Thinking Like An Economist

Chapter 1
Frank/Bernanke,
Principles of
Microeconomics

Id like to introduce you to Marty

Thorndecker. Hes an economist but hes
really very nice.

Hi, I am Marty.

Hi, I am Marty.

Can we express yourself?

Suppose you had the chance to meet the Chief
Executive in a cocktail party. You were asked to
express your opinion on minimum wage
legislation in Hong Kong.
How do you express your views and
convince him/her in five minutes?

Can you express yourself?

Most students who take introductory economics
leave the course without really having learned even
the most important basic economic principles.
Their ability to answer simple economic questions
several months after leaving the course is not
measurably different from that of people who never
took a principles course.*
*Hansen, W. L., M. K. Salemi, and J. J. Siegfried (2002) Use it or
lose it: teaching economic literacy, American Economic Review
(Papers and Proceedings), 92 (May): 463-72.

How do we learn a new language

Start simple
Repetition and drill
Active learning
Have fun

How much is this?

Should there be 12 separate sections of

Econ 101, with 25 students each?

Or should there be only one section, with

300 students?

What is the Optimal Class Size?

To maximize learning without consideration of cost?
How would considering costs change our answer?
A personal tutorial course in economics might
cost $40,000
A class of 300 students might cost $200/student
Extreme case: a class of infinite students might
cost less than $0.1/student
What trade-offs must university administrators and
students consider when choosing class size?

10

The Scarcity Principle

(also called no-free-lunch principle)
Boundless wants cannot be satisfied with limited
resources.
Therefore, having more of one thing usually
means having less of another.
Because of scarcity we must make choices.
Even Bill Gates (once valued as having US$100
billion) still faces scarcity
There are only 24 hours

11

Selling Seats Through An English Auction

In the classroom, the teacher owns the seats. As usual, the

teacher can assign seats. Here, we do it in the economics
way -- the teacher will sell seats through an English
auction. In an English auction, bidders cry out their bid for
a good item until no one is willing to submit a higher bid.
The highest bidder will get the item. This kind of auction
has been used in Hong Kongs land auction. There is no
restriction on how many seats a student can buy or resale
activity.
Bidders suggest a seat for auction. A suggestion is also
taken as minimum bid of HK$0.5. The minimum price of
the seat is HK$0.5. Each cry should be at a HK$0.5 or
higher. When submitting a bid, raise your number plate
and cry out the bid. Students who do not get a seat will
have to seat on the floor.
The teacher will collect the money/ IOU and put it in a jar.
The money collected will be used to fund class
refreshments as determined by the class later.

12

What are the alternatives to English

auction?

First come, first served;

Teacher assigned;
Class negotiation.

13

Microeconomics
The study of how people make choices under
conditions of scarcity and of the results of those
choices for society.
In a market system, allocation of resources occur
via the price system, incomes and preferences

14

Rationality assumption and The Incentive

Principle
People have goals and try to fulfill them as best
as they can.
The Incentive Principle: An agent (person, firm or
society) is more likely to take an action if its
benefit rises, and less likely to take it if its cost
rises. Incentives matter in our analysis of
behavior and in designing economic policies

15

The Cost-Benefit Principle

An 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 as great as the extra costs

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.
16

Should we make the econ class larger?

Benefit of making the class size larger = the
reduction in cost per student = B(x)
Cost of making the class size bigger = The
amount people would be willing to pay to avoid
the reduced quality of instruction = C(x)

17

Some relevant costs:

Faculty salary: $90,000 per course
Per student faculty salary cost:
1 section: $90,000/300 = $300
12 sections: $90,000/25 = $3600

18

Benefits and costs

Benefit of increasing class size from 25 students
to 300 students = ($3600 - $300) = $3300 =
B(x)
If you were currently in a class with 25 students,
how much would you be willing to pay to avoid
switching to one with 300 students? C(x)
If C(x) < $3300, then it makes sense to offer the
larger class.

19

Optimal class size

Observations
The best class from an economic point of
view will generally not be the same as the
best size from the point of view of an
educational psychologist.
People will feel differently about the value of
smaller classes.

