1 Thinking Like an Economist. 2 Philosophy of This Course Focus on covering the core ideas of economics rather than covering many topics superficially.

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Thinking Like an EconomistThinking Like an Economist

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Philosophy of This CoursePhilosophy of This CourseFocus on covering the core ideas of

economics rather than covering many topics superficially – chances are, you’re not going to be economists …

Encourage active learning--one must do and see economics in order to learn it

Uses examples, exercises, and applicationsEncourages thinking critically when considering the

problemsEncourages discussing interesting insights with friends

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Core Principles 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

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Core PrinciplesCore Principles

The Equilibrium Principle

The Principle of Increasing Opportunity Cost

The Efficiency Principle

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Economic NaturalismEconomic NaturalismUsing your insights from economics to

make sense of observations from everyday life

Learning economic principles enables us to see the ordinary details of life in a new lightE.G., Look for differences in costs and

benefits

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Economic NaturalismEconomic NaturalismExamples of Economic Naturalism

Questions:Why did people switch from big cars to

little cars in the 1970’s only to switch back again in the 1990’s?

Why do drive-up teller machines have Braille dots on the keypads?

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?

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Economic NaturalismEconomic Naturalism

Why do people shout at parties?Why do drug stores offer senior citizen

discounts 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?

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ScarcityScarcity

Scarcity is a fact of lifeNever enough time, money, energy….

Economics is the study of how people make choices under conditions of scarcity and of the results of those choices for society

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Scarcity PrincipleScarcity Principle

Because of scarcityTradeoffs are widespreadHaving more of one good usually means

having less of anotherAKA the “No free lunch Principle”

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Scarcity implies opportunity costs

Scarcity implies opportunity costs

Opportunity Cost The value of the next best (unchosen)

alternative.

Example: job choice.Option 1: IBM in RTP, salary = $70 k

Option 2: Own surf shop in Wilm, salary = $30k

If you select option 2, what is your opportunity cost?

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Opportunity CostOpportunity Cost

The opportunity cost of selecting job option 2 is giving up job option 1.

= $70 k salary, living in Raleigh, etc…Everything that you gave up.

* We must keep costs and benefits separate!

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Opportunity CostOpportunity Cost

Opportunity Cost: The value of the next-best alternative that must be forgone in order to undertake an activity

Decisions depend upon opportunity costsIt is not the combined value of all other

forgone activities, just the next best one

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Example: Waking up earlyExample: Waking up early

Suppose its Saturday and you have to decide whether to sleep in or get up early and fix the fence.

Do you get up early?A cost-benefit analysis says only if the

benefits outweigh the costs

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Benefit of waking up earlyBenefit of waking up early

The benefit of waking up early is estimated by theHighest price you would be willing and

able to pay to have the fence fixedThis is your reservation price for having a

fixed fenceSuppose this benefit is $200

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Cost of waking up earlyCost of waking up early

The cost is estimated by theValue to you of the extra sleep = what you

would be willing to pay for the additional rest

This is your reservation price for the extra hours of sleep

Suppose the cost of getting up early is $100

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Solution to Example 1.1Solution to Example 1.1The benefit of having a fixed fence ($200) is

greater than the cost (not having a fixed fence) ($100) [i.e., your economic surplus is $200-$100= $100]You should get up early

Suppose that the value of your alternatives changePerhaps you have a test on Monday and need the

extra hours to study. In this case, your opportunity costs have changed and you may decided against fixing the fence.

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Everyone Faces ScarcityEveryone Faces ScarcityEven Bill Gates faces scarcity

Should he pick up a $100 bill on the ground?Someone once estimated that his time was so valuable

picking up a $100 bill wouldn’t be worth his while

But, he only has 24 hours a day and a limited amount of energyIf he spends his time building his business empire, then

he cannot use that time doing other things

Do you cut the coupons from the Sunday paper?

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Cost-Benefit PrincipleCost-Benefit PrincipleTake an action if, and only if, the extra

benefits from taking the action are at least as great as the extra costs

Measuring the costs and benefits is often difficultOne may have to use assumptions and/or

approximationsHelps us answer “yes/no” questions

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People Are RationalPeople Are Rational

Economists assume that people are rational — that they try to fulfill their goals as best they can

“Rational” here means only pursuing actions where the benefits are at least as great as the costs.

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Reservation PricesReservation PricesThe highest price one would be willing (and

able) to pay for any good or service“Maximum willingness-to-pay (WTP)”

It is equal to the benefit (value) received from the good or service

What happens if your max WTP is < price?What happens if your max WTP is > price?

