Thinking Like an Economist

1
Thinking Like an Economist
2
Philosophy of This Course

• Focus on covering the core ideas of economics
  rather than covering many topics superficially
  chances are, youre not going to be economists
• Encourage active learning--one must do and see
  economics in order to learn it
• Uses examples, exercises, and applications
• Encourages thinking critically when considering
  the problems
• Encourages discussing interesting insights with
  friends

3
Core Principles

• The Scarcity Principle - No Free Lunch
• The Cost-Benefit Principle
• The Not-All-Costs-and-Benefits-Matter Equally
  Principle
• The Principle of Comparative Advantage

4
Core Principles

• The Equilibrium Principle
• The Principle of Increasing Opportunity Cost
• The Efficiency Principle

5
Economic Naturalism

• Using your insights from economics to make sense
  of observations from everyday life
• Learning economic principles enables us to see
  the ordinary details of life in a new light
• E.G., Look for differences in costs and benefits

6
Economic Naturalism

• Examples of Economic Naturalism Questions
• Why did people switch from big cars to little
  cars in the 1970s only to switch back again in
  the 1990s?
• Why do drive-up teller machines have Braille dots
  on the keypads?
• Why do brides spend thousands on a wedding dress
  that will never be worn again, while grooms rent
  a tuxedo that could be worn again?

7
Economic Naturalism

• Why do people shout at parties?
• Why do drug stores offer senior citizen discounts
  on certain days of the week?
• Why does staying over a Saturday get you a
  cheaper air fare?
• Why did I make more money driving my ice-cream
  truck in trailer parks than in more affluent
  neighborhoods?

8
Scarcity

• Scarcity is a fact of life
• Never enough time, money, energy.
• Economics is the study of how people make choices
  under conditions of scarcity and of the results
  of those choices for society

9
Scarcity Principle

• Because of scarcity
• Tradeoffs are widespread
• Having more of one good usually means having less
  of another
• AKA the No free lunch Principle

10
Scarcity implies opportunity costs

• Opportunity Cost
• The value of the next best (unchosen)
  alternative.
• Example job choice.
• Option 1 IBM in RTP, salary 70 k
• Option 2 Own surf shop in Wilm, salary 30k
• If you select option 2, what is your opportunity
  cost?

11
Opportunity Cost

• The opportunity cost of selecting job option 2 is
  giving up job option 1.
• 70 k salary, living in Raleigh, etc
• Everything that you gave up.
• We must keep costs and benefits separate!

12
Opportunity Cost

• Opportunity Cost The value of the next-best
  alternative that must be forgone in order to
  undertake an activity
• Decisions depend upon opportunity costs
• It is not the combined value of all other forgone
  activities, just the next best one

13
Example Waking up early

• Suppose its Saturday and you have to decide
  whether to sleep in or get up early and fix the
  fence.
• Do you get up early?
• A cost-benefit analysis says only if the benefits
  outweigh the costs

14
Benefit of waking up early

• The benefit of waking up early is estimated by
  the
• Highest price you would be willing and able to
  pay to have the fence fixed
• This is your reservation price for having a fixed
  fence
• Suppose this benefit is 200

15
Cost of waking up early

• The cost is estimated by the
• Value to you of the extra sleep what you would
  be willing to pay for the additional rest
• This is your reservation price for the extra
  hours of sleep
• Suppose the cost of getting up early is 100

16
Solution to Example 1.1

• The benefit of having a fixed fence (200) is
  greater than the cost (not having a fixed fence)
  (100) i.e., your economic surplus is 200-100
  100
• You should get up early
• Suppose that the value of your alternatives
  change
• Perhaps you have a test on Monday and need the
  extra hours to study. In this case, your
  opportunity costs have changed and you may
  decided against fixing the fence.

17
Everyone Faces Scarcity

• Even Bill Gates faces scarcity
• Should he pick up a 100 bill on the ground?
• Someone once estimated that his time was so
  valuable picking up a 100 bill wouldnt be worth
  his while
• But, he only has 24 hours a day and a limited
  amount of energy
• If he spends his time building his business
  empire, then he cannot use that time doing other
  things
• Do you cut the coupons from the Sunday paper?

18
Cost-Benefit Principle

• Take an action if, and only if, the extra
  benefits from taking the action are at least as
  great as the extra costs
• Measuring the costs and benefits is often
  difficult
• One may have to use assumptions and/or
  approximations
• Helps us answer yes/no questions

19
People Are Rational

• Economists assume that people are rational that
  they try to fulfill their goals as best they can
• Rational here means only pursuing actions where
  the benefits are at least as great as the costs.

20
Reservation Prices

• The highest price one would be willing (and able)
  to pay for any good or service
• Maximum willingness-to-pay (WTP)
• It is equal to the benefit (value) received from
  the good or service
• What happens if your max WTP is lt price?
• What happens if your max WTP is gt price?

