Thinking like an economist

The Cost-Benefit Principle  An individual or a firm or a society should take an action if, and only if, the extra benefits from taking the action are at least as great as the extra cost

Chapter 1 Frank/Bernanke, Principles of Microeconomics

Thinking Like An Economist

“I’d like to introduce you to Marty Thorndecker He’s an economist but he’s really very nice.”

Hi, I am Marty….

Hi, I am Marty….

Can we express yourself?

 Suppose you had the chance to meet the Chief

Executive in a cocktail party You were asked to

express your opinion on minimum wage legislation in

Hong Kong

 How do you express your views and convince

him/her in five minutes?

Can you express yourself?

 Most students who take introductory economics leave

the course without really having learned even the most important basic economic principles

 Their ability to answer simple economic questions

several months after leaving the course is not

measurably different from that of people who never

took a principles course.*

* Hansen, W L., M K Salemi, and J J Siegfried (2002) “Use it or lose it:

teaching economic literacy,” American Economic Review (Papers and

Proceedings), 92 (May): 463-72.

How do we learn a new language

Start simpleRepetition and drillActive learningHave fun

“How much is this?”

Should there be 12 separate sections of Econ

101, with 25 students each?

Or should there be only one section, with 300 students?

What is the Optimal Class Size?

 To maximize learning without consideration of cost?

 How would considering costs change our answer?

 A personal tutorial course in economics might cost

$40,000

 A class of 300 students might cost $200/student

 Extreme case: a class of infinite students might cost

less than $0.1/student

 What trade-offs must university administrators and

students consider when choosing class size?

The Scarcity Principle

(also called no-free-lunch principle)

 Boundless wants cannot be satisfied with limited

resources

 Therefore, having more of one thing usually means

having less of another

 Because of scarcity we must make choices

 Even Bill Gates (once valued as having US$100 billion) still faces scarcity

 There are only 24 hours

Selling Seats Through An English Auction

 In the classroom, the teacher owns the seats As usual, the

teacher can assign seats Here, we do it in the economics way the teacher will sell seats through an English auction In an

English auction, bidders cry out their bid for a good item until no one is willing to submit a higher bid The highest bidder will get the item This kind of auction has been used in Hong Kong’s

land auction There is no restriction on how many seats a

student can buy or resale activity

 Bidders suggest a seat for auction A suggestion is also taken as

minimum bid of HK$0.5 The minimum price of the seat is

HK$0.5 Each cry should be at a HK$0.5 or higher When

submitting a bid, raise your “number plate” and cry out the bid Students who do not get a seat will have to seat on the floor.

 The teacher will collect the money/ IOU and put it in a jar The

money collected will be used to fund class refreshments as

determined by the class later

What are the alternatives to English auction?

 First come, first served;

 Teacher assigned;

 Class negotiation

Microeconomics

 The study of how people make choices under conditions

of scarcity and of the results of those choices for

society

 In a market system, allocation of resources occur via

the price system, incomes and preferences

Rationality assumption and The Incentive

Principle

 People have goals and try to fulfill them as best as they can

 The Incentive Principle: An agent (person, firm or

society) is more likely to take an action if its benefit

rises, and less likely to take it if its cost rises

Incentives matter in our analysis of behavior and in

designing economic policies

The Cost-Benefit Principle

 An individual (or a firm or a society) should take an

action if, and only if, the extra benefits from taking the action are at least as great as the extra costs

Should I do activity x?

C(x) = the costs of doing x B(x) = the benefits of doing x

If B(x) > C(x), do x; otherwise don't

Should we make the econ class larger?

 Benefit of making the class size larger = the reduction

in cost per student = B(x)

 Cost of making the class size bigger = The amount

people would be willing to pay to avoid the reduced

quality of instruction = C(x)

Some relevant costs:

 Faculty salary: $90,000 per course

 Per student faculty salary cost:

1 section: $90,000/300 = $300

12 sections: $90,000/25 = $3600

Benefits and costs

 Benefit of increasing class size from 25 students to 300 students = ($3600 - $300) = $3300 = B(x)

 If you were currently in a class with 25 students, how

much would you be willing to pay to avoid switching to one with 300 students? C(x)

 If C(x) < $3300, then it makes sense to offer the larger class

People will feel differently about the value of smaller classes.

Optimal class size

 Who will opt for smaller classes:

Those who value smaller classes more

Those who are less financially constrained

 Observations:

We have colleges of different class size

Colleges of smaller class size generally charge higher tuition fees

But colleges and universities may also be subsidized

Example 1.1

Should I turn down my stereo?

