1. MBMC Thinking Like An Economist

2. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 2 Introduction What is the Optimal Class Size? To maximize learning without consideration of cost? How would considering costs change our answer?  A personal tutorial course in economics might cost $40,000  A class of 300 students might cost $200/student

3. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 3 Introduction What is the Optimal Class Size? What trade-offs must university administrators and students consider when choosing class size?

4. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 4 Economics: Studying Choice In a World of Scarcity The Scarcity Principle Boundless wants cannot be satisfied with limited resources. Therefore, having more of one thing usually means having less of another. Because of scarcity we must make choices.

5. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 5 Economics: Studying Choice In a World of Scarcity Wants vs. Resources ScarcityChoices

6. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 6 Economics: Studying Choice In a World of Scarcity Economics The study of how people make choices under conditions of scarcity and of the results of those choices for society.

7. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 7 Economics: Studying Choice In a World of Scarcity The Cost-Benefit Principle An individual (or a firm or a society) should take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs

8. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 8 Economics: Studying Choice In a World of Scarcity Choosing the Optimal Class Size Revisited Assumptions:  Two class sizes: 100 and 20  Introductory economics classes currently have 100 students Question  Should the class size be reduced to 20 students?

9. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 9 Economics: Studying Choice In a World of Scarcity Observations The “best” class from an economic point of view will generally not be the same as the “best” size from the point of view of an educational psychologist. People will feel differently about the value of smaller classes.

10. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 10 Economics: Studying Choice In a World of Scarcity Application What other examples of scarcity and trade-offs can we identify?

11. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 11 Economics: Studying Choice In a World of Scarcity Choosing the Optimal Class Size Assume:  The cost of a class with 20 students is $1,000 per student more than a class of 100 students What do you think:  Would it be a good idea to reduce the class size?

12. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 12 Applying The Cost-Benefit Principle Rational Person Someone with well-defined goals who tries to fulfill those goals as best he or she can

13. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 13 Applying The Cost-Benefit Principle Should you walk downtown to save $10 on a $25 computer game? The benefit of going downtown = $10 The cost of going downtown is the dollar value of everything you give up to go downtown

14. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 14 Applying The Cost-Benefit Principle Should you walk downtown to save $10 on a $25 computer game? Estimating the cost:  How much would someone have to pay you to walk downtown?  If you would walk downtown for $9; the trip’s cost is $9 The benefit ($10) exceeds the cost of ($9) of buying the game downtown

15. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 15 Applying The Cost-Benefit Principle Question Will everyone choose to buy the computer game downtown?

16. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 16 Applying The Cost-Benefit Principle Economic Surplus The benefit of taking any action minus its cost The goal of economic decision makers is to maximize their economic surplus

17. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 17 Applying The Cost-Benefit Principle Opportunity Cost The value of the next-best alternative that must be forgone to undertake an activity

18. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 18 Applying The Cost-Benefit Principle Question What is the opportunity cost of buying the game downtown?

19. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 19 Applying The Cost-Benefit Principle Assume The benefit of buying the game downtown is $10 The cost of making the trip is $12 Questions What is your economic surplus from buying the game downtown? Where should you buy the game?

20. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 20 Applying The Cost-Benefit Principle The Role of Economic Models Economic models are abstract (simplified descriptions) models that allow us to analyze situations in a logical way Other examples of abstract models  A computer model of climate change  A road map

21. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 21 Applying The Cost-Benefit Principle Observation The cost-benefit principle suggests that we take only those actions that create additional economic surplus.

22. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 22 Four Important Decision Pitfalls Pitfall 1: Measuring cost and benefits as proportions rather than absolute dollar amounts Examples: Should you walk downtown to save $10 on a $2,020 laptop computer? Which is more valuable, saving $100 on a $2,000 plane ticket to Tokyo or saving $90 on a $200 plane ticket to Chicago?

23. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 23 Four Important Decision Pitfalls Pitfall 2: Ignoring Opportunity Costs Example:  Should you use your frequent-flyer coupon to fly to Fort Lauderdale for spring break? Assume:  Round trip airfare is $500 and is equal to your frequent flyer coupon  Other costs equal $1,000

24. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 24 Four Important Decision Pitfalls Pitfall 2: Ignoring Opportunity Costs Assume (cont):  The most you are willing to pay for the Fort Lauderdale trip is $1,350  Alternate use for the frequent flyer coupon is to attend a wedding in Boston the week after spring break and the Boston airfare is $400 (coupon expires just after the wedding)

25. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 25 Four Important Decision Pitfalls Pitfall 2: Ignoring Opportunity Costs Example:  Should you use your frequent flyer coupon to fly to Fort Lauderdale for spring break? Without the coupon:  Benefits = $1,350  Cost = $1,400 ($400 opportunity cost + $1,000 other costs) Question  What would you do if the coupon expires just after spring break?

26. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 26 Four Important Decision Pitfalls Pitfall 2: Ignoring Opportunity Costs The key to using the concept of opportunity cost correctly lies in recognizing precisely what taking a given action prevents us from doing.

27. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 27 Four Important Decision Pitfalls Pitfall 3: Failure To Ignore Sunk Costs The only costs that should influence a decision about whether to take an action are those that we can avoid by not taking the action

28. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 28 Four Important Decision Pitfalls Pitfall 3: Failure To Ignore Sunk Costs Sunk cost  A cost that is beyond recovery at the moment a decision must be made

29. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 29 Four Important Decision Pitfalls Pitfall 3: Failure To Ignore Sunk Costs Example  How much should you eat at an all-you-can-eat restaurant? Assume:  Price = $5  20 randomly selected guests will get lunch on the house

30. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 30 Four Important Decision Pitfalls Pitfall 3: Failure To Ignore Sunk Costs Example  How much should you eat at an all-you-can-eat restaurant? Question:  If all diners are rational, will there be any difference in the average quantity of food consumed by these two groups?

31. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 31 Four Important Decision Pitfalls Pitfall 4: Failure To Understand the Average-Marginal Distinction Marginal Benefit  The increase in total benefit that results from carrying out one additional unit of an activity

32. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 32 Four Important Decision Pitfalls Pitfall 4: Failure To Understand the Average-Marginal Distinction Marginal Cost  The increase in total cost that results from carrying out one additional unit of an activity

33. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 33 Four Important Decision Pitfalls Pitfall 4: Failure To Understand the Average-Marginal Distinction Example  Should NASA expand the space shuttle program from four launches per year to five?  Benefits o$24 billion (average of $6 billion/launch)  Costs o$20 billion (average of $5 billion/launch)

34. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 34 Four Important Decision Pitfalls Pitfall 4: Failure To Understand the Average-Marginal Distinction Average Cost  The total cost of undertaking n units of an activity divided by n

35. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 35 Four Important Decision Pitfalls Pitfall 4: Failure To Understand the Average-Marginal Distinction Average Benefit  The total benefit of undertaking n units of an activity divided by n

36. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 36 Four Important Decision Pitfalls # of Launches Total Cost Average Cost Marginal Cost ($ billion) ($ billion/launch)($ billion/launch) What is the optimal number of launches? 000 133 273.5 3124 4205 5326.4 Assume: Average Benefit = Marginal Benefit = $6 billion 3 4 5 8 12

37. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 37 Normative Economics vs. Positive Economics Normative Economic Principle One that says how people should behave  Example: Cost-benefit principle Positive Economic Principle One that predicts how people will behave  Example: The incentives matter principle oA person (or a firm or society) is more likely to take an action if its benefit rises and less likely if its cost rises)

38. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 38 Economics: Micro and Macro Microeconomics The study of individual choice under scarcity and its implications for the behavior of prices and quantities in individual markets

39. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 39 Economics: Micro and Macro Macroeconomics The study of the performance of national economies, and of the policies that governments use to try to improve that performance

40. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 40 The Approach of This Text Focus on core economic concepts Scarcity principle Cost-benefit principle Incentive principle Learning economics through applications

41. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 41 Economic Naturalism Using insights from economics to help make sense of observations from everyday life

42. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 42 Economic Naturalism Question Why do so many computer hardware manufacturers include more than $1,000 worth of “free” software with a computer selling for only slightly more than that?

43. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 43 Economic Naturalism Questions Why don’t automobile manufacturers make cars without heaters? Why do the keypad buttons on drive-up automatic teller machines have Braille dots?

44. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1: Thinking Like an Economist Slide 44 Economic Naturalism Applications Use cost-benefit analysis to explain some pattern of events or behavior you have observed in your own environment

45. MBMC End of Chapter End of Chapter