eee OF ,ECONOMICS aa McDowell ¢ Rodney Thom ® Ivan Pastine ‘obert Frank © Ben Bernanke = ge10 " 12 3 1% Tay Cm melt ly Preface Guided Tour Online Resources Connect Acknowledgements PART 1 Introduction Thinking Like an Economist Markets, Specialisation and Economic Efficiency Markets, Supply, Demand and Elasticity PART 2 Competition and the ‘Invisible Hand” Demand: the Benefit Sie of the Market Perfectly Competitive Supply: the Cost Side of the Marker Bfficiency and Exchange Profits, Entry and Exit: the Basis for the ‘Invisible Hand’ PART3_ Market Imperfections (1): Market Power Imperfect Competition and the Consequences of Market Power Thinking Strategically (1): Interdependence, Decision Making and the ‘Theory of Games ‘Thinking Strategically 2): Competition Among the Few PART 4 Market Imperfections (2): Externalities, Information, Distribution and the Role of the Government in a Market Economy Externalities and Property Rights ‘The Economics of Information Labour Markets, Income Distribution, Wealth and Poverty Government in the Market Economy: Public Sector Production and Regulation 43 ry 197 27 259 281 309 331 49 15 The Credit Crunch and the Great Contraction: An Application of some Microeconomics to Help Explain a Macroeconomic Crisis, PARTS Macroeconomics: Issues and Data 16 Macroeconomics: the Bird's Eye View of the Economy 17 Measuring Economic Activity Gross Domestic Product 18 Measuring the Price Level and Inflation 19 The Labour Market: Wages and Unemployment PART 6 The Economy in the Long Run 20 Economic Growth, Productivity and Living Standards 21 Capital Markets: Saving, Investment and Financial Intermediaries PART7 The Economy in the Short Run 22 Short-Term Economic Fluctuations 23 Money and Interest Rates 24 The IS-LM Model 25 Stabilising the Economy (1): the Role of Fiscal Policy 26 Stabilising the Economy (2): the Role of Monetary Policy 27 Aggregate Demand, Aggregate Supply and Inflation 28 The New Keynesian Phillips Curve: Expectations and Inflation Policy PART The International Economy 29 exchange Rates, Capital Flows and the Balance of Payments Index 485 485 sat 503 599 627 ost ootDetailed Table of Contents Preface Guided Tour Online Resources Connect Acknowledgements PART 1 Introduction Thinking Like an Economist Economics: studying choice in a world ofsearcity Applying the Cost-Benefit Principle Economic surplas Opportunity cost "The role of economic models RECAP Cost-benefit analysis Four important decision pitfalls Pitfall 1: measuring costs and benefits 4s proportions rather than absolute Pitfall: ignoring opportunity costs Pitfall 3: failure o ignore sunk costs Pitfall 4 failure to understand the average marginal distinction RECAP: Fous important decision pitfalls Economics: micro and macro "The approach Economic naturalism Economic Naturalist 1.1 Adobe supplies its ‘Acrobat Reader software to anyone free of charge from the internet. Why is this? Economic Naturalist 1.2 Why can you not buy a Jaguar without air-conditioning? Economic Naturalist 1.3 Way do the keypad buttons on drive-in automatic teller machines (ATMs) have Braille dots? A cautionary note: economists ‘and economics of this text Summary Review questions Problems References Appendix A Working with equations, graphs and tables Using a verbal description to construct an equation Graphing the equation ofa straight line Deriving the equation of a straight line from its graph Changes in the vertical intercept and slope 4 “4 1 ‘Constructing equations and graphs from tables Appendix B Elements of calculus for use in economics Dealing with the problem How do we deal with this? ‘The solutions: use calculus ~ differentiating Markets, Specialisation and Economic Efficiency Exchange and opportunity cast The principle of comparative advantage Economic Naturalist 2.1 What has happened to football (soccer)? They just don't seem tobe able to score goals lke they used to! Sources of comparative advantage Economic Naturalist 2.2 How is India's education focus reflected in its trade? RECAP Exchange and opportunity cost Comparative advantage and production possibilities “The production possibilities curve How individual productivity affects the slope and position ofthe PPC The gains from specialisation APF for a many-person economy RECAP Comparative advantage and production possibilities Factors that shift the economy's PPE ‘Why have some countries been slow to specialise? Can we have too much specialisation? ‘onomic Naturalist 2.3 How did branding restore Switzerland's watch-making industry? Comparative advantage and the gains from international trade Economic Naturalist 2.4 Iftrade between nations is so beneficial, why did the WTO talks collapse so spectacularly in 2003? RECAP Comparative advantage and international trade Summary Review questions Problems References Markets, Supply, Demand and Elasticity Buyers and sellers in markets The demand curve 2s 2 a 2 Hu 31 40 0 40 4 8 “ 45 8 50 50 1 2 “4 54 55 55 7 5 ot aDetailed Table of Contents ‘The supply curve RECAP Demand and supply curves Market equilibrium Economic Naturalist 3.1 Why does an inerease in demand or an interruption of supply cause few or no problems in the market for cornflakes, but can lead