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Thinking Like
An Economist
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Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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
Economics: Studying
Choice In a World of Scarcity
The Scarcity Principle: No Free Lunch
Our wants are unlimited while our
resources are limited.
 Even in a rich country like the US there
isn’t enough resources (time, money,
energy, etc.) to do or have everything we
want.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 2
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
Economics: Studying
Choice In a World of Scarcity
The Scarcity Principle: No Free Lunch
Scarcity implies we need to make choices
 Scarcity means that we encounter tradeoffs
 Scarcity implies that having more of one
thing usually means giving up something
else.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 3
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Economics: Studying
Choice In a World of Scarcity
Wants vs. Resources
Scarcity
Choices
Copyright c 2004 by The McGraw-Hill
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Chapter 1: Thinking Like an Economist
Slide 4
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
Economics: Studying
Choice In a World of Scarcity
Economics is therefore
The study of how people make choices
under conditions of scarcity and what the
effects of these choices are on society.
 The study of Economics will help you make
more informed choices.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 5
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
Economics: Studying
Choice In a World of Scarcity
The Cost-Benefit Principle

An individual (or a firm or a society) should
take an action if, and only if, the extra or
additional benefits from taking the action
are at least as great as the extra or
additional costs.
 In
Economics, extra or additional is
called Marginal
Copyright c 2004 by The McGraw-Hill
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Chapter 1: Thinking Like an Economist
Slide 6
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Cost Benefit Principle

What is the Optimal Class Size for Econ
1011?



Let’s build a simple model to answer this.
Simplifying Assumptions
 Suppose the only cost of offering classes is the
professor’s salary and the cost of a classroom
large enough.
 Assume that the university charges tuition only
to cover costs (no profits).
Data
o Professor’s salary is $100,000 per semester
and space costs $30 per student per
semester
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 7
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Application of Cost-Benefit Principle
Should the University offer more small sections of
Micro Principles?

BENEFITS

COSTS

Improved learning
outcome with better
student-teacher
interaction.

Higher cost of
instruction per
student which
translates to higher
tuition.
Copyright c 2004 by The McGraw-Hill
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Application of Cost-Benefit Principle

Cost of a 225 student
large lecture

Cost of a 45 student
small section

Total cost : 100,000 +
225 x 30 = $106,750

Total cost : 100,000
+ 45 x 30 = $101,350

Cost per student:
$474.44

Cost per student:
$2,252.22
Copyright c 2004 by The McGraw-Hill
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Application of Cost-Benefit Principle

Choosing the Optimal Class Size
Revisited
 Should the class size be reduced to
45 students?
 Yes, if the value of the additional
(marginal) learning is at least $2,252 $474 = $1,778 to you.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 10
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Application of Cost-Benefit Principle

Does Bill Gates face scarcity?
 Will it be worthwhile for Bill Gates to stop to
pick up a $100 bill lying on the sidewalk?
 Probably not! The distraction will probably
not be worth his while!
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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Application of Cost-Benefit Principle

Does Bill Gates face scarcity?
 Bill Gates’ wealth is estimated at about $80
billion. Clearly he has more money than
most.
 However, he still is constrained by 24 hours
in a day and a limited amount of energy,
and yes, a limited amount of money!
Copyright c 2004 by The McGraw-Hill
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Application of Cost-Benefit Principle
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
Why do vending machines allow you to take
only one soda can but as many newspapers
as you want?
Why do we have rectangular milk cartons and
cylindrical soda cans?
Why did many cars sold in the southern US
not have heaters on them in the 1950s but
now they all do?
Why do women’s clothes button from the left
and men’s clothes button from the right?
Copyright c 2004 by The McGraw-Hill
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Principle of Opportunity Cost



What is your total cost of attending
college?
Accountant’s view (lay person’s view) –
Tuition, housing, books and supplies,
entertainment, etc., - a total of $60,000
+ per year.
Economist’s view – To the above add
opportunity cost - the value of foregone
wages.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 14
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Principle of Opportunity Cost
 The
opportunity cost of an activity is
the value of the next best alternative
that must be foregone to undertake
this activity.
 It is not the total value of everything
that you could have done had you not
pursued this activity. It is simply the
highest valued one.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 15
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

Principle of Opportunity Cost – An
Example
Say you are considering going to concert
tonight. The ticket costs $60. You could
also have tutored Dan in high school Math
for $40 or you could have cleaned Prof. B’s
garage for $30.
If you choose to go to the concert your total
cost (thinking like an economist) will be
$100;

