1. PowerPoint® Lecture Slides Prepared By
Amy Peng, Ryerson University

2. Chapter Outline
 1.1 Economics: Studying Choice in a World of Scarcity
 1.2 Applying the Cost– Benefit Principle
 1.3 Three Common Pitfalls
 1.4 Pitfall 1: Ignoring Opportunity Costs
 1.5 Pitfall 2: Failure to Ignore Sunk Costs
 1.6 Pitfall 3: Failure to Understand the Average–Marginal Distinction
 1.7 Economics: Micro and Macro
 1.8 The Approach of This Text
 1.9 Economic Naturalism
© 2009 McGraw-Hill Ryerson Limited Outline Ch1 -2

3. 1.1 Economics: Studying
Choice in a World of Scarcity

4. The Scarcity Problem
 We have boundless needs and wants.
 The resources available to us, including time, are limited.
limited
 Scarcity means that we have to make choices
 having more of one good thing usually means having less of another.
 Trade-offs are widespread and important
 Economics: the study of how people make choices under
conditions of scarcity and of the results of those choices for
society.
© 2009 McGraw-Hill Ryerson Limited Economics: Studying Choice in a World of Scarcity Ch1 -4

5. The Cost-Benefit Principle I of III
 The Cost–Benefit Principle: An individual (or a firm or a society)
will be better off taking an action if, and only if, the extra
benefits from taking the action are greater than the extra costs.
 Measuring costs and benefits often difficult.
© 2009 McGraw-Hill Ryerson Limited Economics: Studying Choice in a World of Scarcity Ch1 -5

6. The Cost-Benefit Principle II of III
 Example: “Best” Class Size
 Assumption
 Class size 20 or 100 students
 Room costs 5000, instructor costs $15000 per class
 Cost Calculation:
 For class size 20: ($5000+$15000)/20 = $1000
 For class size 100: ($5000+$15000)/100 = $200
 The cost of reducing class size: $1000 – $200 = $800
 Would you (or your parents) be willing to pay an extra 800 for a
smaller economics class?
© 2009 McGraw-Hill Ryerson Limited Economics: Studying Choice in a World of Scarcity Ch1 -6

7. The Cost-Benefit Principle III of III
More Analysis on the “Best” Class Size
 Education Psychologist may have a different view
 Increasing class size in Canadian colleges and universities
 Public operating grants decreased by 25% in the last decade
 Federal government’s effort to reduce deficit
 Students pay higher tuition (twice more) and attend larger class
 Government believe tax payers are not willing to raise taxes to
increase the funding of postsecondary education.
 Insufficient amount of people are willing to bear the cost of small
class.
© 2009 McGraw-Hill Ryerson Limited Economics: Studying Choice in a World of Scarcity Ch1 -7

8. 1.2 Applying the Cost-Benefit
Principle

9. Rationality
 Economists usually assume that people are rational
 in the sense that they know their own goals and try to fulfill these
goals as best they can
 Using cost-benefit principle to study how people make rational
choice
 Example 1.1: Will you be better off if you walk downtown to save
$10 on a $25 computer game?
 Extra benefit: $10
 What is your cost of a 30 minutes walk?
© 2009 McGraw-Hill Ryerson Limited Applying the Cost-Benefit Principle Ch1 -9

10. Economic Surplus
 Economic surplus
 the benefit of taking any action minus its cost
 If the cost of walking downtown is $9, the economic surplus of
buying the computer game from downtown is $1
 In general, you will be best off if you choose those actions that
generate the largest possible economic surplus.
 Money isn’t everything, dollar is a convenient unit.
© 2009 McGraw-Hill Ryerson Limited Applying the Cost-Benefit Principle Ch1 -10

11. Opportunity Cost
 Opportunity Cost: The value of the next-best alternative that
must be forgone in order to undertake an activity.
 Rational decisions depend upon opportunity costs
 Opportunity cost is value of the next best alternative
 A crucial economic concept – with many practical applications
© 2009 McGraw-Hill Ryerson Limited Applying Cost-Benefit Principle Ch1 -11