 You have settled into a comfortable chair and are listening

to your stereo when you realize that the next two tracks

on the album are ones you dislike

 If you had a programmable disc player or a remote

control, you would have programmed them not to play

 But you don't, and so you must decide whether to get up and turn the music down, or to stay put and wait it out.

Example 1.1

Should I turn down my stereo?

Suppose C(x) = $1.00 = the minimum amount it would

take to get you out of your chair

B(x) = the maximum you would be willing to pay

someone to turn down the volume

If B(x) > $1, then turn your stereo down by yourself

If B(x) < $1, then don't

The Cost-Benefit Principle

 An individual (or a firm, or a society) should take an

action if, and only if, the extra benefits from taking the action are at least as great as the extra costs

 Critics of the cost-benefit approach often object that

people don’t really calculate costs and benefits when

deciding what to do

People often behave as if they were comparing the relevant costs and benefits.

People often make bad decisions because they fail to compare the relevant costs and benefits.

Can cost-benefit analysis help you make better decisions?

Example 1.2

You are about to buy a $20

alarm clock at the campus store

when a friend tells you that

Fortress has the same alarm

clock on sale for $10

Do you travel to Fortress?

Can cost-benefit analysis help you make better decisions?

Example 1.3 You are about to

buy a $6510 laptop computer

from the campus store when a

friend tells you that Fortress has

the same computer on sale for

$6500

Do you travel to Fortress?

Example 1.2 and 1.3

Should you travel to Fortress?

 B(x) = benefit of traveling to Fortress

= $10 in both cases.

 C(x) = cost of traveling to Fortress

= the same amount in both cases.

 So your answer should be the same in both cases.

Can cost-benefit analysis help you make better decisions?

Example 1.4 Choosing a public health program.

A rare disease will claim 600 lives if we do nothing We

must choose between the following two programs:

Which program would you choose? A or B?

Program A: save 200

lives with certainty Program B: save 600 lives with probability 1/3, and save

zero lives with probability 2/3

Can cost-benefit analysis help you make better decisions?

Example 1.5 Choosing a public health program.

A rare disease will claim 600 lives if we do nothing We

must choose between the following two programs:

Which program would you choose? C or D?

Program C: 400 people

will die with certainty Program D: 1/3 chance that no one will die, and 2/3

chance that all 600 will die

Example 1.4 vs Example 1.5

 In Example 1.4, most people choose to save 200 lives

with certainty (Program A)

 In Example 1.5, most people choose to save all 600

lives with prob 1/3 (Program D)

 Yet the two pairs of programs are equivalent:

A=C and B=D

 If the list of alternatives among which we choose are

the same in two cases, then the particular alternative

we choose should also be the same in both cases

 Yet people seem to prefer the safe alternative when the alternatives are framed as choices between different

numbers of lives saved, and to prefer the risky

alternative when the alternatives are framed as choices between different numbers of lives lost

Example 1.6 Losing a $100 bill

Do you buy a ticket and see the play anyway?

You have just arrived at the

theater to buy your ticket and

discover that you have lost a

$100 bill from your wallet

Example 1.7 A lost theater ticket.

You have just arrived at the theater and

discover that you have lost the $100 ticket

you purchased earlier that day

Do you buy another ticket and see

the play anyway?

Example 1.6 vs Example 1.7

 In both cases, you are $100 poorer than before

 In both cases, the benefit of seeing the play is the

same

 In both cases, the additional cost you must incur to see the play is exactly $100

 Since the relevant costs and benefits are the same in

both cases, your decision should also be the same

Example 1.8 How much memory should your

computer have?

Suppose that random access

memory can be added to your

computer at a cost of $0.50 per

megabyte

How many megabytes of memory should you purchase?

Cost-benefit principle:

 Buy an additional megabyte if the marginal benefit of

RAM is at least as great as its marginal cost

 Marginal benefit = added benefit from having 1 more

unit

 Marginal cost = added cost of having 1 more unit

Cost-benefit principle:

MB

MC

4000 3000

2000 1000

Value of an additional megabyte

1.00

Optimal amount of memory

Everyday Choices

"Should I do X?"

"How much X should I buy?"

"Should I buy an additional unit of X?"

