Chapter 1 - Thinking like an economist

Economics: studying choice in a world of scarcity

• Economics: study of how people make choices under conditions of scarcity and of the results of those choices for society.

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• Scarcity principle = no-free-lunch principle: although we have boundless needs and wants, the resources available to us are limited. So having more of one good thing usually means having less of another.

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• Cost-benefit principle: an individual (or a firm/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.

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Applying the cost-benefit principle

• Rational person: someone with well-defined goals who tries to fulfill those goals as best he/she can.

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• Economic surplus: benefit of taking an action minus its cost.

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• Opportunity cost: value of what must be forgone to undertake an activity.

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3 important decision pitfalls

• Measuring costs/benefits proportionally

  • Many decision makers treat a change in cost/benefit as insignificant if it constitutes only a small proportion of the original amount. Absolute dollar amounts, not proportions, should be employed to measure costs and benefits.

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• Ignoring implicit costs

  • When performing a cost-benefit analysis of an action, it’s important to account for all relevant costs, including the implicit value of alternatives that must be forgone in order to carry out the action. A resource (such as a frequent-flyer coupon) may have a high implicit cost, even if you originally got it "for free," if its best alternative use has high value. The identical resource may have a low implicit cost, however, if it has no good alternative uses.

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• Failing to think at the margin

  • When deciding whether to perform an action, the only costs and benefits that are relevant are those that would result from taking the action. It is important to ignore sunk costs.
  • Even though a ticket to a concert may have cost you $100, if you've already bought it and cannot sell it to anyone else, the $100 is sunk cost and shouldn't influence your decision about whether to go the concert.
  • It's also important not to confuse average costs and benefits with marginal costs and benefits. Decision makers often have ready information about the total cost and benefit of an activity, and from these it's simple to compute the activity's average cost and benefit.
  • Sunk cost: cost that is beyond recovery at the moment a decision must be made.
  • Marginal cost: increase in total cost that results from carrying out one additional unit of an activity.
  • Marginal benefit: increase in total benefit that results from carrying out one additional unit of an activity.
  • Average cost: total cost of undertaking n units of an activity divided by n.
  • Average benefit: total benefit of undertaking n units of an activity divided by n.

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Normative economics vs positive economics

• Normative economic principle says how people should behave.
• Positive economic principle predicts how people will behave.

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• Incentive principle: person (or a firm/society) is more likely to take an action if its benefit rises, and less likely to take it if its cost rises. In short, incentives matter.

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Economics: micro and macro

• Microeconomics: study of individual choice under scarcity and its implications for the behavior of prices and quantities in individual markets.

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• Macroeconomics: study of the performance of national economies and the policies that governments use to try to improve that performance.

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