1 Frank & Bernanke 4 th edition, 2009 Ch. 1: Thinking Like an Economist video/us/2010/08/29/gps.far eeds.take.innovate.cnn

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3 ios/board/bernanke.htm ios/board/bernanke.htm

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9 Economics Is the Science of Rational Choice The best choice is the rational decision that includes all the costs and benefits of an action. The best choice is the rational decision that includes all the costs and benefits of an action. The rule-of-thumb is to compare the extra benefits of an action with extra costs. The rule-of-thumb is to compare the extra benefits of an action with extra costs.

10 Scarcity Principle Resources are scarce, therefore, costly. Resources are scarce, therefore, costly. If resources were infinite, there would have been no cost and decision-making (choosing) would have been simpler. If resources were infinite, there would have been no cost and decision-making (choosing) would have been simpler. TANSTAAFL: There-Ain’t-No-Such- Thing-As-A-Free-Lunch. TANSTAAFL: There-Ain’t-No-Such- Thing-As-A-Free-Lunch. What is scarce about Bill Gates? What is scarce about Bill Gates?

11 Measuring Benefits The amount of money you are willing to spend to obtain the item is the value you attach to it. The amount of money you are willing to spend to obtain the item is the value you attach to it. If you get the item for less than your “benefit” then you have an economic surplus. If you get the item for less than your “benefit” then you have an economic surplus. Suppose you are willing to pay at most $4 for breakfast and if someone else wanted you to prepare breakfast, you would charge $6. Suppose you are willing to pay at most $4 for breakfast and if someone else wanted you to prepare breakfast, you would charge $6.

12 Opportunity Cost Opportunity cost includes all explicit and implicit costs. Opportunity cost includes all explicit and implicit costs. The opportunity cost of preparing breakfast for you is the $6 you would charge. The opportunity cost of preparing breakfast for you is the $6 you would charge. If the opportunity cost exceeds the benefit, the rational decision is not to undertake the activity: find a place where they will give you breakfast for $4 or less. If the opportunity cost exceeds the benefit, the rational decision is not to undertake the activity: find a place where they will give you breakfast for $4 or less.

13 Reservation Price The highest amount you are willing to pay for something. The highest amount you are willing to pay for something. It measures the benefit you will get from this activity. It measures the benefit you will get from this activity. If reservation price is greater than what you have to pay, your benefit exceeds your cost. If reservation price is greater than what you have to pay, your benefit exceeds your cost.

14 Example 1 If you have an hour before your economics midterm but in order to study during that hour you have to skip your biology class, what is the rational thing to do? If you have an hour before your economics midterm but in order to study during that hour you have to skip your biology class, what is the rational thing to do? If the loss of biology grade is less than the gain in economics grade, skip class. If the loss of biology grade is less than the gain in economics grade, skip class.

15 Example 2 Bill has invited Joe to lunch and offered to pay. Should Joe accept? Bill has invited Joe to lunch and offered to pay. Should Joe accept? Not if the opportunity cost of lost time is greater than the benefit of having a “free lunch.” Not if the opportunity cost of lost time is greater than the benefit of having a “free lunch.”

16 Example 3 Why do you speed when you know the speeding ticket is costly? Why do you speed when you know the speeding ticket is costly? The probability of getting caught times the cost of the ticket is less than the perceived benefit of getting to the place earlier. The probability of getting caught times the cost of the ticket is less than the perceived benefit of getting to the place earlier.

17 Economic Surplus The difference between the value of benefit and the cost. The difference between the value of benefit and the cost. If there is an economic surplus, then it is rational to consider the action. If there is an economic surplus, then it is rational to consider the action. Why is it to the advantage of the seller to have an auction? Why is it to the advantage of the seller to have an auction?

18 People are Not Always Rational Which would you rather have? Which would you rather have? A discount of $100 on a $2000 plane ticket? A discount of $100 on a $2000 plane ticket? A discount of $90 on a $200 plane ticket? A discount of $90 on a $200 plane ticket? You bought a $30 ticket to a concert. Because you bought it, the benefit must be worth more than $30. You bought a $30 ticket to a concert. Because you bought it, the benefit must be worth more than $30. Would you buy another ticket if you lose your original ticket? Would you buy another ticket if you lose your original ticket? Would you go to the concert if you lose $30 from your wallet? Would you go to the concert if you lose $30 from your wallet?

19 Importance of Marginal Decisions need to be made on the basis of what you expect to get and what you have to pay: MB vs. MC. Decisions need to be made on the basis of what you expect to get and what you have to pay: MB vs. MC. What is spent before is immaterial for your immediate decision. What is spent before is immaterial for your immediate decision.