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
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