Lecture Principles of economics (Brief edition, 2e): Chapter 1 - Robert H. Frank, Ben S. Bernanke

Chapter 1 - Thinking like an economist. This chapter to show that the Cost-Benefit Principle, deciding whether to take an action by comparing the cost and benefit of the action, is a useful approach for dealing with the inevitable trade-offs that scarcity creates. After discussing several important decision pitfalls, the chapter concludes by describing the Incentive Principle and introducing the concept of economic naturalism.

Chapter 1: Thinking Like an

Economist

1 Explain and apply the Scarcity Principle

2 Explain and apply the Cost-Benefit Principle

3 Explain and apply the Incentive Principle

4 Discuss the pitfall of measuring costs and

benefits as proportions rather than as absolute dollar amounts

5 Discuss the pitfall of ignoring implicit costs

6 Discuss the pitfall of failing to weigh costs and

benefits at the margin

The Scarcity Principle

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

Economic Surplus

• The economic surplus of an action is equal

to its benefit minus its costs

Opportunity Cost

• Opportunity cost is the value of what must be

foregone in order to undertake an activity

– Consider explicit and implicit costs

• Examples:

– Give up an hour of babysitting to go to the movies

– Give up watching TV to walk to town

• Caution: NOT the combined value of all possible activities

– Opportunity cost considers only your best

alternative

Economic Models

• Simplifying assumptions

– Which aspects of the decision are absolutely

essential?

– Which aspects are irrelevant?

• 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

Three Decision Pitfalls

• Economic analysis predicts likely behavior

• 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

Pitfall #1

Measuring costs

and benefits as

proportions

instead of

absolute amount

town to save $10 on

a $25 item?

Pitfall #2

Ignoring implicit costs

alternatives – The value of a Frequent Flyer coupon depends on its next

best use

another trip?

Pitfall #3

Failure to think at the

margin

• Sunk costs cannot be

recovered

– Examples:

• Eating at an

all-you-can-eat restaurant

• Attend a second year

of law school

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

Normative and Positive

Economics

– Normative economic

principle says how

people should behave

• Gas prices are too

high

• Building a space base

on the moon will cost

too much

– Positive economic

principle predicts how

people will behave

• The average price of gasoline in May 2008 was higher than in May 2007

• Building a space base

on the moon will cost more than the shuttle

Incentive Principle

Microeconomics and

Macroeconomics

choice and its implications

for price and quantity in

individual markets

topics such as

the performance of national economies and the policies that governments use to try

to improve that performance

Economics Is Choosing

• Focus in this course is on a short list of powerful ideas

– Explain many economic issues

– Predict decisions made in a variety of

circumstances

• Core Principles are the foundation for solving

economic problems