economic basic problem

1. Chapter 1: Thinking as an economistCopyright  1-1
Chapter 1
Thinking as an economist

2. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-2
Introduction
• What is the optimal class size?
– To maximise learning without consideration of cost?
– How would considering costs change our answer?
 A personal tutorial course in economics might cost
$20 000.
 A class of 300 students might cost $100 per student.

3. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-3
Introduction
• What trade-offs must university administrators and
students consider when choosing class size?

4. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-4
Economics: studying choice in a world of
scarcity
• Scarcity exists in Australia, Singapore and New
Zealand!
• The scarcity 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.

5. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-5
Economics: studying choice in a world of
scarcity
Scarcity
Choices
Wants vs. resources

6. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-6
Economics: studying choice in a world of
scarcity
• Economics
– The study of how people make choices under conditions of
scarcity and of the results of those choices for society.

7. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-7
Economics: studying choice in a world of
scarcity
• 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.

8. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-8
Economics: studying choice in a world of
scarcity
• Choosing the optimal class size revisited
– Assumptions
 Two class sizes: 100 and 20
 Introductory economics classes have 100 students
– Question
 Should the class size be reduced to 20 students?

9. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-9
Economics: studying choice in a world of
scarcity
• Choosing the optimal class size
– Assume
 The cost of a class with 20 students is $1000 per student more
than a class of 100 students.
– What do you think?
 Would it be a good idea to reduce the class size?
 How would you make a choice?

10. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-10
Applying the cost-benefit principle
• Rational person
– Someone with well-defined goals who tries to fulfill those
goals as best she or he can.
– This involves making a choice on the basis of costs and
benefits of any action or decision.
– Economists analyse the choices that people make by
comparing the costs and benefits of any action or decision.

11. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-11
Applying the cost-benefit principle
• Should you walk into town to save $10 on a $25
computer game?
– The benefit of going into town = $10.
– The cost of going into town is the dollar value of everything
you give up to go into town.

12. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-12
Applying the cost-benefit principle
– Estimating the cost
 How much could someone have to pay to walk into town?
 If you would walk into town for $9, the trip’s cost is $9.
– The benefit ($10) exceeds the cost of ($9) of buying the
game in town.

13. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-13
Applying the cost-benefit principle
• Economic surplus
– The benefit of taking any action minus its cost.
– The goal of economic decision makers is to maximise their
economic surplus.

14. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-14
Applying the cost-benefit principle
• Opportunity cost
– The value of the next-best alternative that must be forgone
to undertake an activity.
– One opportunity cost of going into town is the time you give
up to go into town.

15. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-15
Applying the cost-benefit principle
• Assume
– The benefit of buying the game in town is $10.
– The cost of making the trip is $12.
• Questions
– What is your economic surplus from buying the game in
town?
– Where should you buy the game?

16. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-16
Applying the cost-benefit principle
• The role of economic models
– Economic models are abstract constructs (simplified
descriptions) that allow us to analyse situations in a logical
way.
– Other examples of abstract models
 A computer model of climate change
 A road map
 Analysis of an economy with two producers and two consumers

17. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-17
Four important decision pitfalls
• Pitfall 1: Measure cost and benefits as absolute dollar
amounts rather than as proportions.
• Examples
– Should you walk into town to save $10 on a $2020 laptop
computer?
– Which is more valuable, saving $100 on a $2000 plane ticket
to Tokyo or saving $90 on a $200 plane ticket to Brisbane?

18. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-18
Four important decision pitfalls
• Pitfall 2: Account for all opportunity costs.
– Example
 Should you use your frequent-flyer coupon to fly to Manila for
the spring break?
– Assume
 Round trip airfare is $500 and is equal to your frequent flyer
coupon.
 Other costs equal $1000.
 The most you are willing to pay for the Manila trip is $1350.
 Alternate use for the frequent-flyer coupon is to attend a
wedding in Perth and the Boston airfare is $400.

19. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-19
Four important decision pitfalls
• Without the coupon
– Benefits = $1350
– Cost = $1400 ($400 opportunity cost + $1000 other costs)
• The key to using the concept of opportunity cost
correctly lies in recognising precisely what taking a
given action prevents us from doing.

20. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-20
Four important decision pitfalls
• Pitfall 3: 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.

21. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-21
Four important decision pitfalls
• Sunk cost
 A cost that is beyond recovery at the moment a decision must
be made.
 Costs already incurred or ‘sunk’ are not relevant to your
decisions.
 The only costs that should influence a decision about whether
or not to take an action are those that we can avoid by not
taking that action.

22. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-22
Four important decision pitfalls
• Example
 How much should you eat at an `all you can eat’ restaurant?
– Assume
 Price = $5
 20 randomly selected guests will get free lunch.
– Question
 If all diners are rational, will there be any difference in the
average quantity of food consumed by these two groups?

23. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-23
Four important decision pitfalls
• The entry fee to an ‘all you can eat’ restaurant is
irrelevant to how much we should eat, once we have
entered and paid.
• Since the marginal cost is zero, we should eat up to
the point where the marginal benefit of eating is zero.
• Failure to observe this rule will lead to indigestion and
regret (negative marginal benefit) through overeating!
The emotion of greed has overcome rational thought!

24. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-24
Four important decision pitfalls
• Pitfall 4: 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.

25. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-25
Four important decision pitfalls
– 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.

26. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-26
Four important decision pitfalls
– Example
 Should NASA expand the space shuttle program from four
launches per year to five?
 Benefits
• $24 billion (average of $6 billion/launch)
 Costs
• $20 billion (average of $5 billion/launch)

27. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-27
Four important decision pitfalls
0 0 0 0
1 3 3 3
2 7 3.5 4
3 12 4 5
4 20 5 8
5 32 6.4 12
Assume: Average benefit = Marginal benefit
= $6 billion
Total cost Average cost
# of Launches ($ billion) ($ billion/launch) Marginal cost
What is the optimal number of launches?

28. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-28
Economics: micro and macro
• Microeconomics
– The study of individual consumer, firm and market
behaviour.

29. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-29
Economics: micro and macro
• Macroeconomics
– The study of the aggregate economy.

30. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-30
The approach of this text
• Focus on core economic concepts
• Learning economics through applications

31. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-31
Economic naturalism
• Using insights from economics to help make sense of
observations from everyday life.
• When a major purchase is considered, families will
collect more information before making the purchase.
An economic naturalist can analyse why.

32. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-32
Economic naturalism
• Question
– Why do so many computer hardware manufacturers include
more than $1000 worth of ‘free’ software with a computer
selling for only slightly more than that?
– Why don’t automobile manufacturers make cars without air
conditioners?
– Why do the keypad buttons on drive-up automatic teller
machines have Braille dots?

33. Chapter 1: Thinking as an economistCopyright © 2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
1-33
Economic naturalism
• An economic naturalist can apply economic insights
to everyday life to answer many of these questions.
• Microeconomics involves two core principles to gain
economic insights
– Scarcity
– Cost-benefit.