to a virtual collapse in the market for electricity? Rent controls reconsidered Pizza price controls? RECAP Market equilibrium Predicting and explaining changes in prices and quantities Shifis in demand Economic Naturalist 3.2 Why does public investment in improving school performance generally end up being enjoyed by the berter off? Shifts in the supply curve Four simple rales RECAP Factors that shift supply and demand Economic Naturalist 3.3, Why do the prices of some goods (such as airline tickets from Europe to the United States) go up during the summer, while others (such as the price of strawberries) go down? And what about supermarket prices for wine, beer and spirits at Christmas? ‘Measuring the impact of price changes on supply and demand: elasticity Price elasticity of demand RECAP Factors that influence price elasticity Some representative elasticity estimates Using price elasticity of demand A graphical interpretation of price elasticity Price elasticity changes along a straight line demand curve ‘Two special cases The midpoint formula Maths Box 3.1 RECAP Calculating price elasticity of demand Blasticity and total expenditure Income elasticity and eross price elasticity of demand RECAP Cross-price and income elasticities The price elasticity of supply Economic Naturalist 3.4 Why might we be ‘concerned that lower food prices could result in arise in inflation? Economic Naturalist 3.5 Do economists always get it right where elasticity is concerned? What markets deliver I: Markets and social welfare Cash on the table Smart for one, dumb for all, RECAP Markets and social welfare What markets deliver 2: Central planning versus the market 6 6 6s 6 ” 9 81 8 3 4 8s % 98 » 100 101 101 ‘Summary 403 Supply and demand 103 Elasticity 104 Review questions 105 Problems 105 References 107 Part 2 Competition and the ‘Invisible Hand” Demand: the Benefit Side of the Market The law of demand ‘The origins of demand Needs versus wants 3 Economic Naturalist 4.1 What happens when people do not have to pay for the water they use? 4 ‘Translating wants into demand 14 Measuring wants: the concept of utility 14 Allocating a fixed income between ‘wo goods ‘The rational spending rule 120 Income and substitution effects revisited a2 RECAP Translating wants into demand, m2 Applying the rational spending rule 123 Substitution at work 13 Economic Naturalist 4.2, Why do the people ‘with the highest incomes in the wealthy countries today live in houses or apartments that are small fractions of the size ofthe accommodation of their equivalents before the First World War? 123, Economic Naturalist 4.3 Do Irish drivers ‘care more about stopping climace change than other Europeans? 124 ‘The importance of income differences 124 Economic Naturalist 4.4 Why can you get a Big Mac on demand in Paris, but usually hhave to bookca table a week in advance at the Tour d’Argent, a restaurant said to be the ne plus ultra in gourmet cuisine in Paris? 124 RECAP Applying the rational spending rule 125, Indifference curve analysis and the demand curve ws The model 126 Income effects 1 Substitution effects 131 Economic Naturalist 4.5 Lipstick isan inferior good? 132 Giffen goods Bs Economic Naturalist 4.6 Can demand curves slope upwards? By RECAP Indifference curve analysis of rational choice i Individual and market demand curves 134 Horizontal addition 14 Demand and consumer surplus ns Caleulating economic surplus 136Summary Review questions Problems Perfectly Competitive Supply: the Cost Side of the Market ‘Thinking about supply: the importance of opportunity cost Production in the short run Some important cost concepts Maths Box 5.1 Why a marginal cost curve ‘must cUtan average cost curve at its lowest point: a mathematical proof Input prices, production capacity and the firm’s cost of supply ‘The ‘law’ of supply Determinants of supply revisited ‘Technology Input prices ‘The number of suppliers Expectations Changes in prices of other products Revenues from sales: profit maximising firms in competitive markets Profit maximisation The demand curve facing a perfectly ‘competitive firm Using costs and revenues to determine how profits are maximised Choosing output to maximise profit A note on the firm’s shutdown condition Average variable cost and average total cost Economic Naturalist 5.1. Loss-making airlines: is bankruptcy good for you? Graphical analysis of the maximum profit condition Maths Box 5.2. ‘The mathematies of profit ‘maximisation under perfect competition RECAP Determinants of supply Applying the theory of supply Economic Naturalist 5.2 Are the laws of supply and demand suspended in California where litter is concerned? ‘Supply and producer surplus Calculating producer surplus ‘Summary Review questions Problems Efficiency and Exchange Market equilibrium and efficiency ficiency is not the only goal Why efficiency should be the frst goal RECAP Equilibrium and efficiency ‘The cost of preventing price adjustments Price ceilings Price subsidies 138 139 19 3 m4 “7 3 130 130 12 154 154 154 158 134 1s ass 1s 17 160 163 163 165 165 165 165 167 167 1m 4 ” m ws 118 178 180 Detailed Table of Contents Economic Naturalist 6.1 How does one of the ‘world’s poorest countries