20

Optimal class size

Who will opt for smaller classes:
Those who value smaller classes more.
Those who are less financially constrained.
Observations:
We have colleges of different class size.
Colleges of smaller class size generally charge
higher tuition fees.
But colleges and universities may also be
subsidized
21

Example 1.1
Should I turn down my stereo?
You have settled into a comfortable chair and are
listening to your stereo when you realize that the
next two tracks on the album are ones you dislike.
If you had a programmable disc player or a remote
control, you would have programmed them not to
play.
But you don't, and so you must decide whether to
get up and turn the music down, or to stay put and
wait it out.

22

Example 1.1.
Should I turn down my stereo?
Suppose C(x) = $1.00 = the minimum amount it
would take to get you out of your chair.
B(x) = the maximum you would be willing to pay
someone to turn down the volume.
If B(x) > $1, then turn your stereo down by
yourself
If B(x) < $1, then don't.

23

The Cost-Benefit Principle

An 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 as great as the
extra costs.
Critics of the cost-benefit approach often object
that people dont really calculate costs and
benefits when deciding what to do.

24

People often behave as if they were

comparing the relevant costs and
benefits.

25

People often make bad decisions because

they fail to compare the relevant costs
and benefits.

26

Can cost-benefit analysis help you make

better decisions?
Example 1.2
You are about to buy a $20
alarm clock at the campus store
when a friend tells you that
Fortress has the same alarm
clock on sale for $10.

Do you travel to
Fortress?

27

Can cost-benefit analysis help you make

better decisions?
Example 1.3. You are about
to buy a $6510 laptop
computer from the campus
store when a friend tells you
that Fortress has the same
computer on sale for $6500.

Do you travel to
Fortress?

28

Example 1.2 and 1.3

Should you travel to Fortress?
B(x) = benefit of traveling to Fortress
= $10 in both cases.
C(x) = cost of traveling to Fortress
= the same amount in both cases.
So your answer should be the same in both cases.

29

Can cost-benefit analysis help you make

better decisions?
Example 1.4. Choosing a public health program.
A rare disease will claim 600 lives if we do nothing.
We must choose between the following two
programs:
Program A: save 200
Program B: save 600 lives
lives with certainty
with probability 1/3, and
save zero lives with
probability 2/3
Which program would you choose? A
or B?
30

Can cost-benefit analysis help you make

better decisions?
Example 1.5. Choosing a public health program.
A rare disease will claim 600 lives if we do nothing.
We must choose between the following two
programs:
Program C: 400
Program D: 1/3 chance
people will die with
that no one will die, and
certainty
2/3 chance that all 600 will
die
Which program would you choose? C
or D?
31

Example 1.4 vs. Example 1.5

In Example 1.4, most people choose to save
200 lives with certainty (Program A).
In Example 1.5, most people choose to save all
600 lives with prob. 1/3 (Program D).
Yet the two pairs of programs are equivalent:
A=C and B=D

32

Illusions
If the list of alternatives among which we choose
are the same in two cases, then the particular
alternative we choose should also be the same in
both cases.
Yet people seem to prefer the safe alternative
when the alternatives are framed as choices
between different numbers of lives saved, and to
prefer the risky alternative when the alternatives
are framed as choices between different
numbers of lives lost.

33

Example 1.6. Losing a $100 bill

You have just arrived at the

theater to buy your ticket
and discover that you have
lost a $100 bill from your
wallet.
Do you buy a ticket and see the play
anyway?

34

Example 1.7. A lost theater ticket.

You have just arrived at the theater
and discover that you have lost the
$100 ticket you purchased earlier
that day.
Do you buy another ticket and
see the play anyway?

35

Example 1.6 vs. Example 1.7

In both cases, you are $100 poorer than before.
In both cases, the benefit of seeing the play is
the same.
In both cases, the additional cost you must incur
to see the play is exactly $100.
Since the relevant costs and benefits are the
same in both cases, your decision should also be
the same.
36

Example 1.8. How much memory should

your computer have?
Suppose that random
access memory can be
added to your computer at
a cost of $0.50 per
megabyte.

