CHAPTER 1: THINKING LIKE AN ECONOMIST
Economist’s approach is, first, based on confronting a hypothesis with evidence before conditionally
accepting it, and second, an economist will always look at motivation
Economics: studying choice in a world of scarcity
Economics is the study of how people make choices under conditions of scarcity and of the results of
those choices for society.
Scarcity makes trade-offs necessary and these trade-offs are a core principle of economics.
Scarcity principle (or no-free-lunch principle; somebody always has to pay): although we have boundless
needs and wants, the resources available to us are limited, so having more of one good thing usually
means having less of another.
Choice involves compromise between competing interests and these trade-offs are resolved by using a
cost-benefit principle; an individual, a firm, or a society should take an action if, and only if, the extra
benefits from taking that action are least as great as the extra costs.
Applying the cost-benefit principle
Rational person: someone with well-defined goals, who fulfills those goals as best she can.
The cost-benefit principle is a fundamental tool for the study of how rational people make choices.
➔ The difficulty in applying the cost-benefit rule is to come up with reasonable measures of the
relevant benefits and costs
Economic surplus: the benefit of taking any action (value) minus its cost (monetary cost, opportunity
cost) → undertake only those actions that create additional economic surplus.
Opportunity cost: the value of the next best alternative to an activity that must be forgone in order to
undertake that activity
The role of economic models
The cost-benefit principle is an abstract model (simplified description capturing essential elements of a
situation and allowing the analysis of these in a logical way) of how an idealized rational individual would
choose among competing alternatives.
Any model is a simplified representation of reality
Four important decision pitfalls → people do not choose rationally all the time
1. Measuring costs and benefits as proportions rather than absolute money amounts: change in
cost/benefit tend to be treated as insignificant if it constitutes only a small proportion of the
original among. However, absolute money amounts, not proportions, should be employed to
measure costs and benefits
a. All other factors being equal, a rational decision maker would make the same decision in
two different situations (walking to town for laptop or computer game)
b. Should you walk 3km to save 10€ on a 1000€ laptop?
, 2. Ignoring opportunity costs: important to account for all relevant opportunity costs
a. A resources may have a high opportunity cost, even if you got it for free, if its best
alternative use has high value
b. Should ask “Should I do A or B” and not “Should I do A?”
3. Failure to ignore sunk costs: the only costs that should influence whether to take an action are
those that we can avoid by not taking the action
a. Sunk costs: a cost that is beyond recovery at the moment a decision must be made, since
they must be borne whether or not an action is taken, they are irrelevant
4. Failure to understand the average marginal distinction
a. The issue is usually not whether to pursue an activity but rather the extent to which it
should be pursued, here the focus should be on the benefit and cost of an additional
unit of activity; the marginal cost and marginal benefit
b. The level of an activity should be increased if, and only if, its marginal benefit exceeds its
marginal cost
c. Marginal cost: the increase in total cost that results from carrying out one additional unit
of an activity
d. Marginal benefit: the increase in total benefit that results from carrying out one
additional unit of an activity
e. Estimates may tell us the average cost and average benefit which are not useful for
deciding whether to expand an activity
f. Average cost: total cost of undertaking n units of an activity divided by n
g. Average benefit: total benefit of undertaking n units of an activity divided by n
Not-all-costs-and-benefits-matter-equally principle: some costs and benefits (opportunity costs and
marginal costs and benefits) matter in making decisions, whereas others (sunk costs and average costs
and benefits do not.
Economics: micro and macro
Microeconomics: the study of individual choice under scarcity, and its implications for the behavior of
prices and quantities in individual markets. Standard economic theory assumes decision makers are
rational.
Macroeconomics: the study of the performance of national economies and the policies that
governments use to try to improve that performance.
Economic naturalism: someone who uses insights from economics to help make sense of observations
from everyday life.
Economists and economics
Positive economics consists in the conclusions of economics that are independent of the ethical value
system of the economist
Normative economics consist in statements in economics that reflect or are based on the ethical value
system of the economist, implicitly, explicitly, or by omission.
