Chapter 1
Thinking Like an Economist
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Learning Objectives
1. Explain and apply the Scarcity Principle, which says that
having more of any good thing necessarily requires having
less of something else.
2. Explain and apply the Cost-Benefit Principle, which says that
an action should be taken if, but only if, its benefit is at least as
great as its cost.
3. Discuss four important pitfalls that occur when applying the
Cost-Benefit Principle inconsistently.
4. Explain and apply the Incentive Principle, which says that if
you want to predict people’s behavior, a good place to start is
by examining their incentives.
5. Describe Adam Smith’s invisible hand theory and give
examples illustrating how his modern disciples sometime
misconstrue its message.
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WHAT IS ECONOMICS
• Economy, “oikonomos” (Greek)
– “One who manages a household”
– Households and economies have much in
common
• Households face many decisions
– Allocate scarce resources
• Ability, effort, and desire
• Society faces many decisions
– Allocate resources and output
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Definition of Economics
– Economics is the social science that studies the
choices that individuals, businesses,
governments, and societies make as they cope
with scarcity (of resources) and the incentives
that influence and adjust those choices.
LE WORKS
Macroeconomics and Microeconomics
•Microeconomics is the study of how households and firms
make decisions and how they interact in markets.
•Macroeconomics is the study of economy-wide phenomena,
including inflation, unemployment and economic growth.
For use with Mankiw and Taylor, Economics 4 th edition
9781473725331 © Cengage EMEA 2017
The Economic Problem
•The three big questions are:
– What goods and services should be produced?
– How should it be produced (see resources)?
– Who should get the goods and services produced?
For use with Mankiw and Taylor, Economics 4 th edition
9781473725331 © Cengage EMEA 2017
GOODS and SERVICES
– Goods and services are the objects that people value and
produce to satisfy wants.
– Goods are physically tangible products that can be purchased,
stored and used later e.g. TVsets, Laptop, Cigarette
– Services are products that can be purchased and used
immediately (can not be stored) e.g. Health, Tourism, Banking
FACTORS OF PRODUCTION
– Goods and services are produced by using productive
resources that economists call factors of production.
– Factors of production are grouped into four categories:
Land
Labor
Capital
Entrepreneurship
FACTORS OF PRODUCTION
– The “gifts of nature” that we use to produce goods and
services are land.
– The work time and effort that people
devote to producing goods and services is labor.
– The quality of labor depends on human capital, which is
the knowledge and skill that people obtain from education,
on-the-job training, and work experience.
FACTORS OF PRODUCTION
– The tools, instruments, machines, buildings, and other
constructions that are used to produce goods and services are
capital.
– The human resource that organizes land, labor, and capital is
entrepreneurship.
FACTORS OF PRODUCTION
– Who gets the goods and services depends on the incomes
that people earn.
Land earns rent.
Labor earns wages.
Capital earns interest.
Entrepreneurship earns profit.
SCARCITY
• Resources are scarce
• Scarcity
– The limited nature of society’s resources
– Society has limited resources and
therefore cannot produce all the goods and
services people wish to have
• Economics
– How society manages its scarce resources
– How people make decisions
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The Scarcity Principle
Economics: The study of how people
make choices under scarcity and the
results of these choices for society.
The Scarcity Principle: We have boundless
needs and wants, but resources are limited.
Having more of one good thing usually
means having less of another.
Also called No Free-Lunch Principle
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The Scarcity Principle:
Examples
Scarcity is involved in
Buying
Global Political Career
bottled
warming elections choices
water
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The Cost-Benefit Principle
• Take an action if and only if the extra benefits
are at least as great as the extra costs
• Costs and benefits are not just money
Marginal
Benefits
Marginal
Costs
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Applying the Cost-Benefit
Principle
• Assume people are rational
– A rational person has well defined goals and tries to fulfill
those goals as best they can
• Would you walk to town to save $10 on an
item?
– Benefits are clear ($10)
– But what are the “costs of walking to town”?
• Hypothetical auction
– Would you walk to town if the savings were $1,000?
– How about savings of $500? $100? $50?
– If you would walk to town for savings of $9, but not for savings
of $8.99, then your costs of walking must be $9!
