Chapter 1: Thinking
Like an Economist
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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
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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
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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
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The Scarcity Principle: Examples
Scarcity is involved in
Water
Distribution
Health
Delivery
Career
Choices
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Enrolling
in
Classes
5
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
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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
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Cost – Benefit Example
 Back to class size example:
 Assume


Two sizes available: 100 and 20 seats
Currently, university is offering 100-seat sections
 Should
to 20?

(for simplicity):
the university reduce the class size
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
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Cost – Benefit Example
 Shall a company produce 49 or 50 units?
 Answer:
yes if, and only if the extra (marginal)
benefits at the 50th 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 7th hour are larger than the extra costs for the
same hour
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Cost – Benefit: Rationality Assumption
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
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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.
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Economic Surplus
 Benefits of an action minus its costs
Total
Costs
Total Benefits
Economic
Surplus
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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
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Economic Surplus: Exercise
To earn extra money in the
summer, you grow tomatoes
and sell them at the farmers’
market for 30 cents per kg.
By adding compost to your
garden, you can increase
your yield as shown in the
table below. If compost costs
50 cents per kg and your
goal is to make as much
money as possible, how
many kilograms of compost
should you add?
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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
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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
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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?
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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
Measuring costs and benefits as proportions
instead of absolute amounts
2. Ignoring implicit costs
3. Failure to think at the margin
1.
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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
Marginal
Benefits
Marginal
Costs
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Action
19
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
Opportunity
Cost
Implicit
Costs
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Opportunity Cost: Example
 You have Frequent flyer miles
Two options:
 Holidays with friends
Costs: round-trip airfare $500
other costs $1000
Willingness to pay: $1350
 Brother’s wedding
Round-trip airfare $400
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Pitfall #3

When deciding whether to take an action, the only costs
and benefits that are relevant are those that would occur as
a result of taking the action

However, many decisions seem to be influenced by costs
and benefits that would have occurred independently of
whether the action was taken
 In this case, people are influenced by “sunk costs”
• Sunk cost = a cost that is beyond recovery at the
moment a decision must be made
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Pitfall #3

Sunk cost
• It is a fixed cost “sunk” into an industry
- Example: air travel industry  plane / pilot /
stewardesses / baggage handlers / jet fuel / airport
• A fixed cost = a cost incurred independently of the
amount of a good produced
• All sunk costs are fixed
• Not all fixed costs are sunk
- Only those fixed costs which cannot be shifted into
other industries would qualify as sunk costs
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Pitfall #3


Failure to think at the margin
 Sunk costs cannot be
recovered
Example:
 Eating at an all-you-can-eat
restaurant
• Are there any differences in
the quantity of food for
those who pay the regular
entry price and those who
were invited by the owner?
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Marginal
Benefits
Marginal
Costs
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Marginal Analysis Ideas
Marginal cost is the increase in total cost
from one additional unit of an activity
 Average
cost is total cost divided by the
number of units
Marginal benefit is the increase in total
benefit from one additional unit of an
activity
 Average
benefit is total benefit divided by the
number of units
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Marginal Analysis: Tennis Tournaments in the
UAE
# of
Tournaments
Total Cost
($m)
0
$0
1
$3
2
$7
3
$12
4
$20
5
$32
Marginal Cost
($m)
Average Cost
($m/tourname
nt)
$3
$0
$4
$3
$5
$3.5
$4
$8
$12
$5
$6.4
 If the marginal benefit is $6 million per tournament, how many
tournaments should the UAE host?
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Normative and Positive Economics

Normative economic
 Positive economic statements
statements say how people
predict how people will behave
should behave
 Economics of “what is” 
 Economics of “what ought to
focuses on facts and can be
be”  cannot be proven true
proven with data
or false
- “The mean price of
- “Gas prices are too high”
gasoline in 2008 was higher
- “The UAE should
than in 2007”
organize more tennis
tournaments”
- “Organizing a tennis
tournament costs more in
• Cost – benefit principle is
an example of normative
Dubai than in Beirut”
economic principle
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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
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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.
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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
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Chapter 1 Appendix
Working with Equations, Graphs, and Tables
Definitions
Equation
Variable
 Dependent
variable
 Independent variable
Parameter (constant)
 Slope
 Intercept
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From Words to an Equation
Identify the variables
Calculate the parameters
 Slope
 Intercept
Write the equation
Example: Phone bill is $5 per month plus
10 cents per minute
B = 5 + 0.10 T
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From Equation to Graph
B = 5 + 0.10 T
 Draw and label axes


Horizontal is independent variable
Vertical is dependent variable
 To



graph,
Plot the intercept
Plot one other
point
Connect the
points
B
D
12
C
8
6
5
A
10
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70
34
T
From Graph to Equation
 Identify


Independent
Dependent
 Identify


variables
parameters
Intercept
Slope
 Write
the equation
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From Graph to Equation
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Changes in the Intercept
 An


increase in the intercept shifts the curve up
Slope is unchanged
Caused by an increase in the monthly fee
A
decrease in
the intercept
shifts the curve
down

Slope is
unchanged
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Changes in the Slope
 An
increase in the slope makes the curve
steeper


Intercept is unchanged
Caused by an increase in the per minute fee
A
decrease in the
slope makes the
curve flatter

Intercept is
unchanged
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From Table to Graph



Time
(minutes/month)
10
20
30
40
Bill
($/month)
$10.50
$11.00
$11.50
$12.00
Identify variables
 Independent
 Dependent
Label axes
Plot points
 Connect points
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From Table to Graph
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From Table to Equation



Time
(minutes/month)
10
20
30
40
Bill
($/month)
$10.50
$11.00
$11.50
$12.00
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 + 0.05 T
12 = f + 0.05 (40) = f + 2
f = 12 – 2 = 10
B = 10 + 0.05 T
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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?
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Simultaneous Equations
Plan 1
B = 10 + 0.04 T
Plan 2
B = 20 + 0.02 T
Plan 1 has higher per minute price while Plan 2
has a higher monthly fee
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Simultaneous Equations
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Simultaneous Equations
Plan 1 B = 10 + 0.04 T
 Plan 2 B = 20 + 0.02 T
 Subtract Plan 2 equation from
Plan 1 and solve for T

B = 10 + 0.04 T
– B = – 20 – 0.02 T
0 = – 10 + 0.02 T
T = 500
T=500

Find B when T = 500
B = 10 + 0.04 T
B = 10 + 0.04 (500)
B = $30
OR
B = 20 + 0.02 T
B = 20 + 0.02 (500)
B = $30
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