AAEC 2305
Shaikh M Rahman
Lecture 1
Text: Principles of Economics, Chapter 1
Learning Objectives
1. Explain and apply the Scarcity Principle
2. Explain and apply the Cost-Benefit Principle
3. Discuss three important pitfalls that occur
when applying the Cost-Benefit Principle
inconsistently
4. Explain and apply the Incentive Principle
The Scarcity Principle
Economics: The study of how people
make choices under scarcity and the
results of these choices for society.
The Scarcity Principle: People have
unlimited wants and limited resources.
Having more of one good means having
less of another.
Also called No Free-Lunch Principle
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
Cost-Benefit Principle - Examples
You clip
grocery
coupons but
Bill and
Melinda
Gates do not
You speed on
the way to
work but not
on the way to
school
At the ball
park, you pay
extra to buy a
soda from the
hawkers in
the stands
You skip your
regular dental
check-up
Should there be 4 separate sections of AAEC
2305, with 50 students each?
6
Or should there be only one
section, with 200 students?
7
Cost-Benefit Analysis
Benefit: Students learn more effectively in
smaller classes.
Cost: But smaller classes are also more
expensive.
8
Cost-Benefit Analysis
Should I do activity x?
C(x) = the costs of doing x
B(x) = the benefits of doing x
If B(x) > C(x), do x; otherwise don't
9
Example 1.1. Should I turn down my stereo?
10
You have settled into a comfortable chair and are
listening to your stereo when you realize that
the next two tracks on the album are ones you
dislike.
If you had a programmable disc player, you
would have programmed them not to play.
But you don't, and so you must decide whether
to get up and turn the music down, or to stay
put and wait it out.
11
Suppose C(x) = $1.00 = the minimum
amount it would take to get you out of
your chair.
B(x) = the maximum you would be willing
to pay someone to turn down the volume.
If B(x) > $1, then turn your stereo down.
If B(x) < $1, then don't.
12
The Cost-Benefit Principle
An individual (or a firm, or a society)
should take an action if, and only if, the
extra (marginal) benefits from taking the
action are at least as great as the extra
(marginal) costs.
13
Critics of the cost-benefit approach often
object that people don’t really calculate
costs and benefits when deciding what
to do.
But, people often behave as if they were
comparing the relevant costs and benefits.
And, people often make bad decisions
because they fail to compare the relevant
costs and benefits.
14
Economic Models
• Simplifying assumptions
– Which aspects of the decision are absolutely
essential?
– Which aspects are irrelevant?
• Abstract representation of key relationships
– The Cost-Benefit Principle is a model
• If costs of an action increase, the action is less likely
• If benefits of an action increase, the action is more
likely
15
Four Decision Pitfalls
• Economic analysis predicts likely behavior
• Four general cases of mistakes
1. Measuring costs and benefits as proportions
instead of absolute amounts
2. Ignoring implicit costs
3. Failure to ignore sunk costs
4. Failure to think at the margin – failure to
understand average-marginal distinction
16
Pitfall #1
Measuring costs and benefits as proportions instead of
absolute amount
• Would you walk
to town to save
$10 on a $100
item?
• Would you walk
to town to save
$10 on a
$1,000 item?
Marginal
Benefits
Marginal
Costs
Action
17
Can cost-benefit analysis help you
make better decisions?
Example 1.2
You are about to buy a
$20 alarm clock at the
campus store when a
friend tells you that
Walmart has the same
alarm clock on sale for
$10.
Do you drive
down to
Walmart?
18
Example 1.3. You are about to buy a $1,010
laptop computer from the campus store,
when a friend tells you that Walmart has
the same computer on sale for $1,000.
Do you drive down to Walmart?
19
Should you drive down to Walmart?
B(x) = benefit of driving down to Walmart
= $10 in both cases
C(x) = cost of driving down to Walmart
= the same amount in both cases.
So your answer should be the same in both
cases.
20
Example 1.4. Choosing a public health
program.
A rare disease will claim 600 lives if we do
nothing. We must choose between the
following two programs:
Program A: save 200 lives with certainty
Program B: save 600 lives with probability
1/3, and save zero lives with probability 2/3
Which program would you choose?
21
Example 1.5. Same disease as in Example
1.4
Program C: 400 people will die with
certainty
Program D: 1/3 chance that no one will
die, and 2/3 chance that all 600 will die
Which program would you choose?
22
In Example 1.4, most people choose to
save 200 lives with certainty (Program A).
In Example 1.5, most people choose to
save all 600 lives with prob. 1/3 (Program
D).
Yet the two pairs of programs are
identical: A=C and B=D
23
If the list of alternatives among which we choose
are the same in two cases, then the particular
alternative we choose should also be the same
in both cases.
