Thinking Like an Economist

Economics is the study of how society manages its scarce resources.

Scarcity: If resources were not scarce there would be no need for economics!

Economics is the study of how individuals and societies choose to allocate their scarce resources.

The Study of Economics

Macro Versus Micro Economics

Microeconomics: The study of how individuals and firms make decisions and interact in markets.

Macroeconomics: The study of economy-wide economic phenomena such as inflation, unemployment, and economic growth.

Principle One:

• People face tradeoffs.

Principle Two:

• The cost of something is what you give up to get it.

Principle Three:

• Rational people think at the margin.

Principle Four:

• People respond to incentives.

Fundamental Principles of Economics

Principles One and Two and the Concept of Opportunity Cost

Because resources are scarce, individuals and societies face tradeoffs: Scarcity necessitates choices.

Opportunity Cost: the value of the next best alternative surrendered when making a choice.

0

GPA

4.0

3.75

2.0

TV time (hours per week)

1510

Tradeoff Between GPA and TV time

The Tradeoff Between Your GPA and TV Time

The Opportunity Cost of Attending Quinnipiac

How Much Does it Cost to Attend QU?

Estimated 2010-11 Cost of Education

:Tuition & Fees $34,250

Room and Board: $12,730

Books and Supplies: $800

Transportation: $500

Personal: $900

The Opportunity Cost of a College Education

Yearly Earnings of High School Graduate with No College: $26,000

Yearly Earnings from Part Time Job While in College: $9,000

Tuition and Fees: $34,250

Books and Supplies: $800

Forgone Wages = ($26,000 - $9,000) = 17,000

Tuition, Fees, Books and Supplies = $35,050

Economic Cost = $17,000 + $35,050 = $52,050

Principles Three and Four and the Concepts of Marginal and Sunk Costs

Marginal Cost: the incremental cost associated with a choice.

Marginal Benefit: the incremental benefit associated with a choice.

Average Cost: Total cost of undertaking N units of an activity divided by N

Sunk Cost: A previously incurred cost, implying a cost that does not change when a choice is made.

Sunk costs must be borne whether or not the action is taken

An Example: Health Care Costs

Problem: Health care costs in the United States have increased substantially over the past 30 years.

In 1970 total health care expenditures were $70 billion.

In 2000 total health care expenditures were $1,300 billion.

An Example: Health Care Costs

Out of Pocket and Third Party Payments

An Example: Health Care Costs

• Original Program: Full-Coverage Health Insurance

• Suppose that it costs you $1,000 per year for full-coverage health insurance. Once you pay the $1,000 you can access all the health services you desire.

• Question: What is the marginal cost of health care services once you pay your premium?

Answer: MC = 0Your health insurance premium is a sunk cost. Once you pay the premium, at the margin the price of health care services is zero!

An Example: Health Care Costs

New Program: Co-payments

Now suppose that every time you visit the doctor you have to pay a co-payment of $20.

Question: Under the new program what is the marginal cost of health care services?

Answer: Marginal Cost is now $20 per visit.

An Example: Health Care CostsOutcome:

A study conducted by Cherkin, Grothaus, and Wagner, examined the effect of a $5 copayment on office visits to health care facilities.

The authors found that, “the introduction of a $5 copayment for office visits resulted in an estimated 10.9% decrease in primary care visits. The effect of copayments on primary care visits by enrollees under 40 years of age was twice as large for females as for males” (Cherkin, Grothaus, and Wagner, 1989).

The effect of office visit copayments on utilization

in a health maintenance organization.

Garbage Collection

Charlottesville Virginia: Population 45,000.

Problem: Landfill was becoming full and few new places available for garbage disposal.

Old Program: Garbage collection financed through a fixed yearly fee that was attached to property tax bill.

Question: Under the old program, what was the marginal cost to a resident of Charlottesville of creating more garbage?

Answer: MC = 0

Garbage Collection is fixed fee, implying at the margin the price is zero!

Garbage Collection Cont.

New Program:

Residents must purchase “garbage stickers” and place them on 32 gallon trash bags.

•Each sticker costs $0.80 and only trash bags with stickers will be picked up.

Question: Under the new program, what was the marginal cost to a resident of Charlottesville of creating more garbage?

Answer: MC = $0.80

Outcome

Number of garbage bags collected fell by 37%!

Amount of garbage collected, measured by weight, fell by only 14%

• Evidently, residents were practicing the “Seattle Stomp.”

Illegal dumping most likely accounts for between 28 and 43 percent of the total reduction in garbage.

Fullerton, D. and Kinnaman, T., “Household Responses to Pricing Garbage by the Bag,” American Economic Review, 1996, 86(4) 971-984.

Positive Versus Normative Analysis

• Positive Analysis: Addresses what is. Uses theory and models to predict observable and testable tendencies in economic relationships.

• Microeconomics provides a set of tools that can be used to make predictions, which can be tested against the evidence. There is little inherent in the tools, per se, that prejudices the decision. For example, a positive statement might be, "a tax on gasoline will be a heavier burden on lower income than higher income households". Microeconomics can help both frame the question and provide you the tools to answer it.

Positive Analysis

Examples:

• Do minimum wage laws cause unemployment?

• Does local funding of education lead to inequities in school funding across school districts?

• Does an increase in welfare payments reduce work effort?

• Do cigarette taxes reduce smoking?

Normative Analysis

• Normative Analysis: Addresses what should (or ought to) be and therefore depends on value judgments.

• Microeconomics, per se, does not provide you any tools to make better value judgments. Once you make a value judgment about a desirable outcome, microeconomics may help find the most efficient way of achieving it.

 

Examples:

• Minimum wages aught to be higher.

• The state should equalize spending per pupil across districts.

• Welfare payments should be reduced.

• The tax on cigarettes should be increased.