Download Chapter 1: Thinking Like an Economist

Chapter 1: Thinking Like an Economist
1. The Scarcity Principle: having more of any good thing
necessarily requires having less of something else
2. The Cost-Benefit Principle: an action should be taken
if and only if its benefit is at least as great as its costs
3. The Incentive Principle: examine people's incentives
to predict their behavior
4. Three pitfalls in reasoning
1. Measuring costs and benefits as proportions
instead of as dollar amounts
2. Ignoring implicit costs
3. Failing to weigh costs and benefits at the margin
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The Scarcity Principle
Economics: The study of choices
and results under scarcity
The Scarcity Principle: Unlimited
wants and limited resources means
having more of one good means
having less of another.
Also called No Free-Lunch Principle
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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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Economic Surplus
 Benefit of an action minus its costs
Total
Benefits
Total
Costs
Economic
Surplus
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Opportunity Cost
 The value of what must be foregone in order to
undertake an activity
 Consider explicit and implicit costs
 Examples:
 Give up an hour of babysitting to go to the movies
 Give up watching TV to walk to town
 Caution: NOT the combined value of all possible
activities
 Opportunity cost considers only your best alternative
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Economic Models
 Simplifying assumptions
 Which aspects of the decision are absolutely
essential?
 Which aspects are irrelevant?
 Abstract representation of key relationships
 The Cost-Benefit Principle is a model
 If costs of an action increase, the action is less likely
 If benefits of an action increase, the action is more
likely
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Three Decision Pitfalls


Economic analysis predicts likely behavior
Three general cases of mistakes
1. Measuring costs and benefits as proportions
instead of absolute amounts
2. Ignoring implicit costs
3. Failure to think at the margin
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Pitfall #1
 Measuring costs and
benefits as
proportions instead of
absolute amount
 Would you walk to
town to save $10
on a $25 item?
 Would you walk to
town to save $10
on a $2,500 item?
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Marginal
Benefits
Marginal
Costs
Action
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Pitfall #2
Explicit
Costs
Opportunity
Cost
Implicit
Costs
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 Ignoring implicit costs
 Consider your
alternatives
 The value of a Frequent
Flyer coupon depends
on its next best use
 Expiration date
 Do you have time for
another trip?
 Cost of the next best
trip
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Pitfall #3
 Failure to think at the
margin
 Sunk costs cannot be
recovered
 Examples:
 Eating at an all-youcan-eat restaurant
 Attend a second year
of law school
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Marginal
Benefits
Marginal
Costs
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Marginal Analysis Ideas
 Marginal cost is the increase in total cost from one
additional unit of an activity
 Average cost is total cost divided by the number of
units
 Marginal benefit is the increase in total benefit from one
additional unit of an activity
 Average benefit is total benefit divided by the number
of units
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Normative and Positive Economics
 Normative economic
statements say how
people should behave
 Gas prices are too
high
 Building a space base
on the moon will cost
too much
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 Positive economic
statements predict 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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Incentive Principle
Incentives are central to people's choices
Benefits
Actions are more likely
to be taken if their
benefits rise
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Costs
Actions are less likely
to be taken if their
costs rise
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Microeconomics and Macroeconomics
 Microeconomics studies
choice and its implications
for price and quantity in
individual markets
 Sugar
 Carpets
 House cleaning services
 Microeconomics considers
topics such as
 Costs of production
 Demand for a product
 Exchange rates
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 Macroeconomics studies the
performance of national
economies and the policies
that governments use to try
to improve that performance
 Inflation
 Unemployment
 Growth
 Macroeconomics considers
 Monetary policy
 Deficits
 Tax policy
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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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