impoverish itself by subsidising fuel oil prices? First-come, first-served policies Economic Naturalist 6.2 How consumer protection damages markets: the BU Commission and overbooked flights RECAP The cost of blocking price adjustments ‘Marginal cost pricing of public services RECAP Marginal cost pricing of public services ‘Who pays a tax imposed on sellers of a good? How a tax collected from a seller affects ‘economic surplus Taxes, elasticity and efficiency ‘Taxes, external costs and efficiency RECAP Taxes and efficiency ‘Summary Review questions Problems : the Basis for Profits, Entry and E: the ‘Invisible Hand" ‘The central role of economic profit ‘Three types of profit RECAP The central role of economic profit ‘The ‘invisible hand’ theory ‘Two functions of price Responses to profits and losses ‘The importance of free entry and exit Economic Naturalist 7.1 What happens when you forget about maximising profits? ‘The importance of public policy on exit: the ‘globalisation’ question RECAP The ‘invisible hand’ theory Economic rent versus economic profit RECAP Economic rent versus economic profit The ‘invisible hand’ in action ‘The ‘invisible hand’ and cost-saving The ‘invisible hand! in regulated markets Economic Naturalist 7.2 ‘The value and cost of restricting entry Economic Naturalist 7.3 Should British ‘Airports Authority (which own London Heathrow, Gatwick and Stansted) be obliged to lower its landing charges? The ‘invisible hand’ in anti-poverty programmes The ‘invisible hand’ in the stock market Maths Box 7.1. A technical digression: how to calculate present values of future costs and benefits ‘The efficient markets hypothesis Economic Naturalist 7.4 Pension funds hold reviews on a regular basis of the performance ofthe fund management firms they retain to invest their clients’ ‘money. Does this make sense? RECAP The ‘invisible hand! in action 12 12 183 184 184 186 186 188 139, 190 m1 192 192 193 197 198 198 200 201 201 201 208 209 an au a2 a2 22 23 as 216 a7 219 20‘The distinction between an equilibrium and a social optimum 20 ‘Smart for one, dumb for all zt RECAP Equilibrium versus social optimum 221 Summary 21 Review questions 22 Problems 223 References 224 Part3 Market Imperfections (11: Market Power 8 Imperfect Competition and the Consequences of Market Power Imperfect competition 28 Different forms of imperfect competition 228 ‘The essential difference between perfectly and imperfectly competitive firms 2s RECAP Imperfect competition 29 Five sources of market power 29 Exclusive control over important inputs 230 Patents and copyrights 230 Government licences or franchises 230 Economies of scale (natural monopolies) 20 Network economies 231 . RECAP Five sources of market power 2 Economies of scale and the importance of fixed costs 22 Economic Naturalist 8.1 Why do some industry experts believe Intel's dominance of the chip market is bound to be eroded? 24 RECAP Economies of scale and the importance of fixed costs Bs Profit-maximisation for the monopolist 235 Marginal revenue for the monopolist 235 ‘The monopolis’s profit-maximising decision rule Being a monopolist does not guarantee an economic profit 238 Maths Box 8.1 Marginal revenue, marginal cost and profit maximisation when a firm hhas market power: the mathematical approach 29 RECAP Profit maximisation for the monopolist 140 ‘Why the ‘invisible hand’ breaks down under ‘monopoly 240 Economic Naturalist 8.2 Can profithungry firms with market power overcome the social-inefficiency problem? 2a RECAP Why the monopolist produces ‘too little’ output me Measuring market power 28 Contestability 28 Price discrimination 24 How price discrimination affects output 25 Economic Naturalist 8.3 Economies of scale have led to the concentration of production of cars into a small number of very large producers. Why, then, do they continue to produce so many different marques? ‘The hurdle method of price discrimination Is price discrimination a bad thing? Examples of price discrimination Economic Naturalist 8.4 If price discrimination can improve economic in turn ene Chapter 3, a long chapter, looks@ cverview of the concepts o basic core ec and familiar k to a chang variable, and how tl elasticity, the pr pply and demand, perhaps the used by nomists. It also loo! in an indThinking Like an Economist A witty saying proves nothing, Voltaire res After studying this chapter you should be able to: 1. Explain the concepts of scarcity and choice, the cost-benefit principle and the importance of incentives; 2. Assess and identify properly costs and benefits; 3. Understand the concept of economic rational 4. Understand why what happens ‘at the margin’ is important; 5. Distinguish between positive and normative statements in economics. een son A health warning: thinking (and then speaking) like an economist can make you very unpopular. Partly this is because economists seem to take a lot of pleasure in puncturing other people's balloons (that is, demonstrating that what their vic tims hold to be self-evident is far from being true). More importantly, economics as a discipline teaches you to think about problems, and solutions to problems, in a way that others find challenging to their way of