$60 = explicit cost, money cost or accounting
cost; $40 = opportunity cost.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 16
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


Principle of Opportunity Cost – Another
Example
Say you won a free ticket to the opera tonight
(can’t be transferred or resold). There is a
Cardinals game on as well and that is your only
other option. A ticket to the game costs $40 and
on any given day you value the game at $50
(implying you will not go to the game if ticket prices
are more than $50, even if you have nothing else
to do). There are no other costs of going either to
the opera or to the game.
What is your OC of attending the opera?
$50 - $40 = $10 (net benefit from the game)
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 17
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Applying The Cost-Benefit Principle

Say you live on campus and want to
purchase a backpack.
 You can buy the exact same
backpack at the University bookstore
for $60 or at Wal-Mart (in nearby
Brentwood) for $25.
 Where will you buy?
 Apply the cost-benefit principle.
Copyright c 2004 by The McGraw-Hill
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Chapter 1: Thinking Like an Economist
Slide 18
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Applying The Cost-Benefit Principle

Compare the additional costs and
additional benefits of the activity.
Additional Benefit of buying at Walmart is:
$60 - $25 = $35.
 Additional cost of buying at Walmart is:
cost of gas, depreciation and the value
of the additional time spent.
 Conclusion:
Buy from Walmart if addl. cost is less
than $35.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 19
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Economic Surplus
Economic surplus from taking an action is the
net benefit (benefit – cost) from it.
 How can I figure out your cost (money cost plus
opportunity cost) of going to Walmart? I can ask
you:
What is the least amount of money I have to
pay you to go to Walmart to buy me
something? Suppose you say $11. Then
your ES from this Wal Mart trip =
 Economic Surplus = Benefit – Cost
= $35 - $11 = $24.
 Conclusion: buy at Walmart if your ES>0.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 20
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






Cardinals Game Vs. Opera – Another
Look
Suppose you now know that the value you place
on the opera is $35 (if you did have to buy tickets
to the opera the maximum you’d pay is $35).
What is the economic surplus from going to the
cardinal’s game?
Minus $25 = ($50 - $40) - $35
What is the Economic Surplus from the opera?
Plus $25 = $35 – ($50 - $40)
Would you go to the game or the opera?
Opera.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 21
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Applying The Cost-Benefit Principle

Observation
The cost-benefit principle suggests that we
take only those actions that create
additional economic surplus.
 The goal of economic decision makers is to
maximize their economic surplus

Copyright c 2004 by The McGraw-Hill
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Chapter 1: Thinking Like an Economist
Slide 22
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Principle of Rationality


A Rational Person is someone with welldefined goals who tries to fulfill those
goals as best he or she can.
Say you have a dinner date tonight.
Your clothes are clean but not ironed
(you dislike ironing clothes). Will you
iron your clothes?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 23
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The Role of Economic Models
 Economic
models are abstract
constructs (simplified descriptions)
that allow us to analyze situations in a
logical way.
 Most of us make sensible decisions
most of the time without calculating
our costs and benefits explicitly.
 An understanding of basic economic
principles help us take decisions in a
more informed way.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 24
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Three Important Decision Pitfalls

Pitfall 1: Measuring cost and benefits as
proportions rather than absolute dollar
amounts
 Which is more valuable:
 Saving $100 on a $2000 plane ticket,
or,
 Saving $90 on a $200 plane ticket?
Assume
you have to make both trips
and you have only one voucher.
Copyright c 2004 by The McGraw-Hill
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Chapter 1: Thinking Like an Economist
Slide 25
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Pitfall 1…continued
 Say
you need to buy a $100 harddrive. It is available at the University
Bookstore at full price and at BestBuy at a $25 discount . There are no
other hidden costs or benefits.
 Where will you buy?
 Now suppose you need to buy a
$1000 camera lens. It is also
available on campus at full price and
at Best-Buy at a $25 discount.
 Where will you buy?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 26
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Three Important Decision Pitfalls

Pitfall 2: Ignoring (Implicit) opportunity costs
People often make bad decisions because they
ignore Implicit opportunity costs.
 Ms. A is trying to plan her Spring break. Round
trip airfare to Fort Lauderdale is $500 and other
costs equal to $1,000. She may also use a
frequent flyer coupon (a Christmas gift from
Mom) that is good for this trip alone. She is
willing to spend a max. of $1350 for the
vacation.
 Should she go?
 Net Benefit = $1350 – $1000; Yes

