Econ2020 Chapter01 Notes

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Dr. Du ffy Microeconom ics

Notes from

CHAPTER 1 ofFrank and Bernanke


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Thinking LikeAn Economist


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Id like to introduce you to Marty Thorndecker.

Hes an economist but hes really very nice.


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What is economics?

Economics is a social science.

Social sciences deal with people and theinstitutions they create.

Economics deals with how people makedecisions to allocate resources to achievetheir goals.


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Economics

Economics has been called the science of scarcity,

because many economic problems deal with constraints.

There are so many hours in the day, which must be

allocated to competing ends (work, study, sleep,recreation). There are so many dollars in a wallet, which

must be allocated to competing products (chips, burgers,

toothpaste, lettuce, books, music, etc.)

Goods are limited, but people are assumed to have

"unlimited wants." (More is preferred to less for most

things.)


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Scarcity in Economics

Scarcity: Resources are (usually) finite.

All economic goods are limited in supply,which economists call scarce.

In a market economy, scarce or limiteditems have prices associated with them.

The notion of unlimited wants is not true for

everyone, but even at our current level ofprosperity, we do not produce enough for

everyone to think they have enough.


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A way of thinking

Economics is the study of choice in a world

of scarcity.

How do people make choices given resource limits?

What are the consequences of those individual choices

for society?


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Economics and Values

Economics is not a system of ethics.

We assume in economics that people are frequentlymotivated by self-interest.

Many people are concerned about others, evenstrangers.

The degree of self-interest/altruism varies fromperson to person, based on disposition, up-bringing,

and experience.

We use our models because they work in general.Some degree of self-interest does motivate most

people at least some of the time.


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The Role of Economic Models

Economic models are abstract (simplifieddescriptions) models that allow us to analyze

situations in a logical way Other examples of abstract models

A computer model of climate change

A road map


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The Scarcity Principle

Also called the no free lunch principle.

Boundless wants cannot be satisfied withlimited resources.

Therefore, having more of one thing usuallymeans having less of another.

Because of scarcity we must make choices.

In other words, trade-offs will involvecompromises between competing interests.


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Opportunity Cost

The value of items not produced because

resources were used for another purpose.

The value of the next-best alternative that must be

forgone to undertake an activity

When there are trade-offs, there are opportunity

costs.


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Defining a Rational Person

In Economics, a rational person issomeone with well-defined goals who triesto fulfill those goals as best he or she can.

Note: No judgment is made about thesocial desirability of the goals.


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The Cost-Benefit Principle

A rational 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 asgreat as the extra costs

Benefits and costs often encompass more

than dollars


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Cost-benefit analysis

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.


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Estimating the opportunity cost of walkingdowntown:

A simple question: How much would someonehave to pay you to walk downtown?

If you would walk downtown for $9; the tripsopportunity cost is $9.

The benefit ($10) exceeds the cost of ($9) of

buying the game downtown.

The economic surplus is $1.00.


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Economic Surplus

The goal of economic decision makers is tomaximize their economic surplus.

Economic surplus is the benefit of taking anaction minus its cost.


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Do Real People Act this Way??

Critics of the cost-benefit approachoften object that people dont really

calculate costs and benefits whendeciding what to do.


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Four Important Economic Pitfalls in Cost-BenefitAnalysis

Pitfall 1: Measuring cost and benefits asproportions rather than absolute dollaramounts

Pitfall 2: Ignoring Opportunity Costs

Pitfall 3: Failure To Ignore Sunk Costs

Pitfall 4: Failure To Understand theAverage-Marginal Distinction


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Pitfall 1: Measuring cost and benefits as proportionsrather than absolute dollar amounts

Pitfall 1 Examples:

Should you walk downtown to save $10 ona $2,020 laptop computer? Would the

calculations differ in any way from thosetaken for the $25 game?

Which is more valuable, saving $100 on a$2,000 plane ticket to Tokyo or saving $90

on a $200 plane ticket to Chicago? How do people act in practice?


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Pitfall 2: Ignoring Opportunity Costs

Should you use your frequent-flyer coupon to flyto Fort Lauderdale for spring break?

Round trip airfare would be $500 if paid in cash.

Other direct cash costs equal $1,000 The most you are willing to pay for the Fort

Lauderdale trip is $1,350 (your benefits).

The alternative use for the frequent flyer coupon is

to attend a wedding in Boston the week afterspring break and the Boston airfare is $400(coupon expires just after the wedding).


