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Thinking LikeAn EconomistThinking LikeAn Economist
Introduction
Example: AccommodationMay 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.
Introduction
What is the Optimal Choice?Option a): benefits: less noise
cost: more expensive
Option b): benefits: cheaper
cost: no peace
Economics: StudyingChoice In a World of Scarcity
The Scarcity PrincipleBoundless 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.
Economics: StudyingChoice In a World of Scarcity
Wants vs. Resources
Scarcity
Choices
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.
Economics: StudyingChoice In a World of Scarcity
The Cost-Benefit PrincipleAn 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
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 = $5The cost of going to the mall is the dollar
value of everything you give up to go to the mall
Applying The Cost-Benefit Principle
cost of making the trip to the
MallBenefit from
the tripMake the trip to
town?
$10 $5 No
$8 $5 No
$5 $5 Possibly
$4 $5 Yes
$3 $5 Yes
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.
Applying The Cost-Benefit Principle
Economic SurplusThe benefit of taking any action minus its
cost The goal of economic decision makers is to
maximize their economic surplus
Applying The Cost-Benefit Principle
Opportunity CostThe value of the next-best alternative that
must be forgone to undertake an activity
Applying The Cost-Benefit Principle
ObservationThe cost-benefit principle suggests that we
take only those actions that create additional economic surplus.
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?
Four Important Decision Pitfalls
Pitfall 2: Ignoring Opportunity CostsExample:
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 couponOther costs equal $1,000
Four Important Decision Pitfalls
Pitfall 2: Ignoring Opportunity CostsAssume (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)
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?
Four Important Decision Pitfalls
Pitfall 3: Failure To Ignore Sunk CostsThe only costs that should influence a
decision about whether to take an action are those that we can avoid by not taking the action
Four Important Decision Pitfalls
Pitfall 3: Failure To Ignore Sunk CostsSunk cost
A cost that is beyond recovery at the moment a decision must be made
Four Important Decision Pitfalls
Pitfall 3: Failure To Ignore Sunk CostsExample
How much should you eat at an all-you-can-eat restaurant?
Assume:Price = $520 randomly selected guests will get lunch on
the house
Four Important Decision Pitfalls
Pitfall 3: Failure To Ignore Sunk CostsExample
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?
Four Important Decision Pitfalls
Pitfall 4: Failure To Understand the Average-Marginal DistinctionMarginal Benefit
The increase in total benefit that results from carrying out one additional unit of an activity
Four Important Decision Pitfalls
Pitfall 4: Failure To Understand the Average-Marginal DistinctionMarginal Cost
The increase in total cost that results from carrying out one additional unit of an activity
Four Important Decision Pitfalls
Pitfall 4: Failure To Understand the Average-Marginal
DistinctionAverage Benefit
The total benefit of undertaking n units of an activity divided by n
Four Important Decision Pitfalls
Pitfall 4: Failure To Understand the Average-Marginal
DistinctionAverage Cost
The total cost of undertaking n units of an activity divided by n
Four Important Decision Pitfalls
Pitfall 4: Failure To Understand the Average-Marginal Distinction
ExampleShould NASA expand the space shuttle
program from four launches per year to five?Benefits
o $24 billion (average of $6 billion/launch)
Costso $20 billion (average of $5 billion/launch)
Four Important Decision Pitfalls
# of Launches Total Cost Average Cost Marginal Cost ($ billion) ($ billion/launch) ($ billion/launch)
What is the optimal number of launches?
0 0 0
1 3 3
2 7 3.5
3 12 4
4 20 5
5 32 6.4
Assume: Average Benefit = Marginal Benefit = $6 billion
3
4
5
8
12
Normative Economicsvs. Positive Economics
Normative Economic PrincipleOne that says how people should behave
Example: Cost-benefit principle
Positive Economic PrincipleOne that predicts how people will behave
Example: The incentives matter principleo 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).
Economics: Micro and Macro
MicroeconomicsThe study of individual choice under
scarcity and its implications for the behavior of prices and quantities in individual markets
Economics: Micro and Macro
MacroeconomicsThe study of the performance of national
economies, and of the policies that governments use to try to improve that performance
Economic Naturalism
Using insights from economics to help make sense of observations from everyday life
Economic Naturalism
QuestionWhy 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?
Economic Naturalism
QuestionsWhy is airline food so bad?Why do the keypad buttons on drive-up
automatic teller machines have Braille dots?
Economic Naturalism
ApplicationsUse cost-benefit analysis to explain some
pattern of events or behavior you have observed in your own environment
End ofChapterEnd of
Chapter