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CHAPTER 1
• Thinking Like an Economist
OUTLINE
1.Scarcity and Choice
2.The Cost Benefit Approach to Decisions
3.The Role of Economic Theory
4.Positive Questions and Normative Questions
5.Microeconomics and Macroeconomics
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THE FLOW-CHART OFMICROECONOMICS
A view of the "forest"_ the course seen as a whole but beware of getting lost is in
the "trees" of individual topics
¾ of the course
Consumer Theory
Production Theory
Subjective Value
Individual Demand
Cost of Production
Market Demand
¼ of the course
Revenue of Producer
Supply and Demand of
Market Inputs
Pricing in
General Equilibrium and
a Theory of Economic
Welfare
Product
Markets
Theory of Decision
Making (MC = MB)
Industrial Organization
1. Perfect Competition
2. Monopoly
3. Monopolistic
Competition
4. Oligopoly
The Rational Choice Model
It is important to stress at least three very important
assumptions of the rational choice model.
a. Behavior is not random.
b. People have reasonably simple objectives common to
most.
c. People behave rationally without regard to emotions
that detract from rationality.
Where these givens are not present, the rational choice
models will fail. For example, the risk aversion
assumption underlying rational choice theory,
uncommon objectives , irrationality are not as rare as
we may sometimes think.
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
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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
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Applying the Cost – Benefit Principle
 Assume people are rational
– A rational person has well defined goals and tries
to fulfill those goals as best they can
 Would you walk to town to save $10 on an item?
– Benefits are clear
– Costs are harder to define
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Cost – Benefit Principle Examples
You clip grocery
coupons but Bill
and Melinda
Gates do not
You speed on
the way to
work but not
on the way to
school
At the ball park,
you pay extra
to buy a soda
from the
hawkers in the
stands
You skip your
regular dental
check-up
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Should there be 32 separate sections of Econ 100B, with 25
students each?--- Trinity University, San Antonio, Texas
**Students learn more effectively in smaller classes.
**But smaller classes are also more expensive.
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Or should there be only one section, with 800 students?University of Texas @Austin: Note 32x25 = 800
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Cost-Benefit Analysis (CBA)
Should I do activity x?
 C(x) = the costs of doing x or value of resources
one needs to give up to do x.
 B(x) = the benefits of doing x
 If B(x) > C(x), do x; otherwise don't.
Should we make the econ class larger?
Benefit of making the class size larger = the
reduction in cost per student = B(x)
Cost of making the class size bigger = The amount
people would be willing to pay to avoid the reduced
quality of instruction = C(x)
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Some relevant costs
Let the Faculty salary: $60,000 per course
Per student faculty salary cost:
1 section: $60,000/800 = $75—large class
32 sections: $60,000/25 = $2400-small class
Benefit (to the university) of increasing class size
from 25 students to 800 students
= ($2400 - $75) = $2,325 = B(x)
If you were currently in a class with 25 students,
how much would you be willing to pay to avoid
switching to one with 800 students? = C(x)
If C(x) < B(x)=$2,325, then it makes sense to offer
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the larger class.
The Cost-Benefit Principle
1. 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.
2. Critics of the cost-benefit approach often
object that people don’t really calculate costs
and benefits when deciding what to do
3. People often behave as if they were
comparing the relevant costs and benefits
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People often make bad decisions because they fail to
compare the relevant costs and benefits
“The Budweiser “or “Corona “Walk
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Example 1.8. How much memory should your
computer have?
Suppose that random access memory (RAM)can be
added to your computer at a cost of $0.50 per
megabyte.
How many megabytes of memory should you purchase?
"Should I do X?"
"How much X should I buy?"
"Should I buy an additional unit of X?"
