Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but...

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Thinking Like An Economist

Transcript of Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but...

Page 1: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Thinking LikeAn EconomistThinking LikeAn Economist

Page 2: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Introduction

Example: AccommodationMay 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.

Page 3: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Introduction

What is the Optimal Choice?Option a): benefits: less noise

cost: more expensive

Option b): benefits: cheaper

cost: no peace

Page 4: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Economics: StudyingChoice In a World of Scarcity

The Scarcity PrincipleBoundless wants cannot be satisfied with

limited resources. Therefore, having more of one thing

usually means having less of another.Because of scarcity we must make

choices.

Page 5: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Economics: StudyingChoice In a World of Scarcity

Wants vs. Resources

Scarcity

Choices

Page 6: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Economics: StudyingChoice In a World of Scarcity

Economics The study of how people make choices

under conditions of scarcity and of the results of those choices for society.

Page 7: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Economics: StudyingChoice In a World of Scarcity

The Cost-Benefit PrincipleAn 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

Page 8: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Applying The Cost-Benefit Principle

Should you go to the mall to save $5 on a $20 computer game?The benefit of going to the mall = $5The cost of going to the mall is the dollar

value of everything you give up to go to the mall

Page 9: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Applying The Cost-Benefit Principle

cost of making the trip to the

MallBenefit from

the tripMake the trip to

town?

$10 $5 No

$8 $5 No

$5 $5 Possibly

$4 $5 Yes

$3 $5 Yes

Page 10: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Applying The Cost-Benefit Principle

Rational Person 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.

Page 11: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Applying The Cost-Benefit Principle

Economic SurplusThe benefit of taking any action minus its

cost The goal of economic decision makers is to

maximize their economic surplus

Page 12: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Applying The Cost-Benefit Principle

Opportunity CostThe value of the next-best alternative that

must be forgone to undertake an activity

Page 13: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Applying The Cost-Benefit Principle

ObservationThe cost-benefit principle suggests that we

take only those actions that create additional economic surplus.

Page 14: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 1: Measuring cost and benefits as proportions rather than

absolute dollar amounts Examples:

Should you go to the mall to save $5 on a $800 digital camera?

Page 15: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 2: Ignoring Opportunity CostsExample:

Should you use your frequent-flyer coupon to fly to Fort Lauderdale for spring break?

Assume:Round trip airfare is $500 and is equal to your

frequent flyer couponOther costs equal $1,000

Page 16: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 2: Ignoring Opportunity CostsAssume (cont):

The most you are willing to pay for the Fort Lauderdale trip is $1,350

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)

Page 17: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 2: Ignoring Opportunity Costs Example:

Should you use your frequent flyer coupon to fly to Fort Lauderdale for spring break?

With the coupon: Benefits = $1,350 Cost = $1,400 ($400 opportunity cost + $1,000

other costs) Question

What would you do if the coupon expires just after spring break?

Page 18: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 3: Failure To Ignore Sunk CostsThe only costs that should influence a

decision about whether to take an action are those that we can avoid by not taking the action

Page 19: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 3: Failure To Ignore Sunk CostsSunk cost

A cost that is beyond recovery at the moment a decision must be made

Page 20: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 3: Failure To Ignore Sunk CostsExample

How much should you eat at an all-you-can-eat restaurant?

Assume:Price = $520 randomly selected guests will get lunch on

the house

Page 21: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 3: Failure To Ignore Sunk CostsExample

How much should you eat at an all-you-can-eat restaurant?

Question:If all diners are rational, will there be any

difference in the average quantity of food consumed by these two groups?

Page 22: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 4: Failure To Understand the Average-Marginal DistinctionMarginal Benefit

The increase in total benefit that results from carrying out one additional unit of an activity

Page 23: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 4: Failure To Understand the Average-Marginal DistinctionMarginal Cost

The increase in total cost that results from carrying out one additional unit of an activity

Page 24: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 4: Failure To Understand the Average-Marginal

DistinctionAverage Benefit

The total benefit of undertaking n units of an activity divided by n

Page 25: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 4: Failure To Understand the Average-Marginal

DistinctionAverage Cost

The total cost of undertaking n units of an activity divided by n

Page 26: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

Pitfall 4: Failure To Understand the Average-Marginal Distinction

ExampleShould NASA expand the space shuttle

program from four launches per year to five?Benefits

o $24 billion (average of $6 billion/launch)

Costso $20 billion (average of $5 billion/launch)

Page 27: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Four Important Decision Pitfalls

# of Launches Total Cost Average Cost Marginal Cost ($ billion) ($ billion/launch) ($ billion/launch)

What is the optimal number of launches?

0 0 0

1 3 3

2 7 3.5

3 12 4

4 20 5

5 32 6.4

Assume: Average Benefit = Marginal Benefit = $6 billion

3

4

5

8

12

Page 28: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Normative Economicsvs. Positive Economics

Normative Economic PrincipleOne that says how people should behave

Example: Cost-benefit principle

Positive Economic PrincipleOne that predicts how people will behave

Example: The incentives matter principleo 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).

Page 29: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Economics: Micro and Macro

MicroeconomicsThe study of individual choice under

scarcity and its implications for the behavior of prices and quantities in individual markets

Page 30: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Economics: Micro and Macro

MacroeconomicsThe study of the performance of national

economies, and of the policies that governments use to try to improve that performance

Page 31: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Economic Naturalism

Using insights from economics to help make sense of observations from everyday life

Page 32: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Economic Naturalism

QuestionWhy 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?

Page 33: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Economic Naturalism

QuestionsWhy is airline food so bad?Why do the keypad buttons on drive-up

automatic teller machines have Braille dots?

Page 34: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

Economic Naturalism

ApplicationsUse cost-benefit analysis to explain some

pattern of events or behavior you have observed in your own environment

Page 35: Thinking Like An Economist. Introduction Example: Accommodation May prefer peace and quiet, but houses are expensive, e.g. house rent for $1,000/mo. Choices:

End ofChapterEnd of

Chapter


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