Chapter 1 Frank/Bernanke, Principles of Microeconomics

1. Chapter 1 Frank/Bernanke, Principles of Microeconomics Thinking LikeAn Economist

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

3. Hi, I am Marty….

4. Hi, I am Marty….

5. 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?

6. 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.

7. How do we learn a new language Start simple Repetition and drill Active learning Have fun “How much is this?”

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

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

10. 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 $40,000 • A class of 300 students might cost $200/student • Extreme 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?

11. 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

12. 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.

13. What are the alternatives to English auction? • First come, first served; • Teacher assigned; • Class negotiation.

14. 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

15. 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

16. 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.

17. 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)

18. Some relevant costs: • Faculty salary: $90,000 per course • Per student faculty salary cost: • 1 section: $90,000/300 = $300 • 12 sections: $90,000/25 = $3600

19. 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.

20. Optimal class size • Observations • The “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.

21. 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

22. Example 1.1Should 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.

23. 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.

24. 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.

25. People often behave as ifthey were comparing the relevant costs and benefits.

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

27. Can cost-benefit analysis help you make better decisions? Example 1.2 You 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?

28. Can cost-benefit analysis help you make better decisions? 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?

29. 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.

30. Can cost-benefit analysis help you make better decisions? 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: Program A: save 200 lives with certainty Program B: save 600 lives with probability 1/3, and save zero lives with probability 2/3 Which program would you choose? A or B?

31. Can cost-benefit analysis help you make better decisions? 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: 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 Which program would you choose? C or D?

32. 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

33. 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.

34. Example 1.6. Losing a $100 bill You have just arrived at the theater to buy your ticket and discover that you have lost a $100 bill from your wallet. Do you buy a ticket and see the play anyway?

35. 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?

36. 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.

37. 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?

38. 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.

39. Cost-benefit principle: Optimal amount of memory

40. Everyday Choices "Should I do X?" "How much X should I buy?" "Should I buy an additional unit of X?"

41. Some Common Pitfalls for Decision Makers Pitfall 1: Measuring cost and benefits as proportions rather than absolute dollar amounts

42. 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?

43. Some Common Pitfalls for Decision Makers 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.

44. 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.

45. Example 1.10. Should I go skiing today?

46. Example 1.10. Should I go skiing today? • 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 busfare, 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.

47. Example 1.10. Should I go skiing today? • 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?"

48. Example 1.10. Should I go skiing today? C(x) = cost of skiing plus value of forgone earnings = $30 + $40 = $70 B(x) = $50 < C(x), So don't go skiing.

49. 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.

50. Many jobs, of course, are not pleasant.