Thinking Like an Economist Federal Reserve Chair: Janet Yellen

Philosophy of Economics One must do and see economics in order to understand it Use examples, exercises, and applications Encourage thinking critically when considering problems Encourage discussing interesting insights with friends

Economic Naturalism Using insights from economics to make sense of everyday observations

Economic Naturalism Examples: Why did we switch from driving big cars to little cars in the 1970’s only to switch back again in the 1990’s? Why do brides spend thousands on a wedding dress that will never be worn again, while grooms rent a tuxedo that could be worn again?

More Examples: Why do drug stores offer senior citizen discounts only on certain days of the week? Why does staying over a Saturday get you a cheaper air fare? Why did I make more money driving my ice-cream truck in poorer neighborhoods than in more affluent neighborhoods?

Core Principles The Scarcity Principle - “No Free Lunch” The Cost-Benefit Principle The “Not-All-Costs-and-Benefits-Matter Equally” Principle The Principle of Comparative Advantage The Equilibrium Principle The Principle of Increasing Opportunity Cost The Efficiency Principle

Scarcity Scarcity-a fact of life Economics is the study of: Never enough time, money, energy, chocolate... Economics is the study of: How people make choices under conditions of scarcity and of the results of those choices for society

1. Scarcity Principle Because of scarcity Tradeoffs are widespread Having more of one good usually means having less of another Thus, the “No Free Lunch Principle”-somebody has got to pay!

Scarcity Leads to Opportunity Costs The value of the next best alternative that you did NOT choose. Example: Where to work? Option 1: IBM; Salary = $70 k Option 2: Surf Shop in California; Salary = $30k If you select option 2, what is your opportunity cost?

Opportunity Cost The Opportunity Cost is $70,000! The opportunity cost of selecting job Option 2 is giving up job Option 1. The Opportunity Cost is $70,000! (But what about what we get????)* * Keep costs and benefits separate.

Opportunity Cost Opportunity Cost: The value of the next-best alternative that must be forgone in order to undertake an activity Decisions depend upon opportunity costs It is not the combined value of all other forgone activities, just the next best one

Everyone Faces Scarcity Should Bill Gates pick up a $100 he sees laying on the street? His time is so valuable that picking up a $100 bill might not be worth his while He has 24 hrs/day and limited energy Time spent building his company does not allow time for doing other things Should you spend an hour cutting coupons on Sunday or cut your neighbor’s yard for $25?

2. Cost-Benefit Principle Take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs

What is in it for you? If the opportunity cost is $50 and the benefit is $80, should the trade-off be made? Taking a sick friend’s shift at work for 5 hours after school you will earn $50 Net (before taxes). If you do not take the shift you could watch football with your friends and bet on the game (winner takes $30). Girls will get this question correct, but will the guys???