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Economic SurplusEconomic Surplus

The benefit of taking an action minus its costEconomic Surplus = Benefit - CostRational decision makers take all actions

that yield a positive economic surplus

Should you buy an item if surplus = 0?Eg: max WTP = $19,500 & P = $19,500

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Role of ModelsRole of ModelsAn “abstract model” is a simplified

description capturing essential elements of a situationIt allows logical analysisIt includes only the major forces at work and will

ignore many details

I.E., the cost-benefit principle is an abstract model of how an idealized individual would choose among competing alternatives

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Imperfect Decision Makers

Imperfect Decision Makers

Rational people will apply the cost-benefit principle using their intuition

However, people can make mistakes when weighing the costs and benefits

People often make inconsistent choices

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Example 1.6Lost Theater Ticket

Example 1.6Lost Theater Ticket

A theater tickets cost $10You have at least $20 and want to see a

play

Would you buy a theater ticket after losing a $10 bill?

Would you buy a second theater ticket after losing the first?

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Example 1.6Lost Theater Ticket

Example 1.6Lost Theater Ticket

Many people say that they would purchase the ticket after losing the $10 but would not purchase a second ticket after losing the firstThis is inconsistent behavior since the financial

loss is equivalent

The choice of whether to see the play depends upon whether seeing the play is worth spending $10

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Marginal AnalysisMarginal Analysis

Comparing incremental or additional costs and benefits

More powerful than traditional CBA because it allows us to make quantity decisions

Always get the “best” answer, while CBA only allows for “good” answers

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Marginal AnalysisMarginal Analysis

Marginal BenefitThe increase in total benefit that results

from carrying out one additional unit of the activity

Marginal CostThe increase in total cost that results from

carrying out one additional unit of the activity

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Marginal AnalysisMarginal AnalysisExample: How

many slices of pizza to eat?

Assume: P = $1.50 per slice

Note: P = cost of an additional unit = marginal cost

Q MC MB

1 $1.50 $4.00

2 $1.50 $3.00

3 $1.50 $2.00

4 $1.50 $1.00

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Marginal AnalysisMarginal Analysis

The optimal quantity here (Q*) is 3 slices.

Why? For slices 1-3 there is a surplus of

benefit over cost – net gain.For the 4th slice MC > MBTotal net gain = surplus = sum of MB –

MC for all units consumed = $4.50

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Marginal Analysis vs. CBAMarginal Analysis vs. CBA

What would happen if we used CBA and the same data to ask:

Should you eat 4 slices … yes or no?

4 slices:

Total Benefit = $10.00 ($4+ $3+$2+$1)

Total Cost = $6.00 ($1.50 x 4)

Net gain (surplus) = $4.00

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The Marginal Cost and Benefit of Additional RAM

The Marginal Cost and Benefit of Additional RAM

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Falling RAM Prices Increase the Optimal Amount of Memory

Falling RAM Prices Increase the Optimal Amount of Memory

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An Increase in the Marginal Benefit of RAM Increases the Optimal

Amount of Memory

An Increase in the Marginal Benefit of RAM Increases the Optimal

Amount of Memory

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Optimal Level Optimal Level If the marginal benefit is greater than

marginal costIncrease output (consume or produce more)

If the marginal benefit is less than the marginal costDecrease output (consumer or produce less)

Optimal output is where marginal benefit equals marginal costMB = MC

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Micro and MacroMicro and Macro

Microeconomics studiesChoices of individual consumers and firmsBehavior of specific marketsHow are prices and quantities determined?

Macroeconomics studiesPerformance of national economiesGovernment policies to change performanceUnemployment rate, and the price level

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Always TradeoffsAlways Tradeoffs

The scope of macro and micro are different

However, both are trying to predict behavior that is based on scarcityClear thinking about economic problems

will always account for tradeoffs--having more of one good thing usually means having less of another

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Decision PitfallsDecision Pitfalls

Dollars or proportions?

Example A: Buy an alarm clock on campus for $20 or drive to K-Mart and buy it for $10?

Is the drive worth saving $10?

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Decision PitfallsDecision Pitfalls

Dollars or proportions?

Example B: Buy a computer on campus for $2,000 or drive to K-mart and buy it for $1,990?

Answer should be the same …

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Decision PitfallsDecision PitfallsDon’t ignore opportunity costs

The most you are WTP for a trip = $1,350 = your benefit from the trip

Airfare = $500Other expenses = $1,000You have a frequent flyer coupon worth

$500, which expires in one year.

Should you go on the trip?

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Decision PitfallsDecision Pitfalls

Ignore sunk costs – they’re sunk!You and a friend are both planning on going to a

concert. You buy your $30 ticket ahead of time, while she waits to buy hers at the gate. The night of the show, there is a snow storm, which makes travel to the concert dangerous.

Who is more likely to go to the concert?

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Decision PitfallsDecision Pitfalls

Average or marginal? Pizza example revisited:4 slices average benefit = $2.50 ($4 + $3 +

$2 +$1) / 44 slices average cost = $1.50 Should you eat 4 slices?

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Not all costs and benefits are the same

Not all costs and benefits are the same

Marginal costs and benefits matterOpportunity costs matter

Sunk costs do not matterAverage costs and benefits do not

matter