12. The Role of Economic Models I of II
 Economists often use abstract models of how an idealized
rational individual would choose among competing alternatives.
 Many economic models are examples of positive economics.
 Positive economics has two dimensions
 It offers cause-and-effect explanations of economic relationships.
 It has an empirical dimension.
© 2009 McGraw-Hill Ryerson Limited Applying Cost-Benefit Principle Ch1 -12

13. The Role of Economic Models II of II
 Other economic models are examples of normative economics.
 Such models overlap with positive economic models.
 But they incorporate valuation of different possible outcomes. They
lead to normative statements about what "ought" to be: say, what is
best, what is most socially efficient, or what is optimal.
 Hence they have an element which cannot be tested with empirical
evidence.
© 2009 McGraw-Hill Ryerson Limited Applying Cost-Benefit Principle Ch1 -13

14. Two Logical Errors
 Two logical errors are to be avoided when modelling economic
relationships.
 The fallacy of composition
occurs if one argues that what is true for a part must also be true for
the whole.
 The post hoc fallacy
occurs if one argues that because event A precedes event B, event A
causes event B.
© 2009 McGraw-Hill Ryerson Limited Applying Cost-Benefit Principle Ch1 -14

15. Rationality And Imperfect Decision
Makers
 Rational people apply the cost–benefit principle most of the time.
 Rational behaviour can help economists predict likely behaviour.
© 2009 McGraw-Hill Ryerson Limited Applying Cost-Benefit Principle Ch1 -15

16. 1.3 Three Common Pitfalls

17. 1.4 Pitfall 1: Ignoring
Opportunity Costs

18. Recognizing the Relevant Alternative I
of IV
 Example 1.4 : Frequent Flyer Coupon
 Assumption:
 Round trip airfare from Edmonton to Vancouver $500
 Vacation at Whistler costs $1000
 The maximum you would be willing to pay is $1350
 You need to go to Ottawa after winter break, airfare from
Edmonton to Ottawa is $400
 A frequent flyer coupon can be applied to either airfare
© 2009 McGraw-Hill Ryerson Limited Pitfall 1: Ignoring Opportunity Costs Ch1 - 18

19. Recognizing the Relevant Alternative
II of IV
 Example 1.4 : Frequent Flyer Coupon
 Calculation 1:(without the coupon)
 Costs :$1500
 Maximum willing to pay: $1350
 Should you go?
 Total costs are higher than maximum willing to pay
 NOT to go
© 2009 McGraw-Hill Ryerson Limited Pitfall 1: Ignoring Opportunity Costs Ch1 - 19

20. Recognizing the Relevant Alternative
III of IV
 Example 1.4 : Frequent Flyer Coupon
 Calculation 2:(use the coupon)
 Costs :1000 (flight is free)
 Maximum willing to pay: $1350
 Should you go?
 Opportunity cost of going to Vancouver : airfare to Ottawa $400
 Total costs: $1400
 Total costs are still higher than maximum willing to pay
 NOT to go
© 2009 McGraw-Hill Ryerson Limited Pitfall 1: Ignoring Opportunity Costs Ch1 - 20

21. Recognizing the Relevant Alternative
IV of IV
 Example 1.5 : Frequent Flyer Coupon expires in a week
 Calculation 3: (cannot use the Coupon to Ottawa)
 Costs :$1000
 Maximum willing to pay: $1350
 Should you go?
 Total costs are lower than maximum willing to pay
 GO!
© 2009 McGraw-Hill Ryerson Limited Pitfall 1: Ignoring Opportunity Costs Ch1 - 21

22. The Time Value of Money I of II
 Example 1.6: Alternative Use of the Coupon
 Calculation 4:
 A trip a year from now costs $363, interest rate is 10% ?
 How much you need to put in the bank now to have $363 in a
year?
 $363/(1+10%) = $330, $330 is the opportunity cost of the trip
 Total costs: $1000 + $330 = $1330
 Total costs are lower than maximum willing to pay
 GO!
© 2009 McGraw-Hill Ryerson Limited Pitfall 1: Ignoring Opportunity Costs Ch1 - 22

23. The Time Value of Money II of II
 Try exercise 1.2: if the interest rate is 2%, will you go?
 Time value of money:
 a given dollar amount today is equivalent to a larger dollar amount
in the future
 money can be invested in an interest-bearing account in the
meantime
© 2009 McGraw-Hill Ryerson Limited Pitfall 1: Ignoring Opportunity Costs Ch1 - 23

