©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 1: Thinking Like an Economist

©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives: Understand 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

©2012 The McGraw-Hill Companies, All Rights Reserved 3 Learning Objectives: Understand 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

©2012 The McGraw-Hill Companies, All Rights Reserved 4 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  even if you are not paying for lunch, the choice of attending it versus not still exists

©2012 The McGraw-Hill Companies, All Rights Reserved 5 The Scarcity Principle: Examples Scarcity is involved in Water Distribution Health Delivery Career Choices Enrolling in Classes

©2012 The McGraw-Hill Companies, All Rights Reserved 6 The Scarcity Principle: trade-offs One consequence of scarcity is trade-off Example: 1.Universities have the choice between offering large or small sections of principles of Economics 2.Their choice will create the following trade-offs: 1. Quality of instruction 2. Reduce cost  reduce tuition Solution?  cost-benefit analysis

©2012 The McGraw-Hill Companies, All Rights Reserved 7 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

©2012 The McGraw-Hill Companies, All Rights Reserved 8 Cost – Benefit Example Back to class size example:  Assume (for simplicity):  Two sizes available: 100 and 20 seats  Currently, university is offering 100-seat sections  Should the university reduce the class size to 20?  Answer: yes if, and only if the value of improvement in instruction outweighs (benefits) its additional cost Extra benefits ≥ extra costs  Rule is simple, but applying it requires a way to measure the relevant costs and benefits

©2012 The McGraw-Hill Companies, All Rights Reserved 9 Cost – Benefit Example Shall a company produce 49 or 50 units?  Answer: yes if, and only if the extra (marginal) benefits at the 50 th unit are larger than the extra (marginal) costs for the same unit  Benefits and costs are not always monetary Should you spend 6 hours or 7 hours with your best friend (or a family member)?  Answer: yes if, and only if the extra benefits for the 7 th hour are larger than the extra costs for the same hour

©2012 The McGraw-Hill Companies, All Rights Reserved 10 Cost – Benefit: Rationality Assumption In the last example, the decision can be affected by your emotions and feelings  However, to study choices under scarcity and cost – benefit analysis, we assume that people are rational Rational people = people with well-defined goals who try to fulfill them as best as they can  Rational decisions are linked to cause and effect or true and false

©2012 The McGraw-Hill Companies, All Rights Reserved 11 Cost – Benefit: Rationality Assumption Rationality Example  You are about to buy a $25 computer game at the nearby campus store.  A friend tells you that the same game is on sale at a downtown store for only $15.  If the downtown store is a 30-minute walk away, where should you buy the game?  Confronted with this choice, people base their choice on how costly they think it is to make the trip downtown.

©2012 The McGraw-Hill Companies, All Rights Reserved 12 Economic Surplus Benefits of an action minus its costs Economic Surplus Total Benefits Total Costs

©2012 The McGraw-Hill Companies, All Rights Reserved 13 Economic Surplus Back to the computer game example  If the cost of making the trip to downtown was $9  Economic surplus = benefit from making the trip – cost from making the trip  Economic surplus = $10 – $9 = $1  Therefore, the cost – benefit principle is similar to a positive economic surplus

©2012 The McGraw-Hill Companies, All Rights Reserved 14 Opportunity Cost Opportunity Cost of an activity (or a choice) = The value of what must be foregone in order to undertake that activity  It is the value of the next best alternative to the choice taken  Rank the alternative choices and calculate the value of the next best alternative to find the opportunity cost of the first choice NOT the combined value of all possible activities  Consider explicit and implicit costs

©2012 The McGraw-Hill Companies, All Rights Reserved 15 Opportunity Cost: Example Going for a medical checkup  Choice taken: medical checkup (2 hours) valued at $50  Potential alternatives: work / watch a movie / go to the gym  Next best alternative: work (2 hours / each hour valued at $10)  Opportunity cost for the medical checkup = explicit cost + implicit cost = $50 + $20 = $70

©2012 The McGraw-Hill Companies, All Rights Reserved 16 Economic Models Economists use economic models as a simplified description that captures the essential elements of a situation  The essential elements will allow us to better analyze these situations Economic models rely heavily on simplifying assumptions  Which aspects of the decision are absolutely essential?  Which aspects are irrelevant?

©2012 The McGraw-Hill Companies, All Rights Reserved 17 Economic Models Example: how can you calculate your total spending on food items on campus until the end of the semester?  Build an economic model  What are the simplifying assumptions? 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

©2012 The McGraw-Hill Companies, All Rights Reserved 18 Three Decision Pitfalls Economic analysis predicts likely behavior  Assuming people are rational, they will apply the cost – benefit principle most of the time and therefore their behavior can be predicted 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

©2012 The McGraw-Hill Companies, All Rights Reserved 19 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?  Key point: economic surplus is the same Action Marginal Costs Marginal Benefits

©2012 The McGraw-Hill Companies, All Rights Reserved 20 Pitfall #2  Ignoring implicit costs  Consider your alternatives  Identify the best next alternative  The opportunity cost of watching a movie is:  The cost of the movie ticket (explicit cost) +  The value placed on the next best alternative (implicit cost) Explicit Costs Implicit Costs Opportunity Cost

