Chapter 1: Thinking like an Economist

Three Important Decision Pitfalls

1. Measuring costs and benefits as proportions rather than absolute dollar amounts 2. Ignoring implicit costs 3. Failure to think at the margin

The Equilibrium Principle

A market in equilibrium leaves no unexploited opportunities for individuals but may not exploit all gains achievable through collective action

The Incentive Principle

A person (or a firm or a 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. A positive economic principle. It stresses that the relevant costs and benefits usually help us predict behavior, but at the same time does not insist that people will behave rationally in each instance

The incentive principle

A person (or firm or society) is more likely to take an action if its benefit rises, and less likely to take it if its cost rises.

Summary

Economics is the study of how people make choices under conditions of scarcity and of the results of those choices for society. Economic analysis of human behavior begins with the assumption that people are rational—that they have well-defined goals and try to achieve them as best they can. In trying to achieve their goals, people normally face trade-offs: Because material and human resources are limited, having more of one good thing means making do with less of some other good thing. LO1 • Our focus in this chapter has been on how rational people make choices among alternative courses of ac- tion. Our basic tool for analyzing these decisions is cost-benefit analysis. The Cost-Benefit Principle says that a person should take an action if, and only if, the benefit of that action is at least as great as its cost. The benefit of an action is defined as the largest dol- lar amount the person would be willing to pay in or- der to take the action. The cost of an action is defined as the dollar value of everything the person must give up in order to take the action. LO2 • Often the question is not whether to pursue an activ- ity but rather how many units of it to pursue. In these cases, the rational person pursues additional units as long as the marginal benefit of the activity (the bene- fit from pursuing an additional unit of it) exceeds its marginal cost (the cost of pursuing an additional unit of it). LO2 • In using the cost-benefit framework, we need not pre- sume that people choose rationally all the time. In- deed, we identified three common pitfalls that plague decision makers in all walks of life: a tendency to treat small proportional changes as insignificant, a tendency to ignore implicit costs, and a tendency to fail to think at the margin—for example, by failing to ignore sunk costs or by failing to compare marginal costs and benefits. LO4, LO5, LO6 • Microeconomics is the study of individual choices and of group behavior in individual markets, while macroeconomics is the study of the performance of national economics and of the policies that govern- ments use to try to improve economic performance.

The Efficiency Principle

Efficiency is an importan social goal because when the economic pie grows larger, everyone can have a larger slice.

The Principle of Comparative Advantage

Everyone does best when each concentrates on the activity for which he or she is relatively most productive.

The Scarcity Principle (no free lunch)

Having more of one good thing usually means having less of another

Normative economic principle

One that predicts how people will behave

Positive economic principle

One that says how people should behave

Excercise 1.6

Skipping classes the same day of a test: As a student, my grade in each of my classes matters to me. I act to increase my GPA as much as possiblew. In my mind, skipping the classes that occur immediately before a test has a far greater benefit to me by increasing my performance during the test than the cost of missing the material covered in the classes that day.

Rational person

Someone with well defined goals who tries to fulfill those goals as best he or she can

The Cost-Benefit Principle

Take no action unless its marginal benefit is at least as great as its marginal cost

Economic Surplus

The economic surplus from taking any action is the benefit of taking that action minus its cost

Marginal benefit

The increase in total benefit that results from carrying out one additional unit of an activity

Marginal cost

The increase in total cost that results from carrying out one additional unit of activity

Economics

The study of how people make choices under conditions of scarcity and of the results of these choices for society

Microeconomics

The study of individual choice under scarcity and its implications for the behavior of prices and quantities in individual markets

Macroeconomics

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

Average benefit

The total benefit of undertaking n units of an activity divided by n

Average cost

The total cost of undertaking n units of an activity divided by n

Opportunity Cost

The value of the next best option that must be forgone in order to undertake the activity

The Principle of Increasing Opportunity Cost

Use the resources with the lowest opportunity cost before turning to those with higher opportunity costs