24. 1.5 Pitfall 2: Failure to Ignore
Sunk Costs

25. Sunk Costs and Decision-making
 Sunk costs are those costs that will be incurred whether or not
an action is taken
 E.g., money that you cannot recover
 Therefore irrelevant to decision on whether to take an action
 should not be counted for decision-making purposes
 Rational decision makers compare benefits to only the
additional costs that must be incurred
© 2009 McGraw-Hill Ryerson Limited Pitfall 2: Failure to Ignore Sunk Costs Ch1 -25

26. Sunk Costs I of III
 Example 1.7: a Hockey Game
 Assumption:
 You and Joe have the same taste
 A nonrefundable ticket from ticketmaster costs $30
 70km drive from Smiths Falls to Ottawa
 Joe will buy ticket at the game, cost $25
 Snowstorm starts at 4pm unexpectedly
 Who is more attend the game?
© 2009 McGraw-Hill Ryerson Limited Pitfall 2: Failure to Ignore Sunk Costs Ch1 - 26

27. Sunk Costs II of III
 Example 1.7: a Hockey Game
 Who is more likely to go to the game?
 Joe has a cost of $25 if he goes to the game.
 $30 is a sunk cost, a money you cannot recover.
cost
 $30 cannot add to the cost-benefit analysis.
 Joe has an opportunity cost of $25 higher than you.
 Joe is less likely to go.
© 2009 McGraw-Hill Ryerson Limited Pitfall 2: Failure to Ignore Sunk Costs Ch1 - 27

28. Sunk Costs III of III
 Example 1.8: Joe has a free ticket
 Who is more likely to go to the game?
 Joe and you has the same relevant costs and benefits.
 Joe and you will make similar decision.
 A sense of regret can play a role
© 2009 McGraw-Hill Ryerson Limited Pitfall 2: Failure to Ignore Sunk Costs Ch1 - 28

29. 1.6 Pitfall 3: Failure to Understand
the Average–Marginal Distinction

30. Pitfall 3: Failure to Understand The Average
and Marginal Distinction
 Marginal cost
 the increase in total cost that results from carrying out one
additional unit of an activity
 Marginal benefit
 the increase in total benefit that results from carrying out one more
unit of an activity
 Average cost
 total cost of undertaking n units of an activity divided by n
 Average benefit
 total benefit of undertaking n units of an activity divided by n
© 2009 McGraw-Hill Ryerson Limited Failure to Understand the Average-Marginal Distinction Ch1 - 30

31. Weighing Marginal Benefits And
Marginal Costs Graphically
FIGURE 1.1: The Marginal Cost and Benefit of Additional RAM
© 2009 McGraw-Hill Ryerson Limited Pitfall 3: Failure to Understand the Average-Marginal Distinction Ch1 -31

32. Example 1:10: Does the cost-benefit principle tell NASA to expand the
space shuttle program from 4 launches per year to 5?
 The gain from the NASA program are estimated at $24 billion
per year (an average of $6 billion per launch)
 The cost are estimated at $20 billion per year
 Table 1.1 How Cost Varies with the Number of Launches
Number of Total costs per year Marginal cost per
Launches per year ($ billions) launch ($ billions)
1 6
2
2 8
4
3 12
The optimal number of launch should only be 3
8
4 20
10
5 30
© 2009 McGraw-Hill Ryerson Limited Pitfall 3: Failure to Understand the Average-Marginal Distinction Ch1 -32

33. 1.7 Economics:
Micro and Macro

34. Micro and Macro
 Microeconomics studies subjects like
 Choices of individuals
 Choices of Firms
 The determinants of prices and quantities in specific markets
 Macroeconomics studies subjects like
 The performance of national economies
 Long run growth and prosperity
 Short run booms and busts
 Government policies to change performance
© 2009 McGraw-Hill Ryerson Limited Economics: Micro and Macro Ch1 -34

35. 1.8 The Approach of this Text

36. The Approach of this Text
 Increase our understanding of economic processes
 Scarcity
 Efficiency
 Obtaining the maximum possible output from a given amount of
inputs
 Equity
 A state of impartiality and fairness
© 2009 McGraw-Hill Ryerson Limited The Approach of This Text Ch1 - 36