Yet people seem to prefer the safe alternative
when the alternatives are framed as choices
between different numbers of lives saved, and
to prefer the risky alternative when the
alternatives are framed as choices between
different numbers of lives lost.
24
Example 1.6. Losing
a $20 bill
You have just arrived at the theater to buy
your ticket and discover that you have lost a
$20 bill from your wallet.
Do you buy a ticket and see the play
anyway?
25
Example 1.7. A lost theater ticket.
You have just arrived at the theater and
discover that you have lost the $20 ticket
you purchased earlier that day.
Do you buy another ticket and see the
play anyway?
26
• In both cases, you are $20 poorer than before.
• In both cases, the benefit of seeing the play, as
measured by what you are willing to pay, may
therefore be slightly smaller, but this benefit is
the same in both cases.
• In both cases, the additional cost you must
incur to see the play is exactly $20.
• Since the relevant costs and benefits are the
same in both cases, your decision should also
be the same.
27
Exercise: Cost-Benefit Principle
• You have a travel coupon that can be used on either
of two upcoming trips:
• Save $90 on your $200 round-trip ticket to Chicago
or
• Save $100 on your $2000 round-trip ticket to Tokyo.
• For which trip should you use the coupon?
28
Pitfall #2
Ignoring Implicit Costs
• Consider your
alternatives
– The value of a
frequent flyer
coupon depends on
its next best use
• Expiration date
• Do you have time
for another trip
• Cost of the next
best trip
Explicit
Costs
Opportunity
Cost
Implicit
Costs
29
Pitfall #2
Ignoring Implicit Costs
• Implicit Cost - If doing activity x means not being able
to do activity y, then the value to you of doing y is an
implicit cost of doing x.
• Many people make bad decisions because they tend
to ignore the value of such foregone opportunities.
• Consider the questions
– Should I do x?
– Should I do x or y?
• In the latter question, y is simply the most highly
valued alternative to doing x.
30
Example 1.8. Should I go skiing today?
31
From experience you can confidently say
that a day on the slopes is worth $50 to
you.
The charge for the day is $30 (which
includes bus fare, lift ticket, and
equipment).
But this is not the only cost of going skiing.
You must also take into account the value
of the most attractive alternative you will
forego by heading for the slopes.
32
Suppose that if you don't go skiing, you will
work at your new job as a research
assistant for one of your professors.
The job pays $40 dollars per day, and you
like it just well enough to have been willing
to do it for free.
"Should I go skiing or stay and work as a
research assistant?"
33
C(x) = Cost of skiing plus value of forgone
earnings
= $30 + $40
= $70
B(x) = $50 < C(x)
So don't go skiing.
34
Many jobs, of course, are not pleasant.
35
Example 1.9. Suppose instead that your
job had been to scrape plates in the dining
hall for the same pay, $40/day, and that
the job was so unpleasant that you would
be unwilling to do it for less than $25/day.
Should you go skiing?
There are two equivalent ways to look at
this decision.
36
I. One of the benefits of going skiing is not
having to scrape plates.
B(x) = $25 + $50 = $75
C(x) is the same as before, namely the
$30 ski charge plus the $40 opportunity
cost of the lost earnings, or $70.
So now B(x) > C(x), which means you
should go skiing.
37
II. Alternatively, we could have viewed the
unpleasantness of the plate-scraping job
as an offset against its salary.
By this approach, the opportunity cost
of not working in the dining hall is only
$40 - $25 = $15/day.
Then C(x) = $30 + $15 = $45 < B(x) = $50,
and again the conclusion is that you
should go skiing.
38
It makes no difference which of these
two ways you handle the valuation of the
unpleasantness of scraping plates.
It is critically important, however, that
you do it either one way or the other.
Don't count it twice!
39
Example 1.9 makes clear that there is a
reciprocal relationship between costs
and benefits.
Not incurring a cost is the same as
getting a benefit.
By the same token, not getting a benefit
is the same as incurring a cost.
40
Example 1.10. An African graduate
student who recently got his degree was
about to return to his home country.
The trade regulations of his nation
permitted people returning from abroad
to bring back a new automobile without
having to pay the normal 50 percent
tariff.
He had been planning to bring back a
new $10,000 Chevrolet and sell it.
41
Since new cars normally face a 50 percent
import tax, the car would sell at a dealership
there for $15,000.
The student
thought he could
easily sell it
privately for
$14,000, which
would net him a
$4000 profit.
42
Then the student's father-in-law asked him
to bring him back a new $10,000
Chevrolet, and sent him a check for exactly
that amount.
What was the opportunity cost of agreeing
to this request?