How many megabytes of memory should you

purchase?
37

Cost-benefit principle:
Buy an additional megabyte if the marginal
benefit of RAM is at least as great as its
marginal cost.
Marginal benefit = added benefit from having 1
more unit.
Marginal cost = added cost of having 1 more
unit.

38

Cost-benefit principle:
Dollars per
megabyte
MB

Value of an additional
megabyte

2.00

Cost of an
additional
megabyte

1.00
MC

0.50
0.25
1000

2000
Megabytes
of memory

3000

Optimal
amount
of
memory

4000

39

Everyday Choices
"Should I do X?"
"How much X should I buy?"
"Should I buy an additional unit of X?"

40

Some Common Pitfalls for Decision Makers

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

41

Example 1.9. Proportion vs. absolute

Your employer has a travel discount voucher that can
be redeemed on one of your next two business trips.
You could use it to save $100 on a $2000 plane ticket
to Tokyo; or you could save $90 on a $200 plane
ticket to Chicago?

If your goal is to do what would be best for your

company, for which trip should you use the
coupon?

42

Some Common Pitfalls for Decision Makers

Pitfall 2: Ignoring Opportunity Costs
If doing activity x means not being able to do
activity y, then the value to you of doing y is an
opportunity cost of doing x.
Many people make bad decisions because they
tend to ignore the value of such foregone
opportunities.

43

Pitfall 2: Ignoring Opportunity Costs

It will almost always be instructive to translate
questions like
"Should I do x?"
into ones like
"Should I do x or y?"
In the latter question, y is simply the most highly
valued alternative to doing x.

44

Example 1.10. Should I go skiing today?

45

Example 1.10. Should I go skiing today?

From experience you can confidently say that a
day on the slopes is worth $50 to you.
The charge for the day is $30 (which includes
bus fare, lift ticket, and equipment).
But this is not the only cost of going skiing. You
must also take into account the value of the
most attractive alternative you will forego by
heading for the slopes.

46

Example 1.10. Should I go skiing today?

Suppose that if you don't go skiing, you will work at
your new job as a research assistant for one of
your professors.
The job pays $40 dollars per day, and you like it
just well enough to have been willing to do it for
free.
"Should I go skiing or stay and work as a research
assistant?"

47

Example 1.10. Should I go skiing today?

C(x) = cost of skiing plus value of forgone earnings
= $30 + $40
= $70
B(x) = $50 < C(x),
So don't go skiing.

48

Willing to do it for free

The fact that you liked your job just well enough
to have been willing to do it for free is another
way of saying that there are no psychic costs
associated with doing it.
This is important because it means that by not
doing the job you would not be escaping
something unpleasant.

49

Many jobs, of course, are not pleasant.

50

Example 1.11
Unwilling to do the job for less than
$25/day
Suppose instead that your job had been to
scrape plates in the dining hall for the same pay,
$40/day, and that the job was so unpleasant that
you would be unwilling to do it for less than
$25/day.
Should you go skiing?

51

I. One of the benefits of going skiing is not

having to scrape plates.
B(x) = $25 + $50 = $75
C(x) is the same as before, namely the $30 ski
charge plus the $40 opportunity cost of the lost
earnings, or $70.
So now B(x) > C(x), which means you should go
skiing.

52

Some Common Pitfalls for Decision Makers

Example 1.11 makes clear that there is a
reciprocal relationship between costs and
benefits.
Not incurring a cost is the same as getting a
benefit.
By the same token, not getting a benefit is the
Economic
Surplus aiscost.
the benefit of taking any
same as incurring
action minus its cost
The goal of economic decision makers is to
maximize their economic surplus.
53

Example 1.12. Is it fair to charge

interest when lending a friend some
money?
Suppose a friend lends you $10,000, and her
primary concern in deciding whether to charge
interest is to decide if it would be "fair" to do so.
She could have put that same money in the
bank, where it would have earned, say, 5 percent
interest, or $500 each year.
If she charges you $500 interest for each year
the loan is out, she is merely recovering the
opportunity cost of her money.
If she didn't charge you any interest, it would be
the same as giving you a gift of $500/yr.
54

Example 1.13. Is it fair to charge

interest when lending a friend some
money?
If someone chooses not to give you a gift, is that
unfair?
If not, it makes no more sense to say that
recovering the opportunity cost of lending
someone money is unfair.