©2012 The McGraw-Hill Companies, All Rights Reserved 21 Pitfall #3  When deciding whether to take an action, the only costs and benefits that are relevant are those that would occur as a result of taking the action  However, many decisions seem to be influenced by costs and benefits that would have occurred independently of whether the action was taken  In this case, people are influenced by “sunk costs” Sunk cost = a cost that is beyond recovery at the moment a decision must be made

©2012 The McGraw-Hill Companies, All Rights Reserved 22 Pitfall #3  Sunk cost It is a fixed cost “sunk” into an industry -Example: air travel industry  plane / pilot / stewardesses / baggage handlers / jet fuel / airport A fixed cost = a cost incurred independently of the amount of a good produced All sunk costs are fixed Not all fixed costs are sunk -Only those fixed costs which cannot be shifted into other industries would qualify as sunk costs

©2012 The McGraw-Hill Companies, All Rights Reserved 23 Pitfall #3  Failure to think at the margin  Sunk costs cannot be recovered  Example:  Eating at an all-you-can-eat restaurant Are there any differences in the quantity of food for those who pay the regular entry price and those who were invited by the owner? Marginal Benefits Marginal Costs

©2012 The McGraw-Hill Companies, All Rights Reserved 24 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

©2012 The McGraw-Hill Companies, All Rights Reserved 25 Marginal Analysis: Tennis Tournaments in the UAE # of Tournaments Total Cost ($m) 0$0 1$3 2$7 3$12 4$20 5$32 Average Cost ($m/tourname nt) $0 $3 $3.5 $4 $5 $6.4 Marginal Cost ($m) $3 $4 $5 $8 $12  If the marginal benefit is $6 million per tournament, how many tournaments should the UAE host?

©2012 The McGraw-Hill Companies, All Rights Reserved 26 Normative and Positive Economics  Normative economic statements say how people should behave  Economics of “what ought to be”  cannot be proven true or false -“Gas prices are too high” -“The UAE should organize more tennis tournaments” Cost – benefit principle is an example of normative economic principle  Positive economic statements predict how people will behave  Economics of “what is”  focuses on facts and can be proven with data -“The mean price of gasoline in 2008 was higher than in 2007” -“Organizing a tennis tournament costs more in Dubai than in Beirut”

©2012 The McGraw-Hill Companies, All Rights Reserved 27 Incentive Principle Incentives are central to people's choices Benefits Actions are more likely to be taken if their benefits rise Costs Actions are less likely to be taken if their costs rise

©2012 The McGraw-Hill Companies, All Rights Reserved 28 Incentive Principle: Examples If a waiter gets paid a fixed $3 per hour and does not get to keep tips.  What are his incentives at work?  Now, the same waiter gets to keep the tips left by his customers, does he still have the same incentive scheme? If your professor says on the first day that everyone is getting an “A” in the class, describe your incentives towards the course.

©2012 The McGraw-Hill Companies, All Rights Reserved 29 Microeconomics and Macroeconomics  Microeconomics studies of individual choice under scarcity and its implications for the behavior of prices and quantities in individual markets  Sugar  Carpets  House cleaning services  Microeconomics considers  Costs of production  Demand for a product  Behavior of consumers  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

Chapter 1 Appendix Working with Equations, Graphs, and Tables

©2012 The McGraw-Hill Companies, All Rights Reserved 31 Definitions Equation Variable  Dependent variable  Independent variable Parameter (constant)  Slope  Intercept

©2012 The McGraw-Hill Companies, All Rights Reserved 32 From Words to an Equation Identify the variables Calculate the parameters  Slope  Intercept Write the equation Example: Phone bill is $5 per month plus 10 cents per minute B = T

©2012 The McGraw-Hill Companies, All Rights Reserved 33 From Equation to Graph B = T  Draw and label axes  Horizontal is independent variable  Vertical is dependent variable  To graph,  Plot the intercept  Plot one other point  Connect the points T B 5 6 A C D

©2012 The McGraw-Hill Companies, All Rights Reserved 34 From Graph to Equation  Identify variables  Independent  Dependent  Identify parameters  Intercept  Slope  Write the equation B = T

©2012 The McGraw-Hill Companies, All Rights Reserved 35 Changes in the Intercept  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

©2012 The McGraw-Hill Companies, All Rights Reserved 36 Changes in the Slope  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

©2012 The McGraw-Hill Companies, All Rights Reserved 37 From Table to Graph  Identify variables  Independent  Dependent  Label axes  Plot points  Connect points Time (minutes/month) Bill ($/month) $10.50$11.00$11.50$12.00

©2012 The McGraw-Hill Companies, All Rights Reserved 38 From Table to Equation  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 T 12 = f (40) = f + 2 f = 12 – 2 = 10 B = T Time (minutes/month) Bill ($/month) $10.50$11.00$11.50$12.00

©2012 The McGraw-Hill Companies, All Rights Reserved 39 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?

©2012 The McGraw-Hill Companies, All Rights Reserved 40 Simultaneous Equations Plan 1B = T Plan 2B = T  Plan 1 has higher per minute price while Plan 2 has a higher monthly fee Find B and T for point A

©2012 The McGraw-Hill Companies, All Rights Reserved 41 Simultaneous Equations  Plan 1 B = T  Plan 2 B = T  Subtract Plan 2 equation from Plan 1 and solve for T B = T – B = – 20 – 0.02 T 0 = – T T = 500  Find B when T = 500 B = T B = (500) B = $30 OR B = T B = (500) B = $30 T=500