Principles of Microeconomics

Lecture 2
Thinking like an Economist

Tien-Der Jerry Han

1
In this lecture, we will learn about: THINKING LIKE AN ECONOMIST

FUTURE: study how individuals, households and firms interact with each other

● individuals: how much of a good they demand & how much labour they supply
● firms: how much of a good they supply & how much labour they demand

But first, we should get an overview of how economists study economics

- build models by focussing on important aspects
- to explain and make predictions about the world

Introduce a few important concepts that will be with us throughout the course

Today we: get an overview of how economists model the world, and we’re going to
build our first models that illustrate some key concepts

2
Lecture outline

1. Economics as a science

2. Some key concepts

3. Thinking at the margin: a model of educational choice

3
Reading

Lipsey and Chrystal, ch. 1, p.5-21

Mankiw and Taylor, ch. 2, p.21-41

Perloff, J. (2018), Microeconomics, 8th edition, Pearson

Sloman Economics news site: Are impulses irrational?

http://pearsonblog.campaignserver.co.uk/?p=8898

4
ECONOMICS AS A SCIENCE

The essence of science is the scientific method. Economics uses this method.

Develop theory

Make predictions Amend theory

Test predictions Predictions

incorrect

Predictions
explain evidence

Theory accepted Theory rejected

Theoretical economics makes predictions. Empirical economics tests predictions.

5
The role of assumptions

Economic theories are often abstract due to extreme assumptions

This is critical in assisting us develop an understanding of the world

Economists are not alone: all scientists make assumptions about the world

Sir Isaac Newton’s theory of gravity assumed that objects fall in a vacuum
Does this mean it is any less of an achievement? So that there is no air resistance

What would Sir Isaac say if he was challenged on this assumption?

● the problem is greatly simplified without air resistance

● the answer is virtually the same, because air resistance is small
● the answer is foundation to build upon: can see effect of air resistance later

Economics uses assumptions in exactly the same way for exactly the same reasons

6
We are used to simplifying things to make them easy to understand.
Consider the tube map:

Like the tube map, a good economic theory:

highlights the important factors by assuming away unimportant factors

What should be assumed away? That depends on the purpose of the model
The complexity of the model depends upon the complexity of the problem 7
What makes a good theory?

“A theory is a good theory if it satisfies two requirements:

it must accurately describe a large class of observations on the
basis of a model that contains only a few observations, and
it must make definite predictions about the results of future
observation”

Professor Stephen Hawking

Paraphrasing…

A theory is good if:

i) it can explain the evidence
ii) it makes clear predictions
8
KEY TERMINOLOGY: Positive and normative analysis

Economists have two roles:

Explain the causes of economic events → scientist

Explain what to do to improve events → policy advisor

Consequently, economists can make two types of statements:

● Positive statements describe causes and effects

They describe how the world is

● Normative statements embody value judgements

They describe how the world ought to be

Statement 1: more people will attend university if tuition fees were lower
Statement 2: all individuals who attend university should have free tuition

Statement 1 is a positive statement, whereas statement 2 is a normative statement

9
KEY CONCEPT: Opportunity cost

When we study choice, it is common to assume that people are rational

i.e. Have well defined goals that they try to fulfil.

A fundamental tool for understanding how rational people choices is the cost-
benefit principle. Take an action if the:

benefits are greater than the costs

Important factor for costs how you would spend your time & money otherwise

Opportunity cost:

measures the cost of doing anything in terms of the

(most highly valued) alternative that could have been chosen instead

IMPLICATION: The cost of an action is not just how much money you spent on it
10
 Quick Discussion
With the person next to you, consider what the cost of
attending university is to you.
KEY CONCEPT: Thinking at the margin

Suppose a society can build hospitals for £12m each.

Economists estimate there is:

total benefit of £20m for building 1 hospital

total benefit of £30m for building 2 hospitals

How many hospitals should be built?

● Naïve thinking: 2 hospitals should be built because £30m > £24m

● Thinking at the margin: compare the marginal benefits with the marginal costs

The marginal cost of a hospital is: £12m

The marginal benefit of the 1st hospital is: £20m = (£20m – £0m)
the 2nd hospital is: £10m = (£30m – £20m)

Build 1st hospital (£20m > £12m), but not the 2nd (£10m < £12m)
12
A MODEL OF EDUCATIONAL CHOICE

Decision to attend university involved a choice in the presence of scarce resources

Spending money on tuition means you have less to spend on other things
(Even if tuition is free, attending university would still be costly…)

Let’s build a model to answer the following questions:

● How long should someone stay in education?
● What is the effect of increasing the cost of education?

Assume a person’s educational choice is based on monetary costs & benefits only

Costs: tuition, books and time

Benefits: higher income in the future

Assume the person is able to calculate the marginal costs and marginal benefits
… and that they think at the margin
13
 Representing costs and benefits

● marginal benefit = additional benefit of staying in education for another year

● marginal cost = additional cost of staying in education for another year

marginal cost (MC)

The marginal cost of another

year in education is likely to
Costs and benefits in £s

increase over time

The marginal benefit of

another year in education is
likely to decrease over time

marginal benefit (MB)

Years in education
 How much education?

It is rational to do something so long as marginal benefit exceeds marginal cost

marginal cost (MC)

Costs and benefits in £s

MC > MB The optimal number of years

MB > MC of education is where marginal
benefit = marginal cost

marginal benefit (MB)

optimal
Years in education
 What’s the effect of an increase in the cost of education?

Suppose education is now more costly. How does our diagram change?

New marginal cost

marginal cost (MC)

MC > MB
Costs and benefits in £s

An increase in the cost of

education will reduce the number
of years people spend in education

marginal benefit (MB)

after before
Years in education
Summary

Following this lecture, you should be able to:

(1) state the difference between a positive and normative statement

(2) define what is meant by scarcity, opportunity cost, and thinking at the margin

(3) represent the above concepts graphically

17
Summary

Economics is a science: it applies the scientific method

Models are abstract: simplify the world

focus on what’s important
foundation to build upon

Economists have two roles: scientists

policy advisors

Decision makers should: be aware of opportunities costs

think at the margin

23