43
Example 1.11. Is it fair to charge interest
when lending a friend some money?
Suppose a friend lends you $10,000, and
her primary concern in deciding whether
to charge interest is to decide if it would
be "fair" to do so.
She could have put that same money in the
bank, where it would have earned, say, 5
percent interest, or $500 each year.
44
If she charges you $500 interest for each
year the loan is out, she is merely
recovering the opportunity cost of her
money.
If she didn't charge you any interest, it
would be the same as making you a gift of
$500/yr.
45
If someone chooses not to give you a gift,
is that unfair?
If not, it makes no more sense to say that
recovering the opportunity cost of lending
someone money is unfair.
46
As simple as the opportunity cost concept
is, it is one of the most important in
microeconomics.
The art in applying the concept correctly
lies in being able to recognize the most
valuable alternative that is sacrificed by
the pursuit of a given activity.
47
Pitfall #3.
Failure to ignore sunk costs
• An implicit cost will often not seem like a relevant
cost when in reality it is.
• Another pitfall in decision making is that
sometimes an expenditure will seem like a
relevant cost when in reality it is not.
• Such is often the case with sunk costs, costs that
are beyond recovery at the moment a decision is
made.
• Unlike implicit costs, sunk costs should be ignored.
48
Example 1.12. Should I drive to Boston
or take the bus?
You are planning a 250 mile trip to
Boston.
Except for the cost, you are completely
indifferent between driving and taking
the bus.
Bus fare is $100. You don't know how
much it would cost to drive your car, so
you call Hertz for an estimate.
49
Insurance
Interest
Fuel & oil
Maintenance
Total
$1000
$2000
$1000
$1000
$5000
50
Suppose you calculate that these costs come
to $5000/10,000 miles = $0.50/mile and use
this figure to compute that the 250 mile trip
will cost you $125 by car.
And since this is more than the $100 bus fare,
you decide to take the bus.
If you decide in this fashion, you commit the
error of not ignoring sunk costs.
51
Fuel & oil and maintenance costs come to
$2000 for each 10,000 miles you drive, or
$.20/mile.
At $.20/mile, it costs you only $50 to drive
to Boston.
Since this is much less than the bus fare,
you should drive.
52
Suppose you had been willing to pay $60
to avoid the hassle of driving.
Then the real cost of driving would have
been $110, not $50, and you should have
taken the bus.
53
Example 1.13. How, if at all, would your answer
to the question posed in Example 1.12 be
different if the hassle of driving is $20 and if you
average one $28 traffic ticket for every 200
miles you drive?
Someone who gets a $28 traffic ticket every 200
miles driven will pay $35 in fines, on the
average, for every 250 miles driven. Adding that
figure to the $20 hassle cost of driving, then
adding the $50 fuel, oil, and maintenance cost,
we have $105. This is more than the $100 bus
fare, which means taking the bus is best.
54
Example 1.14. The Pizza Experiment.
A local pizza parlor offers an all-you-can-eat
lunch for $3.
You pay at the door, and then the waiter
brings you as many slices of pizza as you
like.
The "waiter" selects half of the tables at
random and gave everyone at those tables
a $3 refund before taking orders.
55
The remaining half of his tables got no
refund.
If all diners were rational, what difference,
if any, would you predict in the amounts
of pizza eaten by these two groups?
56
"Should I eat another slice of pizza?"
57
For both groups, C(x) is exactly zero.
Because the refund group was chosen at
random, B(x) should be the same for each
group, on the average.
People from both groups should keep
eating until B(x) falls to zero.
58
So the two groups should eat the same
amount of pizza, on the average.
The $3 admission fee is a sunk cost, and
should have no influence on the amount of
pizza one eats.
In fact, however, the group that did not get
the refund consumed substantially more
pizza.
59
Pitfall # 4:
Failure to understand the average-marginal distinction
• Marginal cost is the increase in total cost from
one additional unit of an activity
– Average cost is total cost divided by the number
of units
• Marginal benefit is the increase in total
benefit from one additional unit of an activity
– Average benefit is total benefit divided by the
number of units
60
Marginal Analysis: NASA Space Shuttle
# of Launches
Total Cost ($Bill.)
Marginal Cost ($bill.
0
$0
1
$3
$3
2
$7
$4
3
$12
$5
4
$20
$8
5
$32
$12
If the marginal benefit is $6 billion per launch,
how many launches should NASA make?
61
Example 1.15. How much memory should
your computer have?
Suppose that
random access
memory can be
added to your
computer at a cost
of $15 per gigabyte.
62
How many megabytes of memory should
you purchase?
"Should I do X?"
"How much X should I buy?"
"Should I buy an additional unit of X?"
