Thinking Like An Economist

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Thinking LikeAn Economist
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Introduction

• Example Accommodation
• May prefer peace and quiet, but houses are
  expensive, e.g. house rent for 1,000/mo.
• Choices
• a) have one housemate and pay 500/mo
• b) have four housemates and pay 200/mo.

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Introduction

• What is the Optimal Choice?
• Option a) benefits less noise
• cost more expensive
• Option b) benefits cheaper
• cost no peace

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Economics StudyingChoice 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.

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Economics StudyingChoice In a World of
Scarcity

• Wants vs. Resources

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Economics StudyingChoice 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.

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Economics StudyingChoice 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

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Applying The Cost-Benefit Principle

• Should you go to the mall to save 5 on a 20
  computer game?
• The benefit of going to the mall 5
• The cost of going to the mall is the dollar value
  of everything you give up to go to the mall

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Applying The Cost-Benefit Principle
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Applying The Cost-Benefit Principle

• Rational Person
• Someone with well-defined goals who tries to
  fulfill those goals as best he or she can
• -A firm seeks to maximize long-term profits
• -An individual seeks comfort, acceptance, and
  tranquility
• -A college student seeks good grades plus an
  interesting and meaningful college experience.

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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

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Applying The Cost-Benefit Principle

• Opportunity Cost
• The value of the next-best alternative that must
  be forgone to undertake an activity

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Applying The Cost-Benefit Principle

• Observation
• The cost-benefit principle suggests that we take
  only those actions that create additional
  economic surplus.

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Four Important Decision Pitfalls

• Pitfall 1 Measuring cost and benefits as
  proportions rather than absolute dollar amounts
• Examples
• Should you go to the mall to save 5 on a 800
  digital camera?

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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

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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)

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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?
• With 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?

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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

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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

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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

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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?

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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

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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

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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

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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

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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
• 24 billion (average of 6 billion/launch)
• Costs
• 20 billion (average of 5 billion/launch)

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Four Important Decision Pitfalls
of Launches Total Cost Average
Cost Marginal Cost
( billion) ( billion/launch) (
billion/launch)
What is the optimal number of launches?
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Normative Economicsvs. 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
• At the present time, about 13 of the U.S.
  population lives on incomes below the poverty
  level (positive). Congress should pass
  legislation to reduce that to 8 (normative).

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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

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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

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Economic Naturalism

• Using insights from economics to help make sense
  of observations from everyday life

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Economic Naturalism

• Question
• Why do brides spend so much money on wedding
  dresses, while grooms often rent cheap tuxedos,
  even though grooms could potentially wear their
  tuxedos on many other occasions and brides will
  never wear their dresses again?

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Economic Naturalism

• Questions
• Why is airline food so bad?
• Why do the keypad buttons on drive-up automatic
  teller machines have Braille dots?

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Economic Naturalism

• Applications
• Use cost-benefit analysis to explain some pattern
  of events or behavior you have observed in your
  own environment

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End of Chapter