1 Chapter 1 Frank/Bernanke, Principles of Microeconomics Thinking Like An Economist

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Chapter 1 Frank/Bernanke,

Principles of Microeconomics

Thinking Like An Economist

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“I’d like to introduce you to Marty Thorndecker. He’s an economist but he’s really very nice.”

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Hi, I am Marty….

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Hi, I am Marty….

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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?

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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.

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How do we learn a new language

Start simpleRepetition and drill

Active learningHave fun

“How much is this?”

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Should there be 12 separate sections of Econ 101, with 25 students each?

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Or should there be only one section, with 300 students?

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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 $40,000A class of 300 students might cost $200/studentExtreme 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?

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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

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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 Kong’s 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.

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What are the alternatives to English auction?

First come, first served; Teacher assigned; Class negotiation.

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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

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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

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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.

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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)

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Some relevant costs:

Faculty salary: $90,000 per course

Per student faculty salary cost: 1 section: $90,000/300 = $30012 sections: $90,000/25 = $3600

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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.

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Optimal class size

ObservationsThe “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.

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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

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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.

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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.

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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 don’t really calculate costs and benefits when deciding what to do.

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People often behave as if they were comparing the relevant costs and benefits.

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People often make bad decisions because they fail to compare the relevant costs and benefits.

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Can cost-benefit analysis help you make better decisions?

Example 1.2You 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?

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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?

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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.

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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:

Which program would you choose? A or B?

Program A: save 200 lives with certainty

Program B: save 600 lives with probability 1/3, and save zero lives with probability 2/3

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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:

Which program would you choose? C or D?

Program C: 400 people will die with certainty

Program D: 1/3 chance that no one will die, and 2/3 chance that all 600 will die

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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

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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.

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Example 1.6. Losing a $100 bill

Do you buy a ticket and see the play anyway?

You have just arrived at the theater to buy your ticket and discover that you have lost a $100 bill from your wallet.

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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?

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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.

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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?

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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.

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Cost-benefit principle:

MB

MC

4000300020001000

Megabytesof memory

Value of an additionalmegabyte

Dollars permegabyte

2.00

0.500.25

Cost of anadditionalmegabyte

1.00

Optimal amount of memory

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Everyday Choices

"Should I do X?"

"How much X should I buy?"

"Should I buy an additional unit of X?"

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Some Common Pitfalls for Decision Makers

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

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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?

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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.

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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.

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Example 1.10. Should I go skiing today?

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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.

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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?"

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C(x) = cost of skiing plus value of forgone earnings

= $30 + $40

= $70

B(x) = $50 < C(x),

So don't go skiing.

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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.

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Many jobs, of course, are not pleasant.

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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?

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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.

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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 same as incurring a cost. Economic Surplus is the benefit of taking any

action minus its cost

The goal of economic decision makers is to maximize their economic surplus.

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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.

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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.

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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?

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.


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Example 1.14. Why do banks pay interest in the first place?


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.

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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.

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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.

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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

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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?

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"Should I eat another slice of pizza?"

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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.

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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.

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Four Important Decision Pitfalls

Pitfall 4: Failure To Understand the Average-Marginal DistinctionMarginal 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.

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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

CostsTotal of $20 billionAverage of $5 billion/launch

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Example 1.14. Should NASA expand the space shuttle program?

# of Launches Total Cost Average Cost Marginal Cost ($ billion) ($ billion/launch) ($ billion/launch)

What is the optimal number of launches?

0 0 0

1 3 3

2 7 3.5

3 12 4

4 20 5

5 32 6.4

Assume: Average Benefit = Marginal Benefit = $6 billion

3

4

5

8

12

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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?

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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/boatEast 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.

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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

1 100 lbs/boat 130 lbs/boat




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Number of boats

East end West end




4 100 lbs/boat 100 lbs/boatNumber of boats

East end West end Total output

2 2 440 lbs

3 1 430 lbs

1 3 430 lbs

4 0 400 lbs

0 4 400 lbs

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Number of boats East end West end





Marginal output per boat

The n-th boat East end West end

1 100 lbs 130 lbs

2 100 lbs 110 lbs (= 240-130)

3 100 lbs 90 lbs (=330-240)

4 100 lbs 70 lbs (400-330)

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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.

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Normative Economicsvs. Positive Economics

Normative Economic PrincipleOne that says how people should behave

Example: Cost-benefit principle

Positive Economic PrincipleOne that predicts how people will behave

Example: The incentives matter principleA person (or a firm or society) is more

likely to take an action if its benefit rises and less likely if its cost rises

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Economics: Micro and Macro

MicroeconomicsThe study of individual choice under scarcity

and its implications for the behavior of prices and quantities in individual markets.

MacroeconomicsThe study of the performance of national

economies, and of the policies that governments use to try to improve that performance.

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Economic Naturalism

ApplicationsUse 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

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Economic Naturalism

Ask interesting questions

Provide plausible answers

Observe things happening around us

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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?

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Why don’t automobile manufacturers make cars without heaters?

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

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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?

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Why is airline food so bad?

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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?

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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.

Why are foreign films so good?

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End

Documents

1 Chapter 1 Frank/Bernanke, Principles of Microeconomics Thinking Like An Economist