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Thinking Like An Economist Thinking Like An Economist

Introduction n Example: Accommodation l May prefer peace and quiet, but houses are expensive, Introduction n Example: Accommodation l 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.

Introduction n What is the Optimal Choice? Option a): benefits: less noise cost: more Introduction n What is the Optimal Choice? Option a): benefits: less noise cost: more expensive Option b): benefits: cheaper cost: no peace Chapter 1: Thinking Like an Economist 3

Economics: Studying Choice In a World of Scarcity n The Scarcity Principle Boundless wants Economics: Studying Choice In a World of Scarcity n The Scarcity Principle Boundless wants cannot be satisfied with limited resources. l Therefore, having more of one thing usually means having less of another. l Because of scarcity we must make choices. l Chapter 1: Thinking Like an Economist 4

Economics: Studying Choice In a World of Scarcity Wants vs. Resources Scarcity Choices Chapter Economics: Studying Choice In a World of Scarcity Wants vs. Resources Scarcity Choices Chapter 1: Thinking Like an Economist 5

Economics: Studying Choice In a World of Scarcity n Economics l The study of Economics: Studying Choice In a World of Scarcity n Economics l The study of how people make choices under conditions of scarcity and of the results of those choices for society. Chapter 1: Thinking Like an Economist 6

Economics: Studying Choice In a World of Scarcity n The Cost-Benefit Principle l An Economics: Studying Choice In a World of Scarcity n The Cost-Benefit Principle l 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 Chapter 1: Thinking Like an Economist 7

Applying The Cost-Benefit Principle n Should you go to the mall to save $5 Applying The Cost-Benefit Principle n Should you go to the mall to save $5 on a $20 computer game? The benefit of going to the mall = $5 l The cost of going to the mall is the dollar value of everything you give up to go to the mall l Chapter 1: Thinking Like an Economist 8

Applying The Cost-Benefit Principle cost of making the trip to the Mall $10 $8 Applying The Cost-Benefit Principle cost of making the trip to the Mall $10 $8 $5 $4 $3 Benefit from the trip $5 $5 $5 Make the trip to town? No No Possibly Yes

Applying The Cost-Benefit Principle n Rational Person l Someone with well-defined goals who tries Applying The Cost-Benefit Principle n Rational Person l 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. Chapter 1: Thinking Like an Economist 10

Applying The Cost-Benefit Principle n Economic Surplus The benefit of taking any action minus Applying The Cost-Benefit Principle n Economic Surplus The benefit of taking any action minus its cost l The goal of economic decision makers is to maximize their economic surplus l Chapter 1: Thinking Like an Economist 11

Applying The Cost-Benefit Principle n Opportunity Cost l The value of the next-best alternative Applying The Cost-Benefit Principle n Opportunity Cost l The value of the next-best alternative that must be forgone to undertake an activity Chapter 1: Thinking Like an Economist 12

Applying The Cost-Benefit Principle n Observation l The cost-benefit principle suggests that we take Applying The Cost-Benefit Principle n Observation l The cost-benefit principle suggests that we take only those actions that create additional economic surplus. Chapter 1: Thinking Like an Economist 13

Four Important Decision Pitfalls n n Pitfall 1: Measuring cost and benefits as proportions Four Important Decision Pitfalls n n Pitfall 1: Measuring cost and benefits as proportions rather than absolute dollar amounts Examples: l Should you go to the mall to save $5 on a $800 digital camera? Chapter 1: Thinking Like an Economist 14

Four Important Decision Pitfalls n Pitfall 2: Ignoring Opportunity Costs l Example: u Should Four Important Decision Pitfalls n Pitfall 2: Ignoring Opportunity Costs l Example: u Should you use your frequent-flyer coupon to fly to Fort Lauderdale for spring break? l Assume: u Round trip airfare is $500 and is equal to your frequent flyer coupon u Other costs equal $1, 000 Chapter 1: Thinking Like an Economist 15

Four Important Decision Pitfalls n Pitfall 2: Ignoring Opportunity Costs l Assume (cont): u Four Important Decision Pitfalls n Pitfall 2: Ignoring Opportunity Costs l Assume (cont): u The most you are willing to pay for the Fort Lauderdale trip is $1, 350 u 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) Chapter 1: Thinking Like an Economist 16

Four Important Decision Pitfalls n Pitfall 2: Ignoring Opportunity Costs l Example: u Should Four Important Decision Pitfalls n Pitfall 2: Ignoring Opportunity Costs l Example: u Should you use your frequent flyer coupon to fly to Fort Lauderdale for spring break? l With the coupon: u Benefits = $1, 350 u Cost = $1, 400 ($400 opportunity cost + $1, 000 other costs) l Question u What would you do if the coupon expires just after spring break? Chapter 1: Thinking Like an Economist 17

Four Important Decision Pitfalls n Pitfall 3: Failure To Ignore Sunk Costs l The Four Important Decision Pitfalls n Pitfall 3: Failure To Ignore Sunk Costs l 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 Chapter 1: Thinking Like an Economist 18