thinking. consider the following policy issue. It is taken as almost an article of faith by teaching professionals that smaller classes are better, in terms of educational outcomes, particularly at the primary (elementary) level. Children, it is said, do better, controlling for other factors, if they are taught in smaller classes. The result is consistent pressure on governments in many countries to spend more to enable class sizes to be reduced, Most people, parents included, would agree with the class size proposition, and not just because teachers continually argue along these lines. Everyday experience supports the concept of better classroom experience and consequent educational outcomes being linked to smaller class sizes. An economist considering this issue would be likely to ask some hard ques tions. The first would be “What evidence exists to support the proposition that reducing class sizes, all other things being equal, generally improves educational outcomes?’ The economist would ask what accepted metric exists that permits objective evaluation of outcomes and comparison of results. If you can’t objec- tively measure outcomes and make comparisons over time or across schools on a common basis, the proposition cannot be demonstrated to be correct. If the accepted metric demonstrates outcome differences statistically related to class size the economist would agree that there is support for the proposition. If not, ®my Chapter 1 ‘Thinking Like an Economist the economist would be likely to point out that the pressure for smaller classes may reflect the fact that teachers may have a vested interest in pushing for smaller classes as a means of reducing the pressure of work.! People, unfortunately, tend to respond to this in exactly the same way as most people did a few hundred years ago when informed that the Earth was not flat: com mon sense supported the flat Earth hypothesis. A common response is that itis plainly silly even to question the class size hypothesis. People do not like being told that their ‘common sense’ is incorrect. ‘The economist’s approach is, first, based on confronting a hypothesis with evidence before conditionally accepting it. This, of course, is exactly what physicists, geologists, astronomers and cosmologists do. It is why economics can credibly seek to be regarded asa science Second, an economist will always look at motivation. The economist argues that people tend to behave in a selfinterested fashion and respond to incentives. They will combine to press for changes that improve their economic welfare. They may even persuade themselves that what they are seeking is to everyone else's advantage. They are, however, unlikely to combine to press for changes that will reduce their economic welfare. Trades unions do not seek lower wages for their members if unemployment rises. But imputing selfinterest to people who are making ater cr arguments based on hypotheses about the general good is certain t0 cause outrage. There are, of course, exceptions to this, Individual altruism exists. Most people ‘would accept that Mother Teresa of Calcutta sought primarily to improve the lot of the | poor in Calcutta, not to become an international celebrity. People do combine to achieve ends that do not coincide with group selfinterest. They may in some cases be spectacularly wrong-headed in the remedies they support (for example, urging motor ists to switch to bio-fuels), but most environmentalists seeking to avert global warming are not doing so in order to earn a living, Returning to the subject of class size, the next issue for economists would be the cost of reducing class sizes, and whether the cost incurred is warranted by the expected benefits. That, of course, may require putting some monetary value on levels of educa- tional achievement. Unfortunately, where health and education are concerned, this approach tends to call forth Oscar Wilde’s observation about knowing the price of everything and the value of nothing. But the economist’s question is motivated by the fact that there is a social cost involved in putting more money into healthcare or educa tion: the value of the things that can’t be done as a consequence. Finally, the economist is likely to suggest that we should stop reducing class sizes in any case well before further reduictions have no effect on outcomes. The economist will talk about ‘marginal’, or ‘incremental’, costs, and ‘marginal’, or ‘incremental’, benefits ‘The economist will suggest that additional funding to reduce class sizes or to reduce road deaths or to improve the health status of the population should not continue beyond the point where marginal costs equal marginal benefits, even if total benefits could be increased. Try that out on a road safety lobbyist! An acceptable level of deaths on the roads? c Anais Economists interested in tis question have o depend on the research undertaken by edkcational experts in partes conventional wisdom sbout reducing class sizes, following a similar research methodology. A highly readable survey of the isstes and problems, which lat, educational psychologists. They, 100, have been acive in questioning thi angues fo very limited evidence of