Copyright c 2004 by The McGraw-Hill
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Chapter 1: Thinking Like an Economist
Slide 27
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Pitfall 2: Ignoring Implicit
opportunity costs…continued
 On
calling the airline Ms. A finds out
that her frequent flyer coupon is also
good for flying to Chicago (Mom was
wrong, as usual). She wants to
attend a friend’s wedding there in two
weeks time. A ticket to Chicago costs
$400.
 Should she use the coupon to fly to
Fort Lauderdale?
 Net Benefit = $1350 - $1400. No
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 28
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Three Important Decision Pitfalls

Pitfall 3: Failure To Think at the Margin
Not all costs are created equal.
 The only costs that should influence a decision
about whether to take an action are the ones you
CAN avoid by not taking the action
 Similarly, the only benefits that should influence a
decision about whether to take an action are the
ones you WILL forego by not taking the action
 SUNK COSTS are beyond recovery at the time of
decision making and should be ignored.

Copyright c 2004 by The McGraw-Hill
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Chapter 1: Thinking Like an Economist
Slide 29
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Pitfall 3: Failure To Ignore Sunk
Costs…continued
 Say
you walk into an all-you-can-eat
buffet. How much will you eat?
 Suppose the owner offers lunch on
the house to 20 randomly selected
guests. Will they eat any more on
average?
 NO.
Copyright c 2004 by The McGraw-Hill
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Chapter 1: Thinking Like an Economist
Slide 30
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Pitfall 3: Failure To Ignore Sunk
Costs…continued
 In
experiments people eat significantly more
if they pay as opposed to if they get the lunch
on the house.
 Either, people are irrational, or,
 They may have greater implicit costs when
the restaurant offers the lunch free. For
example, you may want to return the favor by
not wanting to look like an insensitive glutton
by eating like there is no tomorrow.
Copyright c 2004 by The McGraw-Hill
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Chapter 1: Thinking Like an Economist
Slide 31
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Pitfall 3: Failure to think at the
Margin…continued
In addition to not ignoring sunk costs, people
often use incorrect measures of costs and
benefits especially when deciding on the extent
of an activity to undertake
 Say I currently produce 100 pages of software
code and am currently incurring $4000 in losses.
Should I chug along?
 Loss implies Total Costs > Total Revenues.
 Also, I have an average loss of $40 which
implies that Average Cost > Average Benefit.

Copyright c 2004 by The McGraw-Hill
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Chapter 1: Thinking Like an Economist
Slide 32
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
Pitfall 3: Failure to think at the
Margin…continued
But the Marginal Benefit may very well be
greater than the Marginal Cost. That’s the key.
Marginal Benefit: The increase in total benefit
that results from carrying out one additional unit
of an activity.
 Marginal Cost: The increase in total cost that
results from carrying out one additional unit of
an activity.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 33
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Pitfall 3: Failure to think at the
Margin…continued
 Average
Benefit: The total benefit of
undertaking n units of an activity
divided by n.
 Average Cost: The total cost of
undertaking n units of an activity
divided by n.
 Economic decisions are taken using
marginal costs.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 34
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Economics: Positive and Normative



Positive Economics
 A study of how people will behave.
Normative Economics
 A study of how people should
behave.
Incentive Principle
 Is a positive economic principle that
predicts that an economic agent is
more (less) likely to take an action if,
ceteris paribus, its benefit (cost) rises.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 35
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Economics: Micro and Macro


Microeconomics
 The study of individual choice under
scarcity and its implications for the
behavior of prices and quantities in
individual markets.
Macroeconomics
 The study of the performance of
national economies, and of the
policies that governments and central
banks use to try to improve that
performance.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 36
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Economic Naturalism
 Why
do many hardware manufacturers
include over $1000 in “free” software on
computers selling for only slightly more than
that?
 Why do keypad buttons on drive-up ATM
machines have Braille dots on them?
 Why do women buy wedding dresses while
men rent them?
 Why do cars have so many “child safety”
additions and most school buses not even
have seat belts?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 1: Thinking Like an Economist
Slide 37
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End of
Chapter
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Copyright c 2004 by The McGraw-Hill
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