55

Example 1.13.
Why do banks pay interest in the first
place?
Suppose you owned a bank and someone
deposited $10,000 in it on January 1 without your
having to pay him interest.
You could then take the money and buy a
productive asset, such as a row of trees.
Suppose that each year trees grow at the rate of 6
percent annually, and that the price of a tree is
proportional to the amount of lumber in it.
At the end of the year you could then sell the trees
for $10,600, and have $600 more than before.
But that same option was available to the person
who put his money in your bank.
Why should he give you the $600 he could have
earned?

56

Example 1.14.
Why do banks pay interest in the first
place?
Why should he give you the $600 he could have
earned?
He will be willing to let you use his money only if
you compensate him for the opportunity cost of
not using it himself.
If you pay him 5 percent interest, he will get
$500, which will probably be acceptable to him
because he won't have to go to the trouble of
tending the trees himself (or of lending the
money to someone who will tend them).
You get to keep the remaining $100 for taking
care of that.
57

Opportunity cost
As simple as the opportunity cost concept is, it is
one of the most important in microeconomics.
The art in applying the concept correctly lies in
being able to recognize the most valuable
alternative that is sacrificed by the pursuit of a
given activity.

58

Marginal cost versus sunk cost

Sunk costs are costs that have already been
incurred and which cannot be recovered to any
significant degree.
Marginal cost is the additional cost required to
make a successful bid.

59

Some Common Pitfalls for Decision Makers

Pitfall 3: Failure To Ignore Sunk Costs
An opportunity cost will often not seem like a
relevant cost when in reality it is.
Another pitfall in decision making is that
sometimes an expenditure will seem like a
relevant cost when in reality it is not.
The only costs that should influence a decision
about whether to take an action are those that
we can avoid by not taking the action.
Sunk cost is a cost that is beyond recovery at
the moment a decision must be made
60

Example 1.15: The Pizza Experiment

How much should you eat at an all-you-can-eat
restaurant?
A local pizza parlor offers an all-you-can-eat lunch
for US$3.
You pay at the door, and then the waiter brings you
as many slices of pizza as you like.
The "waiter" selects half of the tables at random
and gave everyone at those tables a US$3 refund
before taking orders.
If all diners are rational, will there be any difference
in the average quantity of food consumed by these
two groups?

61

"Should I eat another slice of pizza?"

62

"Should I eat another slice of pizza?"

For both groups, C(x) is exactly zero.
Because the refund group was chosen at
random, B(x) should be the same for each group,
on the average.
People from both groups should keep eating until
B(x) falls to zero.

63

"Should I eat another slice of pizza?"

So the two groups should eat the same amount
of pizza, on the average.
The US$3 admission fee is a sunk cost, and
should have no influence on the amount of pizza
one eats.
In fact, however, the group that did not get
the refund consumed substantially more
pizza.

64

Four Important Decision Pitfalls

Pitfall 4: Failure To Understand the AverageMarginal Distinction
Marginal Benefit: The increase in total benefit
that results from carrying out one additional unit
of an activity.
Average Benefit: The total benefit of undertaking
n units of an activity divided by n.
Marginal Cost: The increase in total cost that
results from carrying out one additional unit of an
activity.
Average Cost: The total cost of undertaking n
units of an activity divided by n.

65

Example 1.15. Should NASA expand the

space shuttle program?
NASA currently makes four launches per year.
Should NASA expand the space shuttle program
from four launches per year to five?
Benefits
Total of $24 billion
Average of $6 billion/launch
Costs
Total of $20 billion
Average of $5 billion/launch
66

Example 1.14. Should NASA expand the

space shuttle program?
# of Launches
0

Total Cost

Average Cost

Marginal Cost

($ billion)

($ billion/launch)

($ billion/launch)

3.5

3
4
5
8
12

3
4

12

What is the optimal number of launches?