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The cost-benefit analysis

Benefits = $1,350 (your willingness to pay)

Cost = $1,400 ($400 opportunity cost + $1,000direct cash costs)

Surplus = $-50. Question

What would you do if the coupon expires just afterspring break and before the wedding? What would

be the opportunity cost of the coupon in thatsituation?


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Pitfall 2, summary

The key to using the concept of opportunitycost correctly lies in recognizing preciselywhat taking a given action prevents us from

doing. Opportunity costs are like the Holmes case

with the dog who failed to bark in thenighttime. They are easy to overlook, but can

provide highly relevant information.


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Pitfall 3: Failure To Ignore SunkCosts

The only costs that should influence a decisionabout whether to take an action are those that

we can avoid by not taking the action.


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Sunk Cost Defined

Sunk Cost: A cost alreadyincurred so it is sunk and not

recoverable. No future decisioncan return that cost to you.


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Ignore Sunk Costs!

Sunk costs are costs that are beyondrecovery at the moment a decision is

made.

Unlike opportunity costs, sunk costsshould be ignored.


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Pitfall 4: Failure ToUnderstand the Average-Marginal Distinction

Marginal Benefit: the increase in total benefit thatresults from carrying out one additional unit of anactivity

Marginal Cost: The increase in total cost that resultsfrom carrying out one additional unit of an activity

To an economist, marginal usually means extra oradditional. Well see this word again.


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Pitfall 4 example

Should NASA expand the space shuttle programfrom four launches per year to five?

Benefits of four launches: $24 billion (average of$6 billion/launch)

Costs of four launches: $20 billion (average of $5billion/launch)


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Average Cost and AverageBenefit

Average Cost: The total cost ofundertaking n units of an activity dividedby n.

Average Benefit: The total benefit ofundertaking n units of an activity dividedby n.


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Pitfall 4

Without more information, we cant saywhether NASA should expand theprogram. We need to know the marginal

cost and the marginal benefit of one morelaunch per year.


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Average versus Marginal Cost

Launches Total Average Extra(number) Cost ($B) Cost Cost

0 0 xxx xxx1 3 3 3

2 7 3.5 43 12 4 54 20 5 85 32 6.4 12

A fifth launch would incur marginal costs of $12 billion. We

would not add a fifth launch unless the extra benefit is greater

than $12 billion. So even if the additional benefit equaled the

average benefit of $6 billion, we would not make a fifth launch.


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The Incentive Principle

A person (or firm or society) is more likely to take

an action if its benefit rises or if its costs fall. A

person is less likely to take an action if the benefit

falls or the cost rises.

This principle is sometimes condensed to:Incentives matter.


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Normative Economics & Positive Economics

Normative Economic Principle

One that says how people should behave

Example: Cost-benefit principle

Positive Economic Principle

One that predicts how people will behave

Example: The incentives principle


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Positive and Normative Economics,Alternative Definition

Positive Economics deals with questionsthat can be analyzed objectively, e.g.What is the impact of raising taxes?

Normative Economics may involve ethicalprecepts and norms of fairness, e.g.Should the poor be required to work to

receive government assistance?


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Economics: Micro and Macro

Microeconomics is the study of individual choiceunder scarcity and its implications for thebehavior of prices and quantities in individual

markets.

Macroeconomics is the study of the performanceof national economies, and of the policies thatgovernments use to try to improve thatperformance.


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Microeconomics

. . . is the branch of economics that deals

with the behavior of individual entities,

such as consumers, firms, households,or markets.

A major focus of microeconomics is pricedetermination.

This course deals primarily with

Microeconomics.


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The Other Branch of Economics

. . . is macroeconomics, which is concerned

with overall performance of the economy,

e.g. inflation, unemployment, growth.

Macroeconomics is the more recent of the

two branches. It began around 1935, whenJohn Maynard Keynes published General

Theory of Employment, Interest, and Money.


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The Approach of Your Text

Focus on core economic concepts

Scarcity principle

Cost-benefit principle Incentive principle

Learning economics through applications


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Economic Naturalism

Using insights from economics to help make senseof observations from everyday life.

Why dont automobile manufacturers make cars

without heaters? Why do the keypad buttons on drive-up automatic

teller machines have Braille dots?

Why do so many computer hardware manufacturers

include more than $1,000 worth of free software witha computer selling for only slightly more than that?


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Economic Naturalism

To solve these problems, use cost-benefitanalysis.

Econ2020 Chapter01 Notes

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