significant gains ules class izes are reduced below 20, is ennett, Ni, Annotation: ‘Cass Size and the Quality of Educational Outcomes’, journal of Child Ps pp. 797-804 lay and Paychiary, 3616), 1998,Economics: studying choice in a world of scarcity | ECONOMICS: STUDYING CHOICE IN A WORLD OF SCARCITY No matter how rich a country is and, for most of us, at any rate, as individuals no matter how rich we are, scarcity is a fundamental fact of life. There is never enough time, money or energy to do everything we want to do or have everything we would like to have Scarcity simply means we must choose, and sometimes make hard choices. Economics is the study of how people make choices under} economics the study of how conditions of scarcity, and of the results of those choices for society | people make choices under A parent with a young child going into the educational system | conditions of scarcity and of might definitely prefer schools with a class size of 20 rather than a] the results of those choices for class size of 30, everything else being equal. But suppose fees were | society payable, and that the fees in a small-class school were significantly higher than in a large-class size school. Income is limited. Therefore you must choose. If you choose smal] class sizes you will have to give up something as a result. Your choice will in the end come down to the relative importance of competing demands on that income. If you had a menu of schools with different class sizes to choose from, with fees reflecting class size, you could choose any one of them, In doing so you are trading off other things you might do with your income against perceived @ Scary benefits from class size. That such trade-offs are widespread and important is one of the core principles of economics. We call it the Scarcity Principle, Scarcity Principle (also called because the simple fact of scarcity makes trade-offs necessary, | the No-Free-Lunch Principle) Another name for the scarcity principle is the No-Free-Lunch | although we have boundless aah r needs and wants, the resources. rinciple (which comes from the observation that even lunches available to us are limited, so that are given to you are never really free ~ somebody, somehow, having more of id thin, always has to pay for them), usually means havingless of Inherent in the idea of a trade-off is the fact that choice involves | nother, hence the ehché compromise between competing interests, Economists resolve | “There ain't no such thing as a such trade-offs by using cost-benefit analysis, which is based on the | free lunch’, sometimes reduced disarmingly simple principle that an action should be taken if, | to the acronym TANSTAAFL, and only if, its benefits exceed its costs. We call this statement the | Cost-nenefit Principle an Cost-Benefit Principle, and it, t00, is one of the core principles of | individual (ora firm, or a economics. society) should take an action With the Cost-Benefit Principle in mind, let us think about our | if, and only if, the extra class-size question again. Imagine that classrooms come in only | benefits from taking that two sizes — 40-seat lecture rooms and 20-seat seminar rooms ~ and action are at least as great as that your university currently offers introductory economics | the extra costs courses to classes of 40 students. Question: Should administrators reduce the class size to 20 students? Answer: Reduce if, and only if, the value of the improvement in instruction out: | weighs its additional cost. i This rule sounds simple, but to apply it we need some way to measure the relevant costs and benefits ~a task that is often difficult in practice. If we make a few simplifying | assumptions, however, we can see how the analysis might work. On the cost side, the | primary expense of reducing class size from 40 to 20 is that we will now need two teachers | i t instead of one. We'll also need two smaller classrooms rather than a single big one, and this too may add slightly to the expense of the move. For the sake of discussion, suppose that the cost with a class size of 20 turns out to be €1,000 per student more than the cost per student when the class size is 40. Should administrators switch to the smaller class size? If they apply the cost-benefit principle, they will realise that the reduction in class size makes sense only if the value of attending the smaller class is at least €1,000 per student greater than the value of attending the larger class.Chapter 1 Thinking Like an Economist Would you (or your family) be willing to pay an extra €1,000 for a smaller econom ics class? If not, and if other students feel the same way, then sticking with the larger class size makes sense. But if you and others would be willing to pay the extra tuition fees, then reducing the class size to 20 makes good economic sense. Notice that the ‘best’ class size, from an economics point of view, will generally not be the same as the ‘best’ size from the point of view of an educational psychologist. The difference arises because the economics definition of ‘best’ takes into account both the benefits and the costs of different class sizes. The psychologist ignores costs and looks only at