Thinking Like an Economist

Thinking Like an Economist

Philosophy of This Course • Focus on covering the core ideas of economics rather than covering many topics superficially – chances are, you’re not going to be economists … • Encourage active learning--one must do and see economics in order to learn it • Uses examples, exercises, and applications • Encourages thinking critically when considering the problems • Encourages discussing interesting insights with friends

Core Principles • The Scarcity Principle - “No Free Lunch” • The Cost-Benefit Principle • The Not-All-Costs-and-Benefits-Matter Equally Principle • The Principle of Comparative Advantage

Core Principles • The Equilibrium Principle • The Principle of Increasing Opportunity Cost • The Efficiency Principle

Economic Naturalism • Using your insights from economics to make sense of observations from everyday life • Learning economic principles enables us to see the ordinary details of life in a new light • E.G., Look for differences in costs and benefits

Economic Naturalism • Examples of Economic Naturalism Questions: • Why did people switch from big cars to little cars in the 1970’s only to switch back again in the 1990’s? • Why do drive-up teller machines have Braille dots on the keypads? • Why do brides spend thousands on a wedding dress that will never be worn again, while grooms rent a tuxedo that could be worn again?

Economic Naturalism • Why do people shout at parties? • Why do drug stores offer senior citizen discounts on certain days of the week? • Why does staying over a Saturday get you a cheaper air fare? • Why did I make more money driving my ice-cream truck in poorer neighborhoods than in more affluent neighborhoods?

Scarcity • Scarcity is a fact of life • Never enough time, money, energy…. • Economics is the study of how people make choices under conditions of scarcity and of the results of those choices for society

Scarcity Principle • Because of scarcity • Tradeoffs are widespread • Having more of one good usually means having less of another • AKA the “No free lunch Principle”

Scarcity implies opportunity costs • Opportunity Cost • The value of the next best (unchosen) alternative. Example: job choice. Option 1: IBM in RTP, salary = $70 k Option 2: Own surf shop in Wilm, salary = $30k If you select option 2, what is your opportunity cost?

Opportunity Cost • The opportunity cost of selecting job option 2 is giving up job option 1. = $70 k salary, living in Raleigh, etc… Everything that you gave up. * We must keep costs and benefits separate!

Opportunity Cost • Opportunity Cost: The value of the next-best alternative that must be forgone in order to undertake an activity • Decisions depend upon opportunity costs • It is not the combined value of all other forgone activities, just the next best one

Example: Waking up early • Suppose its Saturday and you have to decide whether to sleep in or get up early and fix the fence. • Do you get up early? • A cost-benefit analysis says only if the benefits outweigh the costs

Benefit of waking up early • The benefit of waking up early is estimated by the • Highest price you would be willing and able to pay to have the fence fixed • This is your reservation price for having a fixed fence • Suppose this benefit is $200

Cost of waking up early • The cost is estimated by the • Value to you of the extra sleep = what you would be willing to pay for the additional rest • This is your reservation price for the extra hours of sleep • Suppose the cost of getting up early is $100

Solution to Example 1.1 • The benefit of having a fixed fence ($200) is greater than the cost (not having a fixed fence) ($100) [i.e., your economic surplus is $200-$100= $100] • You should get up early • Suppose that the value of your alternatives change • Perhaps you have a test on Monday and need the extra hours to study. In this case, your opportunity costs have changed and you may decided against fixing the fence.

Everyone Faces Scarcity • Even Bill Gates faces scarcity • Should he pick up a $100 bill on the ground? • Someone once estimated that his time was so valuable picking up a $100 bill wouldn’t be worth his while • But, he only has 24 hours a day and a limited amount of energy • If he spends his time building his business empire, then he cannot use that time doing other things • Do you cut the coupons from the Sunday paper?

Cost-Benefit Principle • Take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs • Measuring the costs and benefits is often difficult • One may have to use assumptions and/or approximations • Helps us answer “yes/no” questions

People Are Rational • Economists assume that people are rational — that they try to fulfill their goals as best they can • “Rational” here means only pursuing actions where the benefits are at least as great as the costs.

Reservation Prices • The highest price one would be willing (and able) to pay for any good or service • “Maximum willingness-to-pay (WTP)” • It is equal to the benefit (value) received from the good or service • What happens if your max WTP is < price? • What happens if your max WTP is > price?

