 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 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 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