1-1© The McGraw-Hill Companies, Inc., 2009McGraw-Hill/Irwin

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Chapter 1: Thinking Like an Economist

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

4. 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

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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

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Economic Surplus

Benefit of an action minus its costs

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Opportunity Cost

The value of what must be foregone in order to undertake an activity Consider explicit and implicit costs

Examples: Give up an hour of babysitting to go to the movies Give up watching TV to walk to town

Caution: NOT the combined value of all possible activities Opportunity cost considers only your best alternative

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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

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Three Decision Pitfalls

Economic analysis predicts likely behavior Three general cases of mistakes

1. Measuring costs and benefits as proportions instead of absolute amounts

2. Ignoring implicit costs

3. Failure to think at the margin

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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?

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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

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Pitfall #3

Failure to think at the margin Sunk costs cannot be

recovered Examples:

Eating at an all-you-can-eat restaurant

Attend a second year of law school

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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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Normative and Positive Economics

Normative economic statements say how people should behave Gas prices are too

high Building a space base

on the moon will cost too much

Positive economic statements predict how people will behave The average price of

gasoline in May 2008 was higher than in May 2007

Building a space base on the moon will cost more than the shuttle program

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Incentive Principle

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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

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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