, Using a verbal description to construct an equation
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 whose value is determined by the value of the independent variable
Independent variable: a variable whose value determined the dependent variable
Constant (or parameter): quantity that is fixed in value
Economist’s approach is, first, based on confronting a hypothesis with evidence before conditionally
accepting it, and second, an economist will always look at motivation
Economics: studying choice in a world of scarcity
Economics is the study of how people make choices under conditions of scarcity and of the results of
those choices for society.
Scarcity makes trade-offs necessary and these trade-offs are a core principle of economics.
Scarcity principle (or no-free-lunch principle; somebody always has to pay): although we have boundless
needs and wants, the resources available to us are limited, so having more of one good thing usually
means having less of another.
Choice involves compromise between competing interests and these trade-offs are resolved by using a
cost-benefit principle; an individual, a firm, or a society should take an action if, and only if, the extra
benefits from taking that action are least as great as the extra costs.
Applying the cost-benefit principle
Rational person: someone with well-defined goals, who fulfills those goals as best she can.
The cost-benefit principle is a fundamental tool for the study of how rational people make choices.
➔ The difficulty in applying the cost-benefit rule is to come up with reasonable measures of the
relevant benefits and costs
Economic surplus: the benefit of taking any action (value) minus its cost (monetary cost, opportunity
cost) → undertake only those actions that create additional economic surplus.
Opportunity cost: the value of the next best alternative to an activity that must be forgone in order to
undertake that activity
The role of economic models
The cost-benefit principle is an abstract model (simplified description capturing essential elements of a
situation and allowing the analysis of these in a logical way) of how an idealized rational individual would
choose among competing alternatives.
Any model is a simplified representation of reality
Four important decision pitfalls → people do not choose rationally all the time
1. Measuring costs and benefits as proportions rather than absolute money amounts: change in
cost/benefit tend to be treated as insignificant if it constitutes only a small proportion of the
original among. However, absolute money amounts, not proportions, should be employed to
measure costs and benefits
a. All other factors being equal, a rational decision maker would make the same decision in
two different situations (walking to town for laptop or computer game)
b. Should you walk 3km to save 10€ on a 1000€ laptop?
, 2. Ignoring opportunity costs: important to account for all relevant opportunity costs
a. A resources may have a high opportunity cost, even if you got it for free, if its best
alternative use has high value
b. Should ask “Should I do A or B” and not “Should I do A?”
3. Failure to ignore sunk costs: the only costs that should influence whether to take an action are
those that we can avoid by not taking the action
a. Sunk costs: a cost that is beyond recovery at the moment a decision must be made, since
they must be borne whether or not an action is taken, they are irrelevant
4. Failure to understand the average marginal distinction
a. The issue is usually not whether to pursue an activity but rather the extent to which it
should be pursued, here the focus should be on the benefit and cost of an additional
unit of activity; the marginal cost and marginal benefit
b. The level of an activity should be increased if, and only if, its marginal benefit exceeds its
marginal cost
c. Marginal cost: the increase in total cost that results from carrying out one additional unit
of an activity
d. Marginal benefit: the increase in total benefit that results from carrying out one
additional unit of an activity
e. Estimates may tell us the average cost and average benefit which are not useful for
deciding whether to expand an activity
f. Average cost: total cost of undertaking n units of an activity divided by n
g. Average benefit: total benefit of undertaking n units of an activity divided by n
Not-all-costs-and-benefits-matter-equally principle: some costs and benefits (opportunity costs and
marginal costs and benefits) matter in making decisions, whereas others (sunk costs and average costs
and benefits do not.
Economics: micro and macro
Microeconomics: the study of individual choice under scarcity, and its implications for the behavior of
prices and quantities in individual markets. Standard economic theory assumes decision makers are
rational.
Macroeconomics: the study of the performance of national economies and the policies that
governments use to try to improve that performance.
Economic naturalism: someone who uses insights from economics to help make sense of observations
from everyday life.
Economists and economics
Positive economics consists in the conclusions of economics that are independent of the ethical value
system of the economist
Normative economics consist in statements in economics that reflect or are based on the ethical value
system of the economist, implicitly, explicitly, or by omission.
, Using a verbal description to construct an equation
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 whose value is determined by the value of the independent variable
Independent variable: a variable whose value determined the dependent variable
Constant (or parameter): quantity that is fixed in value