Economic Surplus • The benefit of taking an action minus its cost • Economic Surplus = Benefit - Cost • Rational decision makers take all actions that yield a positive economic surplus • Should you buy an item if surplus = 0? Eg: max WTP = $19,500 & P = $19,500

Role of Models • An “abstract model” is a simplified description capturing essential elements of a situation • It allows logical analysis • It includes only the major forces at work and will ignore many details • I.E., the cost-benefit principle is an abstract model of how an idealized individual would choose among competing alternatives

Imperfect Decision Makers • Rational people will apply the cost-benefit principle using their intuition • However, people can make mistakes when weighing the costs and benefits • People often make inconsistent choices

Example 1.6Lost Theater Ticket • A theater tickets cost $10 • You have at least $20 and want to see a play • Would you buy a theater ticket after losing a $10 bill? • Would you buy a second theater ticket after losing the first?

Example 1.6Lost Theater Ticket • Many people say that they would purchase the ticket after losing the $10 but would not purchase a second ticket after losing the first • This is inconsistent behavior since the financial loss is equivalent • The choice of whether to see the play depends upon whether seeing the play is worth spending $10

Marginal Analysis • Comparing incremental or additional costs and benefits • More powerful than traditional CBA because it allows us to make quantity decisions • Always get the “best” answer, while CBA only allows for “good” answers

Marginal Analysis • Marginal Benefit • The increase in total benefit that results from carrying out one additional unit of the activity • Marginal Cost • The increase in total cost that results from carrying out one additional unit of the activity

Marginal Analysis • Example: How many slices of pizza to eat? • Assume: P = $1.50 per slice Note: P = cost of an additional unit = marginal cost

Marginal Analysis • The optimal quantity here (Q*) is 3 slices. • Why? • For slices 1-3 there is a surplus of benefit over cost – net gain. • For the 4th slice MC > MB • Total net gain = surplus = sum of MB – MC for all units consumed = $4.50

Marginal Analysis vs. CBA • What would happen if we used CBA and the same data to ask: Should you eat 4 slices … yes or no? 4 slices: Total Benefit = $10.00 ($4+ $3+$2+$1) Total Cost = $6.00 ($1.50 x 4) Net gain (surplus) = $4.00

The Marginal Cost and Benefit of Additional RAM

Falling RAM Prices Increase the Optimal Amount of Memory

An Increase in the Marginal Benefit of RAM Increases the Optimal Amount of Memory

Optimal Level • If the marginal benefit is greater than marginal cost • Increase output (consume or produce more) • If the marginal benefit is less than the marginal cost • Decrease output (consumer or produce less) • Optimal output is where marginal benefit equals marginal cost • MB = MC

Micro and Macro • Microeconomics studies • Choices of individual consumers and firms • Behavior of specific markets • How are prices and quantities determined? • Macroeconomics studies • Performance of national economies • Government policies to change performance • Unemployment rate, and the price level

Always Tradeoffs • The scope of macro and micro are different • However, both are trying to predict behavior that is based on scarcity • Clear thinking about economic problems will always account for tradeoffs--having more of one good thing usually means having less of another

Decision Pitfalls • Dollars or proportions? • Example A: Buy an alarm clock on campus for $20 or drive to K-Mart and buy it for $10? • Is the drive worth saving $10?

Decision Pitfalls • Dollars or proportions? • Example B: Buy a computer on campus for $2,000 or drive to K-mart and buy it for $1,990? • Answer should be the same …

Decision Pitfalls • Don’t ignore opportunity costs • The most you are WTP for a trip = $1,350 = your benefit from the trip • Airfare = $500 • Other expenses = $1,000 • You have a frequent flyer coupon worth $500, which expires in one year. Should you go on the trip?

Decision Pitfalls • Ignore sunk costs – they’re sunk! • You and a friend are both planning on going to a concert. You buy your $30 ticket ahead of time, while she waits to buy hers at the gate. The night of the show, there is a snow storm, which makes travel to the concert dangerous. • Who is more likely to go to the concert?

Decision Pitfalls • Average or marginal? • Pizza example revisited: • 4 slices average benefit = $2.50 ($4 + $3 + $2 +$1) / 4 • 4 slices average cost = $1.50 • Should you eat 4 slices?

Not all costs and benefits are the same • Marginal costs and benefits matter • Opportunity costs matter • Sunk costs do not matter • Average costs and benefits do not matter

Thinking Like an Economist