Chapter 1

Thinking Like an Economist

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Learning Objectives: Understand
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
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Learning Objectives: Understand
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 Scarcity Principle: Examples

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The Scarcity Principle: trade-offs
One consequence of scarcity is trade-off
Example:
1.Universities have the choice between offering
large or small sections of principles of
Economics
2.Their choice will create the following trade-offs:
1. Quality of instruction
2. Reduce cost  reduce tuition
Solution?  cost-benefit analysis
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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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Cost – Benefit Example
 Back to class size example:
 Assume (for simplicity):
 Two sizes available: 100 and 20 seats
 Currently, university is offering 100 seats sections

 Should the university reduce the class size to 20?

 Answer: yes if, and only if the value of improvement in
instruction outweighs (benefits) its additional cost
 Extra benefits ≥ extra costs
 Rule is simple, but applying it requires a way to
measure the relevant costs and benefits
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Cost – Benefit Example
 Shall a company produce 49 or 50 units?
 Answer: yes if, and only if the extra (marginal)
benefits at the 50th unit are larger than the extra
(marginal) costs for the same unit
 Benefits and costs are not always monetary

 Should you spend 6 hours or 7 hours with your best

friend (or a family member)?
 Answer: yes if, and only if the extra benefits for the
7th hour are larger than the extra costs for the same
hour
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Cost – Benefit: Rationality Assumption
 In the last example, the decision can be affected by
your emotions and feelings
 However, to study choices under scarcity and cost –
benefit analysis, we assume that people are rational

 Rational people = people with well-defined goals who

try to fulfill them as best as they can
 Rational decisions are linked to cause and effect or
true and false

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Cost – Benefit: Rationality Assumption
 Rationality Example
 You are about to buy a $25 computer game at the
nearby campus store.
 A friend tells you that the same game is on sale at a
downtown store for only $15.
 If the downtown store is a 30-minute walk away,
where should you buy the game?

 Confronted with this choice, people base their choice

on how costly they think it is to make the trip
downtown.
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Economic Surplus
 Benefits of an action minus its costs

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Economic Surplus
 Back to the computer game example
 If the cost of making the trip to downtown was $9

 Economic surplus = benefit from making the trip –

cost from making the trip
 Economic surplus = $10 – $9 = $1

 Therefore, the cost – benefit principle is similar to a

positive economic surplus

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Opportunity Cost
 Opportunity Cost of an activity (or a choice) = The
value of what must be foregone in order to undertake
that activity
 It is the value of the next best alternative to the
choice taken
 Rank the alternative choices and calculate the value
of the next best alternative to find the opportunity
cost of the first choice
 NOT the combined value of all possible activities

 Consider explicit and implicit costs

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Opportunity Cost: Example
 Going for a medical checkup
 Choice taken: medical checkup (2 hours) valued at
$50
 Potential alternatives: work / watch a movie / go to
the gym
 Next best alternative: work (2 hours / each hour
valued at $10)
 Opportunity cost for the medical checkup = explicit
cost + implicit cost = $50 + $20 = $70

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Economic Models
 Economists use economic models as a simplified
description that captures the essential elements of a
situation
 The essential elements will allow us to better analyze
these situations

 Economic models rely heavily on simplifying

assumptions
 Which aspects of the decision are absolutely
essential?
 Which aspects are irrelevant?
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Economic Models
 Example: how can you calculate your total spending on
food items on campus until the end of the semester?
 Build an economic model
 What are the simplifying assumptions?