63
Buy an additional megabyte if the marginal
benefit of RAM is at least as great as its
marginal cost
Marginal benefit = added benefit from
having 1 more unit
Marginal cost = added cost of having 1
more unit
64
65
66
Example 1.16. Where should you send your boats?
67
Suppose you own a fishing fleet consisting of a given
number of boats, and can send your boats in whatever
numbers you wish to either of two ends of an
extremely wide lake, east or west.
Under your current allocation of boats, the ones fishing
at the east end return daily with 100 pounds of fish
each, while those in the west return daily with 120
pounds each.
The fish populations at each end of the lake are
completely independent, and your current yields can
be sustained indefinitely.
Where should you send your boats?
68
Average Catch:
West End: 120 lbs./boat
East End: 100 lbs./boat
True or False: If you shift some of your
boats from the east end to the west end,
you will catch more fish.
69
Example 1.17. Now suppose that you have 4
boats and the volume of catch decreases as
more boats are fishing in the west end of the
lake, while the volume of catch remains the
same per boat in the east end.
How many boats should you send to the east
and west ends?
No. of
Boats
East End
(lbs. of fish)
West End
(lbs. of fish)
Total
Average
Marginal
Total
Average
Marginal
1
100
100
100
130
130
130
2
200
100
100
240
120
110
3
300
100
100
330
110
90
4
400
100
100
400
100
70
70
The general rule for allocating a resource
efficiently across different production
activities is:
Allocate each unit of the resource to the
production activity where its marginal
benefit is highest.
71
For a resource that is perfectly divisible,
and for activities for which the marginal
product of the resource is not always
higher in one than in the others, the rule
is:
Allocate the resource so that its marginal
benefit is the same in every activity.
72
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
73
Economics Is Choosing
• Focus in this course is on a short list of
powerful ideas
– Explain many economic issues
– Predict decisions made in a variety of
circumstances
• Core Principles are the foundation for solving
economic problems
1-74
74
Microeconomics and Macroeconomics
 Microeconomics studies
choice and its implications
for price and quantity in
individual markets
 Sugar
 Carpets
 House cleaning services
 Microeconomics considers
topics such as
 Costs of production
 Demand for a product
 Exchange rates
 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
1-75
75
Chapter 1 Appendix
Working with Equations, Graphs,
and Tables
76
Definitions
• Equation: A mathematical expression that describes
the relationship between two or more variables
• Variables: A quantity that is free to take a range of
different values.
– Dependent variable: a variable in an equation
whose value is determined by the value taken by
other variables in the equation
– Independent variable: a variable in an equation
whose value determines the value taken by another
variable in the equation
• Parameter (constant): A quantity that is fixed in value
77
From Words to an Equation
• Identify the variables
• Calculate the parameters
– Slope: In a straight line, the ratio of the vertical
distance the straight line travels between any two
points to the corresponding horizontal distance.
– Intercept: In a straight line, the value taken by the
dependent variable when the independent variable
equals to zero.
• Write the equation
• Example: Phone bill is $5 per month plus 10 cents per
minute
B = 5 + 0.10 T
78
From Equation to Graph
– Equation:
B = 5 + 0.10 T
– Draw and label axes
• Independent variable in the horizontal axis
• Dependent variable in the vertical axis
– To graph,
B
12
• Plot the intercept
C
• Plot one other
8
A
point
6
5
• Connect the
points
10
30
D
70
T
79
From Graph to Equation
– Identify variables
• Independent
• Dependent
– Identify parameters
• Intercept
• Slope
– Write the equation
B = 4 + 0.2 T
80
Changes in the Intercept
– An increase in the intercept shifts the curve up
• Slope is unchanged
• Caused by an increase in the monthly fee
– A decrease in
the intercept
shifts the curve
down
• Slope is
unchanged
81
Changes in the Slope
– An increase in the slope makes the curve steeper
• Intercept is unchanged
• Caused by an increase in the per minute fee
– A decrease in the
slope makes the
curve flatter
• Intercept is
unchanged
82
From Table to Graph
Time
(minutes/month)
10
20
30
40
Bill
($/month)
$10.50
$11.00
$11.50
$12.00
– Identify variables
• Independent
• Dependent
– Label axes
– Plot points
• Connect points
83
From Table to Equation
Time
(minutes/month)
10
20
30
40
Bill
($/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
84
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?
85
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
• Find B and T
for point A
86
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
Find B when T = 500
Use Plan 1 equation
B = 10 + 0.04 T
B = 10 + 0.04 (500)
B = $30
OR
Use Plan 2 equation
B = 20 + 0.02 T
B = 20 + 0.02 (500)
B = $30
87