Four Important Decision Pitfalls n Pitfall 3: Failure To Ignore Sunk Costs l Sunk Four Important Decision Pitfalls n Pitfall 3: Failure To Ignore Sunk Costs l Sunk cost u. A cost that is beyond recovery at the moment a decision must be made Chapter 1: Thinking Like an Economist 19

Four Important Decision Pitfalls n Pitfall 3: Failure To Ignore Sunk Costs l Example Four Important Decision Pitfalls n Pitfall 3: Failure To Ignore Sunk Costs l Example u How much should you eat at an all-you-can-eat restaurant? l Assume: u Price = $5 u 20 randomly selected guests will get lunch on the house Chapter 1: Thinking Like an Economist 20

Four Important Decision Pitfalls n Pitfall 3: Failure To Ignore Sunk Costs l Example Four Important Decision Pitfalls n Pitfall 3: Failure To Ignore Sunk Costs l Example u How much should you eat at an all-you-can-eat restaurant? l Question: u If all diners are rational, will there be any difference in the average quantity of food consumed by these two groups? Chapter 1: Thinking Like an Economist 21

Four Important Decision Pitfalls n Pitfall 4: Failure To Understand the Average-Marginal Distinction l Four Important Decision Pitfalls n Pitfall 4: Failure To Understand the Average-Marginal Distinction l Marginal Benefit u The increase in total benefit that results from carrying out one additional unit of an activity Chapter 1: Thinking Like an Economist 22

Four Important Decision Pitfalls n Pitfall 4: Failure To Understand the Average-Marginal Distinction l Four Important Decision Pitfalls n Pitfall 4: Failure To Understand the Average-Marginal Distinction l Marginal Cost u The increase in total cost that results from carrying out one additional unit of an activity Chapter 1: Thinking Like an Economist 23

Four Important Decision Pitfalls n Pitfall 4: Failure To Understand the Average-Marginal Distinction l Four Important Decision Pitfalls n Pitfall 4: Failure To Understand the Average-Marginal Distinction l Average Benefit u The total benefit of undertaking n units of an activity divided by n Chapter 1: Thinking Like an Economist 24

Four Important Decision Pitfalls n Pitfall 4: Failure To Understand the Average-Marginal Distinction l Four Important Decision Pitfalls n Pitfall 4: Failure To Understand the Average-Marginal Distinction l Average Cost u The total cost of undertaking n units of an activity divided by n Chapter 1: Thinking Like an Economist 25

Four Important Decision Pitfalls n Pitfall 4: Failure To Understand the Average-Marginal Distinction l Four Important Decision Pitfalls n Pitfall 4: Failure To Understand the Average-Marginal Distinction l Example u Should NASA expand the space shuttle program from four launches per year to five? u Benefits o $24 billion (average of $6 billion/launch) u Costs o $20 billion (average of $5 billion/launch) Chapter 1: Thinking Like an Economist 26

Four Important Decision Pitfalls # of Launches Total Cost Average Cost Marginal Cost ($ Four Important Decision Pitfalls # of Launches Total Cost Average Cost Marginal Cost ($ billion) ($ billion/launch) 0 0 0 1 3 3 3 4 5 2 3 4 7 12 3. 5 4 8 12 What is the optimal number of launches? 20 5 Assume: Average Benefit = Marginal Benefit = $6 billion 5 32 6. 4 Chapter 1: Thinking Like an Economist 27

Normative Economics vs. Positive Economics n Normative Economic Principle l One that says how Normative Economics vs. Positive Economics n Normative Economic Principle l One that says how people should behave u Example: n Cost-benefit principle Positive Economic Principle l One that predicts how people will behave u Example: The incentives matter principle o 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). Chapter 1: Thinking Like an Economist 28

Economics: Micro and Macro n Microeconomics l The study of individual choice under scarcity Economics: Micro and Macro n Microeconomics l The study of individual choice under scarcity and its implications for the behavior of prices and quantities in individual markets Chapter 1: Thinking Like an Economist 29

Economics: Micro and Macro n Macroeconomics l The study of the performance of national Economics: Micro and Macro n Macroeconomics l The study of the performance of national economies, and of the policies that governments use to try to improve that performance Chapter 1: Thinking Like an Economist 30

Economic Naturalism n Using insights from economics to help make sense of observations from Economic Naturalism n Using insights from economics to help make sense of observations from everyday life Chapter 1: Thinking Like an Economist 31

Economic Naturalism n Question l Why do brides spend so much money on wedding Economic Naturalism n Question l 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? Chapter 1: Thinking Like an Economist 32

Economic Naturalism n Questions Why is airline food so bad? l Why do the Economic Naturalism n Questions Why is airline food so bad? l Why do the keypad buttons on drive-up automatic teller machines have Braille dots? l Chapter 1: Thinking Like an Economist 33

Economic Naturalism n Applications l Use cost-benefit analysis to explain some pattern of events Economic Naturalism n Applications l Use cost-benefit analysis to explain some pattern of events or behavior you have observed in your own environment Chapter 1: Thinking Like an Economist 34

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