Thinking Like an Economist
Learning Objectives
1. Explain why having more of any good thing necessarily requires having less of something else.
2. Explain and apply the Cost-Benefit Principle, which states that an action should be taken if, but only if, its benefit is at least as great as its cost.
3. Discuss three important pitfalls that occur when applying the Cost-Benefit Principle inconsistently.
4. Explain why if you want to predict people’s behavior, a good place to start is by examining their incentives.
Introduction to Economics
Definition of Economics:
Economics is the study of how people make choices under conditions of scarcity and the results of these choices for society.
Scarcity and Trade-offs:
Individuals have unlimited wants, but the resources available to meet these wants are limited.
Consequently, having more of one thing usually necessitates having less of another.
The Cost-Benefit Principle
Statement of the Principle:
An action should be undertaken if and only if the extra benefits of the action are at least as great as the extra costs.
Understanding Costs and Benefits:
Costs and benefits are not confined to monetary amounts; they can encompass any sacrifices or gains resulting from a decision.
Applying the Cost-Benefit Principle
Assumptions about People:
It is assumed that individuals are rational.
A rational person possesses well-defined goals and endeavors to achieve those goals as effectively as possible.
Hypothetical Scenarios:
Example 1: Would you walk to town to save $10?
Benefits are clear ($10).
However, one must consider the costs of walking to town.
Example 2: If savings were increased to $1,000, would you walk?
How about savings of $500, $100, or $50?
Conclusion from Examples:
If you would walk for savings of $9, but not for $8.99, your walk's costs must be $9.
Cost-Benefit Principle Examples
Example Scenarios:
Clipping grocery coupons vs. Jeff Bezos not doing so.
Speeding on the way to work but not on the way to school.
Choosing to pay more for a soda at a ballpark instead of a convenience store.
Opting to skip a regular dental check-up.
Economic Surplus
Definition:
The economic surplus of an action is calculated as the benefit minus the costs of that action.
Formula:
Example Calculation:
If walking to town saves $10, and the cost is $9, the economic surplus is:
Opportunity Cost
Definition:
Opportunity cost refers to the value of what must be sacrificed to engage in an activity.
It includes both explicit and implicit costs.
Examples of Opportunity Cost:
Choosing to go to the movies instead of spending an hour dog walking.
Opting to walk to town instead of watching a favorite Netflix show.
Important Note:
The opportunity cost is not the cumulative value of all possible alternative activities; it specifically considers the best alternative foregone.
Economic Models
Use of Simplifying Assumptions:
Determine which aspects of a decision are crucial and which are irrelevant.
Abstract Representation of Key Relationships:
The Cost-Benefit Principle can be thought of as a model.
Key insights include:
If costs associated with an action rise, the likelihood of executing the action declines.
If benefits rise, the action becomes more likely.
Three Decision Pitfalls
Economic Analysis Predicts Behavior:
Recognizes three common mistakes when applying the Cost-Benefit Principle:
1. Measuring costs and benefits in relative proportions instead of absolute values.
2. Ignoring implicit costs.
3. Not considering marginal changes effectively.
Pitfall #1: Measuring Costs and Benefits
Examples of Proportional Thinking:
Would you walk to town to save $10 on a $25 item?
Would you make the same choice for a $2,500 item?
Pitfall #2: Ignoring Implicit Costs
Consideration of Alternatives:
For instance, winning a free concert ticket isn't truly