Dr.

Duffy Microeconomics

Notes from CHAPTER 1 of Frank and Bernanke

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Thinking Like An Economist

Id like to introduce you to Marty Thorndecker. Hes an economist but hes really very nice.

What is economics?
Economics is a social science. Social sciences deal with people and the institutions they create. Economics deals with how people make decisions to allocate resources to achieve their goals.

Economics
Economics has been called the science of scarcity, because many economic problems deal with constraints. There are so many hours in the day, which must be allocated to competing ends (work, study, sleep, recreation). There are so many dollars in a wallet, which must be allocated to competing products (chips, burgers, toothpaste, lettuce, books, music, etc.) Goods are limited, but people are assumed to have "unlimited wants." (More is preferred to less for most things.)

Scarcity in Economics
Scarcity: Resources are (usually) finite. All economic goods are limited in supply, which economists call scarce. In a market economy, scarce or limited items have prices associated with them. The notion of unlimited wants is not true for everyone, but even at our current level of prosperity, we do not produce enough for everyone to think they have enough.
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A way of thinking
Economics is the study of choice in a world of scarcity.
How do people make choices given resource limits? What are the consequences of those individual choices for society?

Economics and Values

Economics is not a system of ethics. We assume in economics that people are frequently motivated by self-interest. Many people are concerned about others, even strangers. The degree of self-interest/altruism varies from person to person, based on disposition, up-bringing, and experience. We use our models because they work in general. Some degree of self-interest does motivate most people at least some of the time.
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The Role of Economic Models

Economic models are abstract (simplified descriptions) models that allow us to analyze situations in a logical way Other examples of abstract models
A computer model of climate change A road map

The Scarcity Principle

Also called the 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. In other words, trade-offs will involve compromises between competing interests.
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Opportunity Cost
When there are trade-offs, there are opportunity costs.

The value of the next-best alternative that must be forgone to undertake an activity The value of items not produced because resources were used for another purpose.
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Defining a Rational Person

In Economics, a rational person is someone with well-defined goals who tries to fulfill those goals as best he or she can. Note: No judgment is made about the social desirability of the goals.

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The Cost-Benefit Principle

A rational 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 Benefits and costs often encompass more than dollars

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Cost-benefit analysis 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.
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Estimating the opportunity cost of walking downtown:

A simple question: How much would someone have to pay you to walk downtown? If you would walk downtown for $9; the trips opportunity cost is $9. The benefit ($10) exceeds the cost of ($9) of buying the game downtown. The economic surplus is $1.00.
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Economic Surplus
The goal of economic decision makers is to maximize their economic surplus. Economic surplus is the benefit of taking an action minus its cost.

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Do Real People Act this Way??

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

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Four Important Economic Pitfalls in Cost-Benefit Analysis

Pitfall 1: Measuring cost and benefits as proportions rather than absolute dollar amounts Pitfall 2: Ignoring Opportunity Costs Pitfall 3: Failure To Ignore Sunk Costs Pitfall 4: Failure To Understand the Average-Marginal Distinction
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Pitfall 1: Measuring cost and benefits as proportions rather than absolute dollar amounts

Pitfall 1 Examples: Should you walk downtown to save $10 on a $2,020 laptop computer? Would the calculations differ in any way from those taken for the $25 game? Which is more valuable, saving $100 on a $2,000 plane ticket to Tokyo or saving $90 on a $200 plane ticket to Chicago? How do people act in practice?

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Pitfall 2: Ignoring Opportunity Costs

Should you use your frequent-flyer coupon to fly to Fort Lauderdale for spring break?
Round trip airfare would be $500 if paid in cash. Other direct cash costs equal $1,000 The most you are willing to pay for the Fort Lauderdale trip is $1,350 (your benefits). The alternative use for the frequent flyer coupon is to attend a wedding in Boston the week after spring break and the Boston airfare is $400 (coupon expires just after the wedding).
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The cost-benefit analysis

Benefits = $1,350 (your willingness to pay) Cost = $1,400 ($400 opportunity cost + $1,000 direct cash costs) Surplus = $-50.

Question
What would you do if the coupon expires just after spring break and before the wedding? What would be the opportunity cost of the coupon in that situation?

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Pitfall 2, summary
The key to using the concept of opportunity cost correctly lies in recognizing precisely what taking a given action prevents us from doing. Opportunity costs are like the Holmes case with the dog who failed to bark in the nighttime. They are easy to overlook, but can provide highly relevant information.

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Pitfall 3: Failure To Ignore Sunk Costs

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.

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Sunk Cost Defined

Sunk Cost: A cost already incurred so it is sunk and not recoverable. No future decision can return that cost to you.

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Ignore Sunk Costs!

Sunk costs are costs that are beyond recovery at the moment a decision is made.
Unlike opportunity costs, sunk costs should be ignored.
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Pitfall 4: Failure To Understand the Average-

Marginal Distinction
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 an activity To an economist, marginal usually means extra or additional. Well see this word again.

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Pitfall 4 example
Should NASA expand the space shuttle program from four launches per year to five? Benefits of four launches: $24 billion (average of $6 billion/launch) Costs of four launches: $20 billion (average of $5 billion/launch)

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Average Cost and Average Benefit

Average Cost: The total cost of undertaking n units of an activity divided by n. Average Benefit: The total benefit of undertaking n units of an activity divided by n.

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Pitfall 4
Without more information, we cant say whether NASA should expand the program. We need to know the marginal cost and the marginal benefit of one more launch per year.

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Average versus Marginal Cost

Launches (number) 0 1 2 3 4 5 Total Cost ($B) 0 3 7 12 20 32 Average Cost xxx 3 3.5 4 5 6.4 Extra Cost xxx 3 4 5 8 12

A fifth launch would incur marginal costs of $12 billion. We would not add a fifth launch unless the extra benefit is greater than $12 billion. So even if the additional benefit equaled the average benefit of $6 billion, we would not make a fifth launch. 30

The Incentive Principle

A person (or firm or society) is more likely to take an action if its benefit rises or if its costs fall. A person is less likely to take an action if the benefit falls or the cost rises.
This principle is sometimes condensed to:

Incentives matter.
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Normative Economics & 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 principle

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Positive and Normative Economics, Alternative Definition

Positive Economics deals with questions that can be analyzed objectively, e.g. What is the impact of raising taxes? Normative Economics may involve ethical precepts and norms of fairness, e.g. Should the poor be required to work to receive government assistance?

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Economics: Micro and Macro

Microeconomics is the study of individual choice under scarcity and its implications for the behavior of prices and quantities in individual markets. Macroeconomics is the study of the performance of national economies, and of the policies that governments use to try to improve that performance.
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Microeconomics
. . . is the branch of economics that deals with the behavior of individual entities, such as consumers, firms, households, or markets.
A major focus of microeconomics is price determination. This course deals primarily with Microeconomics.

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The Other Branch of Economics

. . . is macroeconomics, which is concerned with overall performance of the economy, e.g. inflation, unemployment, growth.
Macroeconomics is the more recent of the two branches. It began around 1935, when John Maynard Keynes published General Theory of Employment, Interest, and Money.
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The Approach of Your Text

Focus on core economic concepts Scarcity principle Cost-benefit principle Incentive principle Learning economics through applications

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Economic Naturalism
Using insights from economics to help make sense of observations from everyday life.
Why dont automobile manufacturers make cars without heaters? Why do the keypad buttons on drive-up automatic teller machines have Braille dots? 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?

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Economic Naturalism

To solve these problems, use cost-benefit analysis.

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