37. Chapter Summary
 Economics is the study of how people make choices under
conditions of scarcity and of the results of those choices for
society.
 Our focus in this chapter was on how rational people make
choices between alternative courses of action. Our basic tool for
analyzing these decisions is cost–benefit analysis.
 The rational actor pursues additional units as long as the
marginal benefit of the activity (the benefit from pursuing an
additional unit of it) exceeds its marginal cost (the cost of
pursuing an additional unit of it).
© 2009 McGraw-Hill Ryerson Limited Chapter Summary Ch1 -37

38. Chapter Summary
 The opportunity cost of an activity is the value of the next-best
alternative that must be foregone to engage in that activity.
 A sunk cost is a cost that is already irretrievably committed at
the moment a decision must be made.
 To apply the cost–benefit principle correctly, we must compare
marginal cost with marginal benefit.
benefit
© 2009 McGraw-Hill Ryerson Limited Chapter Summary Ch1 -38

40. Using a Verbal Description to
Construct a Equation I of II
 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
 Constant (or parameter): a quantity that is fixed in value
© 2009 McGraw-Hill Ryerson Limited Using a Verbal Description to Construct a Equation Ch1 -40

41. Using A Verbal Description To
Construct An Equation II of II
 My telephone bill is $5.00 per month plus 10 cents for every minute
that I talk
 Telephone Bill = 5.00 + 0.10 * (Minutes Talked)
B = 5.00 + 0.10 T
 If you make 32 minutes phone call, monthly bill will be:
B = 5.00 + 0.1 (32) = 8.20
 Or one can draw a picture of the relationship
© 2009 McGraw-Hill Ryerson Limited Using a Verbal Description to Construct a Equation Ch1 -41

42. Graphing the Equation of
a Straight Line I of II
B = 5 + 0.1T
Dependent
Variable
12 = 5 + 0.1(70)
8 = 5 + 0.1(30)
6 = 5 + 0.1(10)
Independent
Variable
© 2009 McGraw-Hill Ryerson Limited Graphing the Equation of a Straight Line Ch1 -42

43. Graphing the Equation of
a Straight Line II of II
The graph of the equation B =5 + 0.10T is the straight line shown.
Its vertical intercept is 5, and its slope is 0.10.
Slope = Rise/Run
Slope = 2/20 = 0.1
Vertical Intercept
(Constant) is 5
© 2009 McGraw-Hill Ryerson Limited Graphing the Equation of a Straight Line Ch1 -43

44. Deriving the Equation of a Straight
Line from its Graph
The Equation For the Billing
Plan: B = 4 + 0.20T
Slope = Rise/Run
Slope = 4/20 = 0.2
Vertical Intercept
(Constant) is 4
© 2009 McGraw-Hill Ryerson Limited Deriving the Equation of a Straight Line from its Graph Ch1 - 44

45. Shifting the Curve – Intercept
Changes
 Suppose the fixed fee
D′ New monthly bill
increases from $4 to $8 ?
C′ Original monthly bill
D
 But the per-minute
A′ charge remains the same
C
 Old Telephone Bill was
A determined by the equation
 B = 4 + 0.20 T
 New Bill is determined by
the equation
 B = 8 + 0.20 T
© 2009 McGraw-Hill Ryerson Limited Changes in the Vertical Intercept and Slope Ch1 - 45

46. Shifting the Curve – Slope Changes
 The slope of a graph indicates
C′
New monthly bill
how much of a “rise” one can
expect, for a given “run”
Original monthly bill
Rise = 8
 Old Telephone Bill was
A′ Run = 20
C
determined by the equation
A
 B = 4 + 0.20 T
 New Telephone Bill is
determined by the equation
 B = 4 + 0.40 T
© 2009 McGraw-Hill Ryerson Limited Changes in the Vertical Intercept and Slope Ch1-46

47. Constructing Equations and Graphs
from Tables
Point A
Point C
Slope = Rise/Run
Slope = 1/20 = 0.05
Vertical Intercept
(Constant) is 10
The Equation For the Billing
Plan: B = 10+ 0.05T
© 2009 McGraw-Hill Ryerson Limited Constructing Equations and Graphs from Tables Ch1 -47