Chapter 1: Thinking Like an

Economist
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 The Scarcity Principle

Economics: The study of choices and

results under scarcity

The Scarcity Principle: Unlimited

wants and limited resources means
having more of one good
necessitates having less of another.

Also called No Free-Lunch Principle

 even if you are not paying for
lunch, somebody, somehow, always
has to pay for it

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 The Scarcity Principle: Examples

Scarcity is involved in

Water Health Career Enrolling

Distribution Delivery Choices in Classes

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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. Larger class may lower the quality of
instruction
2. Larger class may 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

Marginal
Benefits

Marginal
Costs

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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-seat sections

 Should the university reduce the class size to

20?
 Answer: yes if, and only if, the value of
improvement in instruction (benefits) outweighs 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

 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
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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 decision on how costly they think it is
to make the trip downtown.
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 Economic Surplus

Back to the computer game example:

 Ifthe cost of making the trip to downtown
was $9

 Economic surplus = benefit from making

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

 Therefore, the cost – benefit principle is

similar to a positive economic surplus

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 Economic Surplus

 Benefits of an action minus its costs

Total Total
Benefits Costs

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
 Itis 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

 Also described as economic cost

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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?
 Ceteris Paribus (Latin meaning “all other things
being equal or held constant”)
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 Economic Models

 Example: understanding how consumers

react to higher prices of goods and services
requires a focus on prices and quantities
and ignoring all other factors that may
affect consumption.

 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 Marginal
Benefits
instead of absolute
amounts
• Would you walk to
Marginal
town to save $10 on Costs
a $25 item?
• Would you walk to Action
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

Explicit  Identify the best next

Costs alternative

Opportunity
Cost  The opportunity cost of
watching a movie is:
Implicit  The cost of the movie
Costs
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

 Sunk cost:
• It is a fixed cost “sunk” into an industry
- Example: air travel industry  plane / pilot /
stewardesses / baggage handlers / jet fuel / airport
• A fixed cost = a cost incurred independently of the
amount of a good produced
• All sunk costs are fixed
• Not all fixed costs are sunk
- Only those fixed costs which cannot be shifted
into other industries would qualify as sunk costs

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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?
• Answer: No, theoretically.
• Psychologists and economists provide experimental
evidence going against theory

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 Marginal Analysis Ideas

Marginal cost is the increase in total

cost from one additional unit of an
activity
 Averagecost is total cost divided by the
number of units
Marginal benefit is the increase in total
benefit from one additional unit of an
activity
 Averagebenefit is total benefit divided by
the number of units
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Marginal Analysis: Tennis Tournaments in
the UAE

Average Cost
# of Total Cost
Marginal Cost ($m/tournamen
Tournaments ($m)
($m) t)
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  Positive economic statements

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

Incentives are central to people's choices

Benefits Costs
Actions are more likely Actions are less likely
to be taken if their to be taken if their
benefits rise 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 and Macroeconomics

 Microeconomics studies the  Macroeconomics studies the

individual choice under performance of national
scarcity and its implications economies and the policies
for the behavior of prices and that governments use to try
quantities in individual to improve that performance
markets  Inflation
 Sugar  Unemployment
 Carpets  Growth
 House cleaning services

 Macroeconomics considers:
 Microeconomics considers:  Monetary policy
 Costs of production  Deficits
 Demand for a product  Tax policy
 Behavior of consumers

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 Economic Naturalist

 Why do many hardware manufacturers

include more than $1,000 worth of “free”
software with a computer selling for only
slightly more than that?
 Norton, when pre-installed, makes
computers more attractive
 Computers, when they include Norton,
make Norton more attractive
 In sum, the benefit of a product depends
on the number of people who own that
product.
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 Chapter 1 Appendix

Working with equations,

graphs, and tables
 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
B D
 To graph, 12
 Plot the intercept C
8
 Plot one other 6
A
point 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
 Slopeis unchanged
 Caused by an increase in the monthly fee
 A decrease in
the intercept
shifts the curve
down
 Slopeis
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
 Plan1 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  Find B when T = 500

 Plan 2 B = 20 + 0.02 T B = 10 + 0.04 T
 Subtract Plan 2 equation B = 10 + 0.04 (500)
from Plan 1 and solve for T 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
T=500

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