Chapter 1

Thinking as an economist

Core principles:
- Scarcity principle
- Cost-benefit principle
- Not all costs are equal principle

1.1 Economics: The study of choice in a world of scarcity

- Economics – the study of how people make choices under conditions of scarcity and of
the results of those choices for society.
- Economic decision – any decision where securing something of value means going
without some other thing of value.
- Scarcity principle (no-free-lunch principle) – although we have boundless needs and
wants, the resources available to us are limited. Consequently, having more of one good
thing usually means having less of another. Trade-offs.
Ø Land, labour capital (manmade, e.g. plant and equipment), enterprise are scarce.
- Cost-benefit principle – an individual should take an action if, and only if, the extra
benefits from taking the actions are at least as great as the extra costs. Extra
cost=marginal cost Two key ingredient in an economic decision.
Ø Implicit cost – hidden, but it’s there.
Ø Explicit cost – what you actually (physically) have to pay.
- Economists use the cost-benefit principle as an abstract model of how an idealized
rational individual would choose among competing alternatives.
- Not-all-costs-and-benefits-are-equal principle – opportunity cost is most important,
followed by marginal cost. These two matter in making decisions where as sunk cost and
average cost don’t.
- Abstract model – a simplified description that captures the essential elements of a
situation
Ø It allows logical analysis.
Ø Ignores the unimportant forces.
- Ceteris paribus – “all else equal”. The assumption that everything that could affect a
variable of interest, other than the thing being studied, stays the same.

1.2 Learning to think as an economist

- Assume that people are rational.
- Economic naturalist – someone who uses basic economic concepts to make sense of
observations about all aspects of everyday life.
- Economic surplus – the gain that results from taking an action when the benefits
outweigh the costs.
Ø The goal of rational economic decision makers is to maximize their economic
surplus.
- Opportunity cost – the value of the next-best alternative to taking a particular action.

1.3 Four important decision pitfalls

- Measure costs and benefits as absolute dollar amounts rather than as proportions.
- Account for all opportunity costs. We tend to overlook the implicit value of activities
that fail to happen.
- Ignore sunk costs. Sunk costs are that that cannot be recovered at the moment a
decision is made.
- Know when to use average costs and benefits and when to use marginal costs and
benefits.
Ø Marginal cost – the increase in costs associated with a small increase in the level of
some activity.
Ø Marginal benefit – the increase in benefits associated with a small increase in the
level of some activity.
Ø Average benefit – the total benefit of undertaking n units of an activity divided by n.

1.5 Microeconomics and macroeconomics

- Microeconomics – the study of individual consumer, firm and market behaviour.
- Macroeconomics – the study of the aggregate economy.