Chapter 1:
The Scope and
Method of
Economics
Chapter 1 Objectives:
1.
2.
3.
4.
5.
Upon completion of this chapter, you should
understand and be able to answer these key
questions:
Why study economics?
What are opportunity costs and how do they differ
from sunk costs?
What does it mean to say that there’s “no free
lunch?”
What’s the difference between positive and
normative questions?
What are some logical pitfalls that often get in the
way of clear thinking about important questions?
To Learn a Way of Thinking
Probably the most important reason for studying economics is to
learn a way of thinking. A good way to introduce economics is to
review three of its most fundamental concepts: opportunity cost,
marginalism, and efficient markets. If your study of economics is
successful, you will use these concepts every day in making
decisions.
You will be a:
 Better problem solver
 More critical thinker
 More informed voter
 More successful person
Source: Case & Fair, Principles of Microeconomics
While there is no doubt that luck, both good
and bad, plays a role in determining the
success of firms, we believe that success is
often no accident. We believe that we can
better understand why firms succeed or fail
when we analyze decision making in terms of
consistent principles of market economics
and strategic action.
Besanko, et. al
Economics of Strategy (2nd)
Key Concepts
(* elaborated on in lecture)
1.
2.
Cartesian coordinate system and graphs*
Criteria for evaluating economic results
a.
b.
3.
Economic growth
Efficiency
c.
d.
Equity
Stability
Criteria for evaluating economic choices (or making
decisions or solving problems)
a.
b.
c.
Opportunity cost*
‘Marginalism’ and sunk costs*
Efficient markets*
Key Concepts (cont’d)
4.
5.
Economics*
Errors or cautions in logic or reasoning*
a.
b.
c.
d.
6.
7.
8.
9.
Post hoc
Fallacy of composition
Ceteris paribus
Correlation vs. causality
Macroeconomics vs. microeconomics*
Models, theories, and variables
Normative vs. positive economics
Negative vs. positive slopes*
Economics is a social science that studies
how people, either individually or collectively,
make choices to use scarce resources.
Q.
Explain further or define each of the
underlined words above.
A.
People 
Choices 
consumers, workers, gov’t officials
consumption, production, exchange,
policies
Scarce 
limited
Resources  natural (e.g. land, water)
capital (man-made bldgs & equip)
labor
managerial skills
financial (i.e. money)
time
Accounting Costs
 Out-of-pocket
costs or costs as an
accountant would define them.
Sometimes referred to as explicit
costs.
Opportunity Costs
 The
best alternative that we forgo,
or give up, when we make a choice
or a decision. These are noncash
or implicit costs.
Economic Costs
 Costs
that include both explicit
costs and the full opportunity costs
(implicit costs) of all inputs.
Sunk Costs
 Costs
that cannot be avoided,
regardless of what is done in the
future, because they have already
been incurred.
Total Fixed Costs
 Costs
that do not depend on the
quantity of output produced.
These must be paid even if output
is zero.
Total variable costs
 Costs
that vary with the level of
output.
Total Cost
 The
total economic cost of all the
inputs used.
Opportunity Cost Examples of
1.
2.
3.
4.
A student skipping Dr. Deiter’s Econ class?
Going to college versus entering the work
place?
An investor waiting a year to sell some
property versus selling now?
A business firm buys some new machinery?
Thought of the Day
“There is no such thing as a
‘free’ lunch.”
- Milton Friedman
Evaluating Choices
Economists are noted for evaluating choices
or alternatives by identifying and quantifying
the associated benefits and costs.
Economists are also noted for emphasizing
marginal (or incremental or additional)
benefits and costs in choosing among
alternatives.
Marginal Analysis



Marginal => additional, incremental
changes
Often involves analyzing how changes in
one variable will change/impact another
variable
Two components of analysis:
1.
2.
Direction of change(s) and
Magnitude of change(s)
Marginal Analysis Example #1
Joe lives in Houston and is traveling to
Kansas City on business. What is the
‘marginal’ cost to Joe of visiting his
grandmother who lives in Des Moines by
extending his trip one more day?
Marginal Analysis Example #2
Why does an airline sometimes set
aside a few seats to be sold at big
discounts through pricline.com or
other Web sites?
Marginal Analysis Example #3
Sue has been asked by her boss to attend a
business meeting 125 miles away by either
renting a car for $50 (fuel costs not included)
or by driving a company-owned car. Her
boss has asked her to choose the cheapest
form of transportation for the company.
Identify marginal and sunk costs of driving
the company car.
Q. What is the favorite bumper sticker of most
economists?
A. Economists Do It ‘Marginally’
Examples of Marginal Analysis Questions
Typically of Interest to Firm Managers
(TR = total revenue, TC = total cost)
What will happen to:
1.
Our TR if we sell 1 more unit of product?
2.
Our TC if we sell 1 more unit of product?
3.
Our profit if we sell 1 more unit of product?
4.
Our production if we hire 1 more unit of labor?
5.
Our TC if we hire 1 more unit of labor?
6.
Our TR if our main competitor lowers the price of their
product by $1?
“Good” Economic Decisions
 Marginal
benefits > marginal costs
Examples of marginal benefits:
 profit
 revenue
 cost
 safety
 risk
Marginal costs = opposite of above examples
‘Efficient’ markets (or situations) implies unequal
‘costs’ or ‘profits’ associated with alternatives are
eliminated as people respond to incentives (e.g.
profit, risk, time savings, price, money, etc.)




Examples:
Drive-through lanes at a bank
Local gas station making ‘excessive’ profits
Business firm producing a product out of two plants
Cautions in analyzing variable
relationships
Caution #1.
Ceteris paribus  hold all relevant
explanatory variables EXCEPT one constant
e.g. # miles driven depends on price of
gasoline, ceteris paribus
Cautions in analyzing variable
relationships
Caution #2.
Post hoc fallacy  falsely assuming a first
event caused second event
e.g. price of gasoline decrease caused the
stock market to decrease
Cautions in analyzing variable
relationships
Caution #3.
Correlation does not imply causality
e.g. the number of cars and number of
crimes in cities are positively correlated; thus,
cars cause crimes
Cautions in analyzing variable
relationships
Caution #4.
Fallacy of composition  what is good for
one is not necessarily good for all
e.g. one person vs. everybody standing up to
get a better view at a sporting event
Equation of a straight line where:

y
x
Y
=
=
=
vertical axis variable
horizontal axis variable
b + mx where
b = vertical-axis intercept
(value of y when x = 0)
m = slope = Δy/Δx =
y1  y2
x1  x2
The slope (m) of a line has two
components:
1.
Sign
> 0  y and x  (or ) together
 positive correlation
2.
Number (or magnitude) which shows
amount y is expected to change for each 1
unit change in x
‘Slope’ and Marginal Analysis
The ‘marginal’ or incremental change in Y as
a result of a 1 unit change in X is given by
the ‘slope’ at that point of the line or curve
connecting paired observations of Y and X.
e.g. ΔY/ΔX = +6/+3 = +2/+1 = +1/+.5
 A +1 unit ΔX results in a +2 unit ΔY or => a
+1 unit ΔY results in a +.5 unit ΔX
Note: the ‘ratio’ of the changes is 2 to 1
Given any 2 points, one can calculate
the actual equation of a straight line:
Step #1)
y y1  y2 rise
m


x x1  x2 run
Step #2)
b  y1  mx1(or b  y2  mx2 )
“Economics is the most quantitative of
the social sciences.”
Karl Case & Ray Fair
Prin. Of Microeconomics, 7th ed.
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