The Economic Way of Thinking An Introduction to Economics

Objectives Define economics and explain the questions that economists try to answer. Explain the core ideas that define the economic way of thinking. Concepts Covered: Incentives Scarcity Opportunity Costs Marginalism

Economics Defined Economics: The study of how people use resources to satisfy wants. Key economic questions include: How do choices end up determining what, how, and for whom goods and services get produced? When do choices made in the pursuit of self-interest also promote the social interest?

The Economic Problem Scarcity having seemingly unlimited human needs and wants, in a world of limited resources. Why does it exist? It exists because wants are unlimited and resources are limited

Economic Thinking People Choose Most situations involve making choices (tradeoffs). People evaluate the costs and benefits of different alternatives and choose the alternative that seems best to them.

Efficiency vs. Equality Examples… Going to a movie the night before your midterm leaves less time for studying. Having more money to buy stuff requires working longer hours, which leaves less time for leisure. Protecting the environment requires resources that could otherwise be used to produce consumer goods. Society faces an important tradeoff – Efficiency vs. Equality Should society get the most from its scarce resources, or should prosperity be distributed evenly among society’s members?

Choice Involves Cost Costs do not necessarily involve money. The most important type of cost is opportunity cost: “The next best alternative that people give up when they make a choice.”

Examples… The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages. If a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead. Seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater. But what about the statement “the best things in life are free?”

Making Economic Choices Two factors affect economic decisions: Incentives – a reward or penalty that encourages people to act in certain ways Utility – the benefit or satisfaction gained from using a good or service Choices vary from individual to individual based on what each thinks is best for them

Incentives Matter Incentives are actions or rewards that encourage people to act in a certain way (motivators). Positive Incentives Pay Raise Extra credit Employee of the month award Negative Incentives Taxes Jail Failing class

Direct/Indirect Incentives Easy to recognize “Shovel my drive and I’ll give you $25” “Get straight A’s and I’ll buy you a car” Indirect Incentives Maybe now you have an indirect incentive to cheat! Maybe you won’t get involved in extracurricular activities

Unintended Consequences An unplanned result (usually negative and unwanted) of an incentive Example: social safety net Most agree we need a safety net for those who are unemployed or low income But… What if the money from the safety net is more than the person can make at a job? Indirect incentive to stay on welfare rather than work!

Incentives and Innovation Patents and copyrights Incentives to innovate Why work hard, bear all costs (time and monetary) if someone could just steal your idea for profit? Result of a strong patent system? More innovation, since people are rewarded for new popular inventions Innovation  economic growth, higher standards of living But … those big, greedy pharmaceutical companies!

People Gain When They Trade Voluntarily People can produce goods and services at lower opportunity costs when they specialize in what they do best. Then they can trade what they produce for goods or services that would be more costly for them to produce. In this way both sides win.

Choices Have Consequences That Lie in the Future The important costs and benefits in economic decision making are those that will appear in the future. The study of economics stresses the importance of making decisions about the future because we can influence only the future; we cannot influence things that happened in the past.

Choices are Made on the Margin Marginal = Additional. A choice on the margin is a decision to do (or buy, or eat, etc.) a little more or a little less of something. Marginal cost is the opportunity cost that arises from a one-unit increase in an activity. Marginal benefit is the benefit that arises from a one-unit increase in an activity.

Examples… When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education. When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue. How clean is your house? Do you (really, your mom) clean the same when… Nothing exciting is going on? Friends are coming over? If you were selling your house?

Question You are selling your 1996 Mustang. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car “as is.” In each of the following scenarios, should you have the transmission repaired? Explain. Blue book value (what you could get for the car) is $6500 if transmission works, $5700 if it doesn’t Blue book value is $6000 if transmission works, $5500 if it doesn’t

Answer Cost of fixing transmission = $600 A. Blue book value is $6500 if transmission works, $5700 if it doesn’t Benefit of fixing transmission = $800 ($6500 – 5700). Get the transmission fixed. B. Blue book value is $6000 if transmission works, $5500 if it doesn’t Benefit of fixing the transmission is only $500. Do not pay $600 to fix it.

Making Economic Choices Factor #1 People are motivated by incentives, expected utility, desire to economize They weigh costs against benefits to make purposeful choices Motivated by self-interest

Making Economic Choices Factor #2 “There’s no such thing as a free lunch” All choices have a cost Choosing one thing means giving up another Cost can take the form of money, time, or anything of value