•Thinking Like an Economist

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OUTLINE1.Scarcity and Choice2.The Cost Benefit Approach to Decisions3.The Role of Economic Theory4.Positive Questions and Normative Questions 5.Microeconomics and Macroeconomics

CHAPTER 1

Consumer Theory

Subjective ValueProduction Theory

Cost of Production

Theory of Decision Making

Supply and Demand of Market Inputs

General Equilibrium and a Theory of EconomicWelfare

(MC = MB)

Industrial Organization1. Perfect Competition2. Monopoly3. Monopolistic

Competition4. Oligopoly

Revenue of Producer

Individual Demand

Market Demand

Product

Markets

Pricing in

A view of the "forest"_ the course seen as a whole but beware of getting lost is in the "trees" of individual topics

THE FLOW-CHART OFMICROECONOMICS

¼ of the course

¾ of the course

The Rational Choice Model

It is important to stress at least three very important assumptions of the rational choice model. a. Behavior is not random.b. People have reasonably simple objectives common to most.c. People behave rationally without regard to emotions that detract from rationality.

Where these givens are not present, the rational choice models will fail. For example, the risk aversion assumption underlying rational choice theory, uncommon objectives , irrationality are not as rare as we may sometimes think.

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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 circumstancesCore Principles are the foundation for

solving economic problems

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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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Applying the Cost – Benefit Principle

Assume people are rational– A rational person has well defined

goals and tries to fulfill those goals as best they can

Would you walk to town to save $10 on an item?– Benefits are clear– Costs are harder to define

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Cost – Benefit Principle Examples

Should there be 32 separate sections of Econ 100B, with 25 students each?--- Trinity University, San Antonio, Texas

**Students learn more effectively in smaller classes.**But smaller classes are also more expensive.

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Or should there be only one section, with 800 students?- University of Texas @Austin: Note 32x25 = 800

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Cost-Benefit Analysis (CBA)

Should I do activity x?C(x) = the costs of doing x or value of

resources one needs to give up to do x. B(x) = the benefits of doing x If B(x) > C(x), do x; otherwise don't.

Should we make the econ class larger?Benefit of making the class size larger =

the reduction in cost per student = B(x)Cost of making the class size bigger = The

amount people would be willing to pay to avoid the reduced quality of instruction = C(x)

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Some relevant costsLet the Faculty salary: $60,000 per coursePer student faculty salary cost:

1 section: $60,000/800 = $75—large class32 sections: $60,000/25 = $2400-small class

Benefit (to the university) of increasing class size from 25 students to 800 students

= ($2400 - $75) = $2,325 = B(x)

If you were currently in a class with 25 students, how much would you be willing to pay to avoid switching to one with 800 students? = C(x)

If C(x) < B(x)=$2,325, then it makes sense to offer the larger class.

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The Cost-Benefit Principle

1. An individual (or a firm, or a society) should take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs.2. Critics of the cost-benefit approach often object that people don’t really calculate costs and benefits when deciding what to do3. People often behave as if they were comparing the relevant costs and benefits

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People often make bad decisions because they fail to compare the relevant costs and benefits

13“The Budweiser “or “Corona “Walk

Example 1.8. How much memory should your computer have?

Suppose that random access memory (RAM)can be added to your computer at a cost of $0.50 per megabyte.

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?" 14

Cost-Benefit principleRule:a. Buy an additional megabyte if the marginal benefit

of RAM is at least as great as its marginal cost, i.e. MB ≥MC

b. Do not buy an additional megabyte if the marginal benefit of RAM is less than its marginal cost, i.e. MB < MC

c. You are indifferent if the marginal benefit of RAM equivalent to its marginal cost, i.e. MB ≈ MC

where Marginal benefit (MB)= added benefit from having

1 more unit Marginal cost (MC)= added cost of having 1 more

unit 15

MB

MC

4000300020001000

Megabytesof memory

Value of an additionalmegabyte

Dollars permegabyte

2.00

0.500.25

Cost of anadditionalmegabyte

1.00

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Optimal amount of memory

http://www.csus.edu/dev/managed/College-of-SSIS/econ/faculty/faculty%20webpages/Professors/dube1.html

Power Point Slides: Chapters 1-4 for now

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Marginal Analysis Ideas

Marginal cost is the increase in total cost from one additional unit of an activity (q)

MC =∆TC/∆q– Average cost is total cost divided by the

number of units, AC= TC/q

Marginal benefit is the increase in total benefit from one additional unit of an activity

MB =∆TB/∆q– Average benefit is total benefit divided by the

number of units, AB = TB/q

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Normative and Positive Economics

– Normative economic principle says how people should behave•Gas prices are too

high•Building a space

base on the moon will cost too much

– Positive economic principle predicts 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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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 (B)• Example: Phone bill is $5 per month plus

10 cents per minute (T =time)B = $5 +$0.10 T

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B = 5 + 0.10 T– Draw and label axes

• Horizontal is independent variable =T• Vertical is dependent variable =B

– To graph,• Plot the intercept (T=0; B=5)• Plot one other point(T=30;B=8)• Connect the points (0,5) and (30,8)

From Equation to Graph

T

B

56

A

C

D12

8

10 30 70

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From Graph to Equation

– Identify variables• Independent (T)• Dependent (B)

– Identify parameters• Intercept (=4 if T=0)• Slope (4/20=0.2)Thus, we can write the equation as:

B = 4 + 0.2 T

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Changes in the Intercept (from 4 to 8)

– 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 (from 4/20=0.2 to 8/20=0.4)

– 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

– Identify variables•Independent•Dependent

– Label axes– Plot points

•Connect points

Time =T (minutes/mo

nth) 10 20 30 40

Bill ($/month)

=B$10.50 $11.00 $11.50 $12.00

From Graph to Equation: is B= 10 + 0.05T

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From Table to Equation

– 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; At B =12 and T=4012 = f + 0.05 (40) = f + 2f = 12 – 2 = 10B = 10 + 0.05 T

Time (minutes/month)

10 20 30 40

Bill ($/month)

$10.50 $11.00 $11.50 $12.00

B= f + bT

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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 equationExample

– Two billing plans for phone service•How many minutes make the two plans cost the same?

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• Plan 1 B = 10 + 0.04 T• Plan 2 B = 20 + 0.02 T

– Plan 1 has higher per minute price ($0.04) while Plan 2 has a higher monthly fee ($20)

Find B and T for point A

Simultaneous Equations

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– Find B when T = 500B = 10 + 0.04 TB = 10 + 0.04 (500)B = $30

OR

B = 20 + 0.02 TB = 20 + 0.02 (500)B = $30

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