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Cost – Benefit Principle
Examples
You clip grocery You speed on
coupons, but the way to work
Jeff Bezos but not on the
does not way to school
At the ballpark,
you pay extra to You skip your
buy a soda from regular dental
the hawkers in check-up
the stands
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Economic Surplus
• The economic surplus of an action is equal
to its benefit minus its costs
Total
Total Benefits
Costs
Economic
Surplus
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Economic Surplus
• The economic surplus of an action is equal
to its benefit minus its costs
• Economic surplus = Total Benefits – Total
Costs
• If we get $10 of savings from walking to town,
and our costs of walking to town are $9, then
the economic surplus from walking to town
is $10 - $9 = $1.
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Opportunity Cost
• Opportunity cost is the value of what must be
foregone in order to undertake an activity
– Consider explicit and implicit costs
• Examples:
– Give up an hour of dogwalking to go to the movies
– Give up watching your favorite Netflix show to walk
to town
• Caution: NOT the combined value of all
possible activities
– Opportunity cost considers only your best
alternative
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Economic Models
• Simplifying assumptions
– Which aspects of the decision are absolutely
essential?
– Which aspects are irrelevant?
• Abstract representation of key relationships
– The Cost-Benefit Principle is a model
• If costs of an action increase, the action is less
likely
• If benefits of an action increase, the action is more
likely
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Our First
Our FirstModel: The Circular-Flow
Model: The
Diagram
Circular-F low DiagramOur First Model: The C
• The circular-flow diagram is a visual model of
the economy that shows how dollars flow
through markets among households and
firms.
For use with Mankiw and Taylor, Economics 4 th edition
9781473725331 © Cengage EMEA 2017
Figure 1 The Circular Flow
MARKETS
Revenue FOR Spending
GOODS AND SERVICES
• Firms sell
Goods Goods and
• Households buy
and services services
sold bought
FIRMS HOUSEHOLDS
• Produce and sell • Buy and consume
goods and services goods and services
• Hire and use factors • Own and sell factors
of production of production
Factors of MARKETS Labour, land,
production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, • Households sell Income
and profit • Firms buy
= Flow of inputs
and outputs
= Flow of euros
Copyright©2011 Cengage
Our First Model: The Circular-Flow
Diagram
• Firms
– Produce and sell goods and services
– Hire and use factors of production
• Households
– Buy and consume goods and services
– Own and sell factors of production
Our First Model: The Circular-Flow
Diagram
• Markets for Goods and Services
– Firms sell
– Households buy
• Markets for Factors of Production
– Households sell
– Firms buy
Marginal Analysis Ideas
• Marginal cost is the increase in total cost
that results from carrying one additional
unit of an activity
– Average cost is total cost divided by the
number of units
• Marginal benefit is the increase in total
benefit that results from carrying out one
additional unit of an activity
– Average benefit is total benefit divided by the
number of units
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Marginal Analysis:
SpaceX Rocket
# of Total Cost Marginal
Average Cost
Launches ($B) ($B/launch)
($B)
0 $0 $0
$3
1 $3 $3
$4
2 $7 $3.5
$5
3 $12 $4
$8
4 $20 $5
$12
5 $32 $6.4
If the marginal benefit is $6 billion per launch, how many launches
should SpaceX make?
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Normative and Positive
Economics
– Normative – Positive economic
economic principle principle predicts
says how people how people will
should behave behave
• People shouldn’t • People will pollute less
pollute so much if you tax pollution
• SpaceX should launch • SpaceX will choose to
as many rockets as launch rockets that it
possible believes will be
profitable
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Incentive Principle
Incentives are central to people's choices
Benefits Costs
Actions are more likely to Actions are less likely to
be taken if their benefits be taken if their costs
rise rise
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The Invisible Hand
• Adam Smith’s Invisible Hand Theory in his
1776 treatise, The Wealth of Nations
• Self-interested business owners introduce
improvements and cost-saving
innovations not for the benefit to society,
but to lure customers away from rival firms
– Pursuit of private gain often benefits society
• Externalities can be positive or negative
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Microeconomics and
Macroeconomics
Microeconomics studies Macroeconomics studies the
choice and its implications for performance of national
price and quantity in individual economies and the policies that
markets governments use to try to
Sugar improve that performance
Carpets Inflation
House cleaning services Unemployment
Microeconomics considers Growth
topics such as Macroeconomics considers
Costs of production Monetary policy
Demand for a product Deficits
Exchange rates Tax policy
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Economics Is Choosing
• Focus on a short list of core ideas
(principles) that will be referenced and
repeated throughout the text
– Explain many economic issues
– Predict decisions made in a variety of
circumstances
• Core Principles are the foundation for
solving economic problems
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Economics Is Everywhere
• There are many things that economics
can help to explain
• Economic Naturalist topics
– Why is expensive software bundled with
computers?
