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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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What is Economics?
The word economy comes from a Greek word
for one who manages a household.
A household and an economy
face many decisions:
Who will work?
What goods and how many of them should
be produced?
What resources should be used in
production?
At what price should the goods be sold?


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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Thinking Like an Economist
Economics trains you to. . . .
Think in terms of alternatives.
Evaluate the cost of individual and social
choices.
Examine and understand how certain
events and issues are related.
The economic way of thinking . . .
Involves thinking analytically and
objectively.
Makes use of the scientific method.

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The Scarcity Principle: trade-offs
Economics: The study of choices and results
under scarcity
The Scarcity Principle: society has limited
resources and therefore cannot produce all
the goods and services people wish to have
Also called No Free-Lunch Principle To get
one thing, we usually have to give up another
thing.
One consequence of scarcity is trade-off
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
Marginal
Benefits
Marginal
Costs
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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 50
th
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 7
th
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
Economic
Surplus
Total
Benefits
Total
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




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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

Action
Marginal
Costs
Marginal
Benefits
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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)

Explicit
Costs
Implicit
Costs
Opportunity
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
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?

Marginal
Benefits
Marginal
Costs
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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
Tournaments
Total Cost
($m)
0 $0
1 $3
2 $7
3 $12
4 $20
5 $32
Average Cost
($m/tourname
nt)
$0
$3
$3.5
$4
$5
$6.4
Marginal Cost
($m)
$3
$4
$5
$8
$12
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
Incentives are central to people's choices
Benefits
Actions are more likely
to be taken if their
benefits rise
Costs
Actions are less likely
to be taken if their
costs rise
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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 vs
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
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,
Plot the intercept
Plot one other
point
Connect the
points
T
B
5
6
A
C
D
12
8
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
Identify variables
Independent
Dependent
Label axes
Plot points
Connect points
Time
(minutes/month)
10 20 30 40
Bill
($/month)
$10.50 $11.00 $11.50 $12.00
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From Table to Equation
Identify independent and dependent variables
Calculate slope
Slope = (11.5 10.5) / (30 10) = 1/20 = 0.05
Solve for intercept, f, using any point
B = f + 0.05 T
12 = f + 0.05 (40) = f + 2
f = 12 2 = 10
B = 10 + 0.05 T
Time
(minutes/month)
10 20 30 40
Bill
($/month)
$10.50 $11.00 $11.50 $12.00
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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

B = 10 + 0.04 T
B = 20 0.02 T
0 = 10 + 0.02 T
T = 500

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

OR

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

T=500