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Cost-Benefit principle
Rule:
a. Buy an additional megabyte if the marginal benefit of RAM
is at least as great as its marginal cost, i.e. MB ≥MC
b. Do not buy an additional megabyte if the marginal benefit
of RAM is less than its marginal cost, i.e. MB < MC
c. You are indifferent if the marginal benefit of RAM
equivalent to its marginal cost, i.e. MB ≈ MC
where
Marginal benefit (MB)= added benefit from having 1 more
unit
Marginal cost (MC)= added cost of having 1 more unit
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Dollars per
megabyte
MB
Value of an additional
megabyte
2.00
Cost of an
additional
megabyte
Optimal amount
of memory
1.00
MC
0.50
0.25
1000
2000
Megabytes
of memory
3000
4000
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Power Point Slides: Chapters 1-4 for now
http://www.csus.edu/dev/managed/College-ofSSIS/econ/faculty/faculty%20webpages/Professors/dube1.html
Marginal Analysis Ideas
Marginal cost is the increase in total cost from
one additional unit of an activity (q)
MC =∆TC/∆q
– Average cost is total cost divided by the number
of units, AC= TC/q
Marginal benefit is the increase in total
benefit from one additional unit of an
activity
MB =∆TB/∆q
– Average benefit is total benefit divided by the
number of units, AB = TB/q
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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
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Working with Equations, Graphs, and
Tables
Definitions
• Equation
• Variable
– Dependent variable
– Independent variable
• Parameter (constant)
– Slope
– Intercept
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From Words to an Equation
• Identify the variables
• Calculate the parameters
– Slope
– Intercept
• Write the equation (B)
• Example: Phone bill is $5 per month plus 10 cents
per minute (T =time)
B = $5 +$0.10 T
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From Equation to Graph
B = 5 + 0.10 T
– Draw and label axes
• Horizontal is independent variable =T
• Vertical is dependent variable =B
– To graph,
•Plot the intercept (T=0; B=5)
•Plot one other point(T=30;
B=8)
•Connect the points (0,5) and
(30,8)
B
D
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C
8
6
5
A
10
30
70
T
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From Graph to Equation
– Identify variables
• Independent (T)
• Dependent (B)
– Identify parameters
• Intercept (=4 if T=0)
• Slope (4/20=0.2)
Thus, we can write the
equation as:
B = 4 + 0.2 T
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Changes in the Intercept (from 4 to 8)
– An increase in the intercept shifts the curve up
• Slope is unchanged
• Caused by an increase in the monthly fee
– A decrease in
the intercept
shifts the curve
down
• Slope is
unchanged
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Changes in the Slope (from 4/20=0.2 to
8/20=0.4)
– An increase in the slope makes the curve steeper
• Intercept is unchanged
• Caused by an increase in the per minute fee
– A decrease in the
slope makes the
curve flatter
• Intercept is
unchanged
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From Table to Graph
Time =T
10
(minutes/month)
Bill
$10.50
($/month) =B
20
30
40
$11.00
$11.50
$12.00
– Identify variables
• Independent
• Dependent
– Label axes
– Plot points
• Connect points
From Graph to Equation: is B= 10 + 0.05T
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From Table to Equation
B= f + bT
Time
(minutes/month)
10
20
30
40
Bill
($/month)
$10.50
$11.00
$11.50
$12.00
– Identify independent and dependent variables
– Calculate slope
• Slope = (11.5 – 10.5) / (30 – 10) = 1/20 = 0.05
– Solve for intercept, f, using any point
B = f + 0.05 T; At B =12 and T=40
12 = f + 0.05 (40) = f + 2
f = 12 – 2 = 10
B = 10 + 0.05 T
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Simultaneous Equations
• Two equations, two unknowns
• Solving the equations gives the values of the
variables where the two equations intersect
– Value of the independent and dependent
variables are the same in each equation
Example
– Two billing plans for phone service
• How many minutes make the two plans
cost the same?
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Simultaneous Equations
• Plan 1
B = 10 + 0.04 T
• Plan 2
B = 20 + 0.02 T
– Plan 1 has higher per minute price ($0.04) while
Plan 2 has a higher monthly fee ($20)
Find B and T for point A
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Simultaneous Equations
– Plan 1
B = 10 + 0.04 T
– Plan 2
B = 20 + 0.02 T
– Subtract Plan 2 equation from
Plan 1 and solve for T
B = 10 + 0.04 T
– B = – 20 – 0.02 T
0 = – 10 + 0.02 T
T = 500
– Find B when T = 500
B = 10 + 0.04 T
B = 10 + 0.04 (500)
B = $30
OR
B = 20 + 0.02 T
B = 20 + 0.02 (500)
B = $30
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