Some Common Pitfalls for Decision Makers

Pitfall 1: Measuring cost and benefits as

proportions rather than absolute dollar amounts

Example 1.9 Proportion vs absolute

 Your employer has a travel discount voucher that can

be redeemed on one of your next two business trips

 You could use it to save $100 on a $2000 plane ticket

to Tokyo; or you could save $90 on a $200 plane ticket

to Chicago?

If your goal is to do what would be best for your

company, for which trip should you use the coupon?

Some Common Pitfalls for Decision Makers

Pitfall 2: Ignoring Opportunity Costs

 If doing activity x means not being able to do activity

y, then the value to you of doing y is an opportunity cost of doing x

 Many people make bad decisions because they tend to ignore the value of such foregone opportunities

Pitfall 2: Ignoring Opportunity Costs

 It will almost always be instructive to translate

questions like

"Should I do x?"

into ones like

"Should I do x or y?"

 In the latter question, y is simply the most highly

valued alternative to doing x

Example 1.10 Should I go skiing today?

Example 1.10 Should I go skiing today?

 From experience you can confidently say that a day on the slopes is worth $50 to you

 The charge for the day is $30 (which includes bus fare, lift ticket, and equipment)

 But this is not the only cost of going skiing You must also take into account the value of the most attractive

alternative you will forego by heading for the slopes

Example 1.10 Should I go skiing today?

 Suppose that if you don't go skiing, you will work at your new job as a research assistant for one of your

Example 1.10 Should I go skiing today?

C(x) = cost of skiing plus value of forgone earnings

= $30 + $40

= $70 B(x) = $50 < C(x),

So don't go skiing.

Willing to do it for free

 The fact that you liked your job just well enough to

have been willing to do it for free is another way of

saying that there are no psychic costs associated with

doing it

 This is important because it means that by not doing

the job you would not be escaping something

unpleasant

Many jobs, of course, are not pleasant.

Example 1.11

Unwilling to do the job for less than $25/day

 Suppose instead that your job had been to scrape

plates in the dining hall for the same pay, $40/day, and that the job was so unpleasant that you would be

unwilling to do it for less than $25/day.

 Should you go skiing?

I One of the benefits of going skiing is not

having to scrape plates

Some Common Pitfalls for Decision Makers

 Example 1.11 makes clear that there is a reciprocal

relationship between costs and benefits

 Not incurring a cost is the same as getting a benefit

 By the same token, not getting a benefit is the same as incurring a cost

Economic Surplus is the benefit of taking any action

minus its cost

Example 1.12 Is it fair to charge interest

when lending a friend some money?

 Suppose a friend lends you $10,000, and her primary

concern in deciding whether to charge interest is to

decide if it would be "fair" to do so

 She could have put that same money in the bank,

where it would have earned, say, 5 percent interest, or

$500 each year

 If she charges you $500 interest for each year the loan

is out, she is merely recovering the opportunity cost of her money

If she didn't charge you any interest, it would be the

same as giving you a gift of $500/yr

Example 1.13 Is it fair to charge interest

when lending a friend some money?

 If someone chooses not to give you a gift, is that

unfair?

 If not, it makes no more sense to say that recovering

the opportunity cost of lending someone money is

unfair

Example 1.13

Why do banks pay interest in the first place?

 Suppose you owned a bank and someone deposited

$10,000 in it on January 1 without your having to pay

him interest

 You could then take the money and buy a productive

asset, such as a row of trees

 Suppose that each year trees grow at the rate of 6

percent annually, and that the price of a tree is

proportional to the amount of lumber in it

 At the end of the year you could then sell the trees for

$10,600, and have $600 more than before

 But that same option was available to the person who

put his money in your bank

 Why should he give you the $600 he could have earned?

 Suppose you owned a bank and someone deposited

$10,000 in it on January 1 without your having to pay

him interest

 You could then take the money and buy a productive

asset, such as a row of trees

 Suppose that each year trees grow at the rate of 6

percent annually, and that the price of a tree is

proportional to the amount of lumber in it

 At the end of the year you could then sell the trees for

$10,600, and have $600 more than before

 But that same option was available to the person who

put his money in your bank

 Why should he give you the $600 he could have earned?

Example 1.14

Why do banks pay interest in the first place?

 Why should he give you the $600 he could have

earned?

 He will be willing to let you use his money only if you

compensate him for the opportunity cost of not using it himself

 If you pay him 5 percent interest, he will get $500,

which will probably be acceptable to him because he

won't have to go to the trouble of tending the trees

himself (or of lending the money to someone who will

tend them)

 You get to keep the remaining $100 for taking care of