20
5

Assume: Average Benefit = Marginal

Benefit = $6 billion
5

32

6.4

67

Example 1.15. Fishing boat allocation

Suppose you own a fishing fleet consisting of a
given number of boats, and can send your boats
in whatever numbers you wish to either of two
ends of an extremely wide lake, east or west.

Where should
you send your
boats?

68

Example 1.15. Fishing boat allocation

Under your current allocation of boats, the ones
fishing at the east end return daily with 100
pounds of fish each, while those in the west
return daily with 120 pounds each.
The fish populations at each end of the lake are
completely independent, and your current yields
can be sustained indefinitely.
Average Catch:
West End: 120 lbs/boat
East End: 100 lbs/boat
True or False: If you shift some of your boats from
the east end to the west end, you will catch more
fish.
69

Example 1.16. Should you move one of

your boats from the east end to the west
end?
Currently two boats are sent to the east end and
two to the west end.
Average output per boat
Number of
boats

East end

West end

100 lbs/boat

130 lbs/boat

100 lbs/boat

120 lbs/boat

100 lbs/boat

110 lbs/boat

100 lbs/boat

100 lbs/boat

70

Example 1.16. Should you move one of

your boats from the east end to the west
end?
Average output per boat
Number of
boats

East end

West end

100 lbs/boat

130 lbs/boat

100 lbs/boat

120 lbs/boat

100 lbs/boat

110 lbs/boat

100 lbs/boat
Number of boats

100 lbs/boat

East end

West end

Total output

440 lbs

430 lbs

430 lbs

400 lbs

400 lbs

71

Example 1.16. Should you move one of

your boats from the east end to the west
end?
Average output per boat
Number of boats

East end

West end

100 lbs/boat

130 lbs/boat

100 lbs/boat

120 lbs/boat

100 lbs/boat

110 lbs/boat

100 lbs/boat

100 lbs/boat

Marginal output per boat

The n-th boat

East end

West end

100 lbs

130 lbs

100 lbs

110 lbs (= 240-130)

100 lbs

90 lbs (=330-240)

100 lbs

70 lbs (400-330)

72

Rules for allocating resources

The general rule for allocating a resource
efficiently across different production activities is:
Allocate each unit of the resource to the
production activity where its marginal benefit
is highest.
For a resource that is perfectly divisible, and for
activities for which the marginal product of the
resource is not always higher in one than in the
others, the rule is:
Allocate the resource so that its marginal
benefit is the same in every activity.

73

Normative Economics
vs. 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 matter principle
A person (or a firm or society) is more
likely to take an action if its benefit rises
and less likely if its cost rises
74

Economics: Micro and Macro

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 of the policies that
governments use to try to improve that
performance.
75

Economic Naturalism
Applications
Use cost-benefit analysis to explain some
pattern of events or behavior you have
observed in your own environment

Start simple
Repetition and drill
Active learning apply to real life phenomena
76

Economic Naturalism
Observe things happening around us

Ask interesting questions

Provide plausible answers

77

Ask an interesting question

Why do so many computer hardware
manufacturers include more than $1,000 worth
of free software with a computer selling for
only slightly more than that?

78

Ask an interesting question

Why dont automobile manufacturers make cars
without heaters?

79

Ask an interesting question

Why do the keypad buttons on
drive-up automatic teller
machines have Braille dots?

80

Ask an interesting question .

Why are round-trip
fares from Hawaii to
the mainland US
higher than the
corresponding fares
from the mainland US
to Hawaii?

81

Ask an interesting question .

Why is airline food so bad?

82

Ask an interesting question .

Why does a telecommunications equipment
manufacturer offer free BMW sedans to employees with
more than one year of service?

BMW lease price

was $9000/year.
Why not give
employees
$9000/year in
extra salary
instead?
83

Ask an interesting question .

Why are foreign films so
good?
Criteria for choosing a film to see:
Is it by a well-known director?
Does it feature a favorite actor or actress?
Has it gotten rave reviews in the media?
Word of mouth?

The only foreign films with a chance to make

it in the HK market are really good ones
those able to generate strong reviews and
word of mouth.

84

End

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