the learning benefits of different class sizes, In practice, of course, different people will feel differently about the value of smaller classes. People with high incomes, for example, tend to be willing to pay more for the advantage, which helps to explain why average class size is smaller, and tuition fees higher, at private schools whose students come predominantly from high-income families. Scarcity and the trade-offs that result also apply to resources other than money. Bill Gates is one of the richest men on Earth. He has enough money to buy more houses, cars and other goods than he could possibly use. Yet Gates, like the rest of us, has only 24 hours in his day and a limited amount of energy. So even he confronts trade-offs, in that any activity he pursues ~ whether it be building his business empire or redecorating his mansion — uses up time and energy that he could otherwise spend on other things. APPLYING THE COST-BENEFIT PRINCIPLE In studying choice under scarcity, we shall usually begin with the rational person someone with | premise that people are rational, meaning they have well-defined well-defined goals, who fulfils goals and try to fulfil them as best they can. The Cost-Benefit those goals as best she can Principle illustrated in our class-size example is a fundamental tool Example 1.1 for the study of how rational people make choices. Often the only real difficulty in applying the cost-benefit rule is to come up with reasonable measures of the relevant benefits and costs. Only in rare instances will exact money measures be conveniently available. But the cost-benefit framework can lend structure to your thinking even when no relevant market data are available. Toillustrate how we proceed in such cases, the following example asks you to decide whether to perform an action whose cost is described only in vague, qualitative terms. Should you walk to the centre of town to save €10 on a €25 computer game? Imagine you are about to buy a €25 computer game at the nearby college book shop when a friend tells you that the same game is on sale at a city-centre store for only €15 If the store in question is a 30-minute walk away, where should you buy the game? The Cost-Benefit Principle tells us that you should buy it from the store in the city centre if the benefit of doing so exceeds the cost. Here, the benefit of buying elsewhere is exactly €10, since that is the amount you will save on the purchase price of the game The cost of buying in the city centre is the money value you assign to the time and trouble it takes to make the trip. But how do we estimate that money value? Imagine that a stranger has offered to pay you to do an errand that involves the same walk to the centre of town (perhaps to drop off a letter for her at the post office). If she offered you a payment of, say, €1,000, would you accepr? If $0, we know that your cost of walking to the centre of town and back must be less than €1,000. Now imagine her offer being reduced in small increments until you finally refuse the last offer. For exam ple, if you would agree to walk there and back for €9.00 but not for €8.99, then your cost of making the trip is €9.00. In this case, you should buy the game in the town centre, because the €10 you'll save (your benefit) is greater than your €9.00 cost of making the trip.‘The toe of econo models E: But suppose, alternatively, that your cost of making the trip had been greater than €10. In that case, your best bet would have been to buy the game from the nearby col- lege book shop. Confronted with this choice, different people may choose differently, depending on how costly they think itis to make the trip into town. But although there is no uniquely correct choice, many people who are asked what they would do in this situation say they would buy the game from the city-centre store. ECONOMIC SURPLUS Suppose again that in Example 1.1 your ‘cost’ of making the trip to the city centre was €9. Compared with the alternative of buying the game at the college store, buying it elsewhere resulted in an economic surplus of €1, the difference between the benefit of making the trip and its cost. In general, your goal as an economic decision maker is to economic surplus the economic surplus from taking any action is the benefit of choose those actions that generate the largest possible economic | taking that action minus its surplus. This means taking all actions that yield a positive total} cost economic surplus, which is just another way of restating the Cost- Benefit Principle. ‘The fact that your best choice was to buy the game in the city doesn’t imply that you enjoy making the trip. It simply means that the trip to town is less unpleasant than the prospect of paying €10 extra for the game. Once again, you've faced a trade-off — in this case, the choice between a cheaper game and the free time gained by avoiding the trip. OPPORTUNITY COST Suppose now that the time required for the trip isthe only time you ; have left to study for a difficult test the next day. In such a case, we | 9PPortunity cost the say that the opportunity cost of making the trip -thatis, the value} OPPo*tunity cost of an activity is the value of the next