 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
 Assuming people are rational, they will apply the
cost – benefit principle most of the time and
therefore their behavior can be predicted

 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?
 Key point: economic
surplus is the same
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Pitfall #2
 Ignoring implicit costs
 Consider your alternatives
 Identify the best next
alternative

 The opportunity cost of

watching a movie is:
 The cost of the movie
ticket (explicit cost) +
 The value placed on the
next best alternative
(implicit cost)
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Pitfall #3
 When deciding whether to take an action, the only
costs and benefits that are relevant are those that
would occur as a result of taking the action

 However, many decisions seem to be influenced by

costs and benefits that would have occurred
independently of whether the action was taken
 In this case, people are influenced by “sunk costs”
 Sunk cost = a cost that is beyond recovery at the
moment a decision must be made

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Pitfall #3

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Pitfall #3
 Failure to think at the margin
 Sunk costs cannot be
recovered
 Example:
 Eating at an all-you-can-eat
restaurant
 Are there any differences
in the quantity of food for
those who pay the regular
entry price and those who
were invited by the owner?

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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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Marginal Analysis: Tennis Tournaments in
the UAE
# of Total Cost Average Cost
($m/tourname Marginal Cost
Tournaments ($m) ($m)
nt)
0 $0 $0 $3
1 $3 $3 $4
2 $7 $3.5 $5
3 $12 $4 $8
4 $20 $5 $12
5 $32 $6.4
 If the marginal benefit is $6 million per tournament, how many
tournaments should the UAE host?

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 Normative and Positive Economics
 Normative economic
statements say how people
should behave
 Economics of “what ought to
be”  cannot be proven true
or false
 Gas prices are too high
 The UAE should organize
more tennis tournaments
 Cost – benefit principle is
an example of normative
economic principle
 Positive economic statements
predict how people will
behave
 Economics of “what is” 
focuses on facts and can be
proven with data
 The mean price of
gasoline in 2008 was
higher than in 2007
 Organizing a tennis
tournament costs more
in Dubai than in Beirut
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Incentive Principle

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Incentive Principle: Examples
 If a waiter gets paid a fixed $3 per hour and does not
get to keep tips.
 What are his incentives at work?
 Now, the same waiter gets to keep the tips left by his
customers, does he still have the same incentive
scheme?

 If your professor says on the first day that everyone is

getting an “A” in the class, describe your incentives
towards the course.

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Microeconomics and Macroeconomics
 Microeconomics studies of
individual choice under scarcity
and its implications for the
behavior of prices and
quantities in individual markets
 Sugar
 Carpets
 House cleaning services
 Microeconomics considers
 Costs of production
 Demand for a product
 Behavior of consumers
 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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 Chapter 1 Appendix

Working with Equations, Graphs, and Tables

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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
 Example: Phone bill is $5 per month plus 10 cents per
minute
B = 5 + 0.10 T

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From Equation to Graph

B = 5 + 0.10 T
 Draw and label axes
 Horizontal is independent variable
 Vertical is dependent variable
 To graph, B D
12
 Plot the intercept
C
 Plot one other 8
A
point 6
5
 Connect the
points T
10 30 70

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From Graph to Equation

 Identify variables
 Independent
 Dependent
 Identify parameters
 Intercept
 Slope
 Write the equation

B = 4 + 0.2 T

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Changes in the Intercept
 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

 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

Time
10 20 30 40
(minutes/month)
Bill
$10.50 $11.00 $11.50 $12.00
($/month)

 Identify variables
 Independent
 Dependent
 Label axes
 Plot points
 Connect points
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From Table to Equation
Time
10 20 30 40
(minutes/month)

Bill
$10.50 $11.00 $11.50 $12.00
($/month)

 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
12 = f + 0.05 (40) = f + 2
f = 12 – 2 = 10
B = 10 + 0.05 T
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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 equation
 Example
 Two billing plans for phone service
 How many minutes make the two plans cost the
same?

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Simultaneous Equations

 Plan 1 B = 10 + 0.04 T
 Plan 2 B = 20 + 0.02 T
 Plan 1 has higher per minute price while Plan 2 has a
higher monthly
fee
 Find B and T
for point A

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

B = 10 + 0.04 T OR
– B = – 20 – 0.02 T
0 = – 10 + 0.02 T B = 20 + 0.02 T
T = 500 B = 20 + 0.02 (500)
B = $30

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