– Why can't you buy a car without heaters
– Drive-up ATMs with Braille dots
– Videos are available via the eBook in
McGraw Hill Connect®
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Economic Naturalist:
Check-Splitting
• Sharing a restaurant bill equally increases the
total
• The dessert options and Sven's reservation price
suggest no dessert tonight if Sven pays
• Check-splitting with 9 friends reduces cost to Sven to
10% of its menu price
• $3 surplus from pudding and $2.40 from mousse
• Sven's friends follow same logic
Pumpkin Bread
Chocolate Mousse
Pudding
Menu Price $10 $6
Reservation Price $4 $3
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Chapter 1 Appendix
Working with Equations,
Graphs, and Tables
Definitions
• Equation a mathematical expression that
describes the relationship between two or
more variables
• Variable a quantity that is free to take a range
of different values
– Dependent variable a variable in an equation
whose value is determined by the value taken by
another variable in the equation
– Independent variable a variable in an equation
whose value determines the value taken by
another variable in the equation
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Definitions
• Constant (or parameter) a quantity
that is fixed in value
– Vertical intercept in a straight line, the
value taken by the dependent variable
when the independent variable equals zero
– Slope in a straight line, the ratio pf the
vertical distance the straight line travels
between any two points (rise) to the
corresponding horizontal distance (run)
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From Words to an Equation
• Identify the variables
• Calculate the parameters
– Slope
– Intercept
• Write the equation
• Example: Scooter rental charges $1 to
unlock the scooter plus 20 cents per
minute
B = 1 + 0.20T
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From Equation to Graph
B = 1 + 0.20T
– Draw and label axes
• Horizontal is
independent variable
• Vertical is dependent
variable
– To graph,
• Plot the intercept
• Plot one other
point
• Connect the
points
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From Graph to Equation
– Identify variables
• Independent
• Dependent
– Identify parameters
• Intercept
• Slope
– Write the equation
B=2+
0.10T
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Changes in the Intercept
– An increase in the
intercept shifts the
curve up
• Slope is unchanged
• Caused by an
increase in the fee
– A decrease in
the intercept
shifts the curve
down
• Slope is
unchanged
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Changes in the Slope
– An increase in the
slope makes the curve
steeper
• Intercept is unchanged
• Caused by an increase
in the per minute fee
– A decrease in the
slope makes the
curve flatter
• Intercept is
unchanged
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From Table to Graph
Length of ride
Total bill ($/ride)
(minutes/ride)
$2.50 5
$3.75 10
$5.00 15
$6.25 20
– Identify variables
• Independent
• Dependent
– Label axes
– Plot points
• Connect points 43
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From Table to Equation
Long-distance bill Total long-distance calls
($/month) (minutes/month)
$2.50 5
$3.75 10
$5.00 15
$6.25 20
– Identify independent and dependent variables
– Calculate slope
• Slope = (6.25 – 3.75) / (20 – 10) = 2.50/10 = 0.25
– Solve for intercept, f, using any point
B = f + 0.25T
6.25 = f + 0.25(20) = f + 5
f = 6.25 – 5 = 1.25
B = 1.25 + 0.25T © McGraw Hill LLC. All Rights Reserved. 44
Simultaneous Equations
• Two equations, two unknowns
• Solving the equations gives the values of
the variables where the two lines intersect
– Lines intersect when the values of the
independent and dependent variables are the
same in the equations for both lines
• Example
– Two companies for electric scooter rentals
• How many minutes long would your rides have to
be to make the two companies break even?
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Simultaneous Equations
• Company 1
B = 0.50 + 0.30T
• Company 2
B = 2 + 0.15T
Company 1 has higher
per minute price while
Company 2 has a higher
unlocking fee
Find B and T for point A
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Simultaneous Equations
– Company 1 B = 0.50 + 0.30T Find B when T = 10
– Company 2 B = 2 + 0.15T B = 0.50 + 0.30T
– Subtract Company 2 equation B = 0.50 + 0.30(10)
from Company 1 and solve for T B = $3.50
B = 0.50 + 0.30T OR
– B = – 2 – 0.15T
0 = – 1.5 + 0.15T B = 2 + 0.15T
B = 2 + 0.15(10)
T = 10 B = $3.50
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