best alternative that must be forgone in order to undertake the activity of what you must sacrifice to walk to the city centre and back ~ is high, and you are more likely to decide against making the trip. If watching a movie on TV, the movie is the most valuable oppor- tunity that conflicts with the trip to the city centre, the opportunity cost of making the trip is the money value you place on watching the movie — thats, the largest amount you'd be willing to pay to avoid missing it. Note that the opportunity cost of making the trip is not the combined value of all possible activities you could have pursued, but only the value of your best alternative - the one you would have chosen had you not made the trip. ‘Throughout the text we will pose exercises like Exercise 1.1. You will find that paus- ing to answer them will help you to master key concepts in economics. Because doing these exercises isn't very costly (indeed, many students report that they are actually fun), the Cost-Benefit Principle indicates that it’s well worth your while to do them. You would again save €10 by buying the game in the city rather than at the college | Exercise 1.1 store, but your cost of making the trip is now €12, not €9. How much economic surplus would you get from buying the game in the city? Where should you buy it? THE ROLE OF ECONOMIC MODELS Non-cconomists sometimes attack the economist’s cost-benefit model on the grounds that people in the real world never conduct complicated mental comparisons between costs and benefits of hypothetical options until a winner emenges before deciding whether to make trips to town, But this criticism betrays a fundamental misunderstanding of7 Chapter Thinking Like an Economist how abstract models can help to explain and predict human behaviour. Economists know perfectly well that people don’t conduct hypothetical mental ‘auctions’ between options when they make simple decisions. All the Cost-Benefit Principle really says is that a rational decision is one that is explicitly or implicitly based on a weighing of costs and benefits Most of us make sensible decisions most of the time, without being consciously aware that we are weighing costs and benefits, just as most people ride a bike without being consciously aware of what keeps them from falling off. Through trial and error, we gradually learn what kinds of choices tend to work best in different contexts, just as bicycle riders internalise the relevant laws of physics, usually without being conscious of them. ‘The Cost-Benefit Principle is an abstract model of how an idealised rational individual would choose among competing alternatives, (By ‘abstract model’ we mean a simplified description that captures the essential elements of a situation and allows us to analyse them in a logical way.) A computer model of a complex phenomenon such as climate change, which must ignore many details and include only the major forces at work, isan example of an abstract model A model is to an economist in many ways what a laboratory experiment is to a physical scientist. Supposing you climbed the Leaning Tower of Pisa to test Newton's theory of gravity by dropping a feather and a kilogram of lead, you would observe that the lead fell faster and hit the ground first, and might conclude that gravity affects metals to a greater degree than it does organic material. A physicist would demonstrate that this is not the case by creating a vacuum and repeating the experiment. We live in a real world where air pressure and resistance affect how objects fall, We create a simplified world to test the gravity hypothesis by removing the pressure and resistance effects. Would you agree with someone who said that there is little value in talking about the workings of gravity because in the real world we don’t live in a vacuum? Cost-benefit analysis Scarcity is a basic fact of economic life. Having more of one good thing almost always means having less of another (the Scarcity Principle). The Cost-Benefit Principle holds that an individual (or a firm, or a society) should take an action if, and only if, the extra benefit from taking the action is at least as great as the extra cost. The benefit of taking any action minus the cost of taking the action is called the economic surplus from that action. Hence the Cost-Benefit Principle suggests that we take only those actions that create additional economic surplus. FOUR IMPORTANT DECISION PITFALLS? Knowing that rational people tend to compare costs and benefits enables economists to predict the likely behaviour of people in the aggregate. However, there are some pitfalls of which you need to be aware in analysing how rational choices are made. People who . think they are behaving rationally sometimes get it wrong, People are not born with an infallible instinct for weighing the relevant costs and benefits of many daily decisions Indeed, one of the rewards of studying economics is that it can improve the quality of your decisions. The examples in this section reflec: the work of Danie! Kahneman and the late Amos Twersky: Kahneman was awarded the 2008 Nobel Prize in Economics for his efforts to integrate insights from psychology into economics,