21
Economic Surplus

• The benefit of taking an action minus its cost
• Economic Surplus Benefit - Cost
• Rational decision makers take all actions that
  yield a positive economic surplus
• Should you buy an item if surplus 0?
• Eg max WTP 19,500 P 19,500

22
Role of Models

• An abstract model is a simplified description
  capturing essential elements of a situation
• It allows logical analysis
• It includes only the major forces at work and
  will ignore many details
• I.E., the cost-benefit principle is an abstract
  model of how an idealized individual would choose
  among competing alternatives

23
Imperfect Decision Makers

• Rational people will apply the cost-benefit
  principle using their intuition
• However, people can make mistakes when weighing
  the costs and benefits
• People often make inconsistent choices

24
Example 1.6Lost Theater Ticket

• A theater tickets cost 10
• You have at least 20 and want to see a play
• Would you buy a theater ticket after losing a 10
  bill?
• Would you buy a second theater ticket after
  losing the first?

25
Example 1.6Lost Theater Ticket

• Many people say that they would purchase the
  ticket after losing the 10 but would not
  purchase a second ticket after losing the first
• This is inconsistent behavior since the financial
  loss is equivalent
• The choice of whether to see the play depends
  upon whether seeing the play is worth spending 10

26
Marginal Analysis

• Comparing incremental or additional costs and
  benefits
• More powerful than traditional CBA because it
  allows us to make quantity decisions
• Always get the best answer, while CBA only
  allows for good answers

27
Marginal Analysis

• Marginal Benefit
• The increase in total benefit that results from
  carrying out one additional unit of the activity
• Marginal Cost
• The increase in total cost that results from
  carrying out one additional unit of the activity

28
Marginal Analysis

• Example How many slices of pizza to eat?
• Assume P 1.50 per slice
• Note P cost of an additional unit marginal
  cost

29
Marginal Analysis

• The optimal quantity here (Q) is 3 slices.
• Why?
• For slices 1-3 there is a surplus of benefit over
  cost net gain.
• For the 4th slice MC gt MB
• Total net gain surplus sum of MB MC for all
  units consumed 4.50

30
Marginal Analysis vs. CBA

• What would happen if we used CBA and the same
  data to ask
• Should you eat 4 slices yes or no?
• 4 slices
• Total Benefit 10.00 (4 321)
• Total Cost 6.00 (1.50 x 4)
• Net gain (surplus) 4.00

31
Fig. 1.1 The Marginal Cost and Benefit of
Additional RAM
32
Fig. 1.2Falling RAM Prices Increase the Optimal
Amount of Memory
33
Fig. 1.3An Increase in the Marginal Benefit of
RAM Increases the Optimal Amount of Memory
34
Optimal Level

• If the marginal benefit is greater than marginal
  cost
• Increase output (consume or produce more)
• If the marginal benefit is less than the marginal
  cost
• Decrease output (consumer or produce less)
• Optimal output is where marginal benefit equals
  marginal cost
• MB MC

35
Micro and Macro

• Microeconomics studies
• Choices of individual consumers and firms
• Behavior of specific markets
• How are prices and quantities determined?
• Macroeconomics studies
• Performance of national economies
• Government policies to change performance
• Unemployment rate, and the price level

36
Always Tradeoffs

• The scope of macro and micro are different
• However, both are trying to predict behavior that
  is based on scarcity
• Clear thinking about economic problems will
  always account for tradeoffs--having more of one
  good thing usually means having less of another

37
Decision Pitfalls

• Dollars or proportions?
• Example A Buy an alarm clock on campus for 20
  or drive to K-Mart and buy it for 10?
• Is the drive worth saving 10?

38
Decision Pitfalls

• Dollars or proportions?
• Example B Buy a computer on campus for 2,000 or
  drive to K-mart and buy it for 1,990?
• Answer should be the same

39
Decision Pitfalls

• Dont ignore opportunity costs
• The most you are WTP for a trip 1,350 your
  benefit from the trip
• Airfare 500
• Other expenses 1,000
• You have a frequent flyer coupon worth 500,
  which expires in one year.
• Should you go on the trip?

40
Decision Pitfalls

• Ignore sunk costs theyre sunk!
• You and a friend are both planning on going to a
  concert. You buy your 30 ticket ahead of time,
  while she waits to buy hers at the gate. The
  night of the show, there is a snow storm, which
  makes travel to the concert dangerous.
• Who is more likely to go to the concert?

41
Decision Pitfalls

• Average or marginal?
• Pizza example revisited
• 4 slices average benefit 2.50 (4 3 2
  1) / 4
• 4 slices average cost 1.50
• Should you eat 4 slices?

42
Not all costs and benefits are the same

• Marginal costs and benefits matter
• Opportunity costs matter
• Sunk costs do not matter
• Average costs and benefits do not matter