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
Distributi
on

Health
Enrollin
Career
Deliver
g in
Choices Classes
y

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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 tradeoffs:
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 welldefined 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:
If

the 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
Benefits

Total
Costs

Economi
c 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
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

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.
2.
3.

Measuring costs and benefits as proportions

instead of absolute amounts
Ignoring implicit costs
Failure to think at the margin

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Pitfall #1

Measuring costs and

benefits as
proportions instead
of absolute amounts
Would you walk
Margina
to town to save
l Costs
$10 on a $25
item?
Would you walk
to town to save
$10 on a $2,500
item?
Key point:
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Action

17

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 (implicit18

Explic
it
Costs

Opportuni
ty Cost
Implic
it
Costs

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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
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
Tournament
s

Total Cost
($m)

$0

$3

$7

$12

$20

$32

Marginal
Cost
($m)
$3

Average
Cost
($m/tourna
ment)
$0

$4

$3

$5

$3.5

$8

$4

$12

$5
$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
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 and
Macroeconomics
Microeconomics studies the
individual choice under
scarcity and its implications
for the behavior of prices
and quantities in individual
markets
Sugar
Carpets
House cleaning services

Macroeconomics studies the

performance of national
economies and the policies
that governments use to try
to improve that
performance
Inflation
Unemployment
Growth

Microeconomics considers:
Costs of production
Demand for a product
Behavior of consumers

Macroeconomics considers:
Monetary policy
Deficits
Tax policy

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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

To

Horizontal is independent variable

Vertical is dependent variable

graph,
Plot the intercept
Plot one other
point
Connect the
points

12

8
6
5

C
A

10

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30

70
32

From Graph to Equation

Identify

Independent
Dependent

Identify

variables

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

Time
(minutes/month)

10

20

30

40

Bill
($/month)

$10.50

$11.00

$11.50

$12.00

Identify variables
Independent
Dependent
Label axes
Plot points
Connect points
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From Table to Equation

Time
(minutes/month)

10

20

30

40

Bill
($/month)

$10.50

$11.00

$11.50

$12.00

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
Plan 2

B = 10 + 0.04 T
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
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