1CHAPTER TWO: THE ECONOMIC FRAMEWORKThe Economic Way of Thinking1And you may find yourself living in a shotgun shackAnd you may find yourself in another part of the worldAnd you may find yourself behind the wheel of a large automobileAnd you may find yourself in a beautiful house, with a beautiful wifeAnd you may ask yourself - Well...How did I get here?The Bottom Line…Economics then is about decision-making•What does that mean?•Everyone (you, households, firms, the government, society) should weigh the costs and benefits properly when making any decision•Example, should you go to college or get a full-time job out of high school?• What are the benefits of going to college?• What are the costs?• What are the benefits and costs of choosing a major?2Benefits, Costs and IncentivesIs your real estate agent really on your side?•Assume:• You wish to sell your home• You hire a real estate agent to help show your home• Agent earns 3% of the sales price• Therefore, the higher your house sells for, the more money you make and the more $ the agent makes•Are your incentives (what you want) and your agent’s incentives (what they want) perfectly aligned?•Not quite•Why does that matter?3Weighing Costs and BenefitsTHE BENEFITS…When making a decision, what do you gain by saying “yes”?• Benefits are normally fairly straightforward• Should the government build a new road? • Benefit is obviously a new road• Should you buy that house? • Benefit is the enjoyment you expect to get out of the house• Should you go to college after high school? • Benefit is…• One year of college education42Weighing the Costs and BenefitsTHE COSTS…Economists like to think this is our big contribution to the world• Perhaps a slightly different way to frame a problem, but we feel very strongly that it is the correct way to view the problem before making the correct decision•When making a decision, what do you lose by saying “yes”?•How much does a movie cost?•How much does it cost to go to college for a year?5Example of Economic Cost: CollegeHow much does 1 year (2 semesters) of college cost? • instate UT, fall 14 – spring 15 Costs:• Tuition: $ 11,600 (in-state, returning undergraduates)• Books: $ 1,000 (10 classes, $100 per class)• Room and Board: Would have to pay that anyway• Your time: $25,000 (foregone full-time salary)Total Economic Cost: $37,600 Per Year6***HUGE IDEA IN ECONOMICS!!***When calculating the cost of a decision, you should alwaysinclude the opportunity costOPPORTUNITY COST: THE VALUE OF THE NEXT BEST FOREGONE OPPORTUNITY WHENEVER A DECISION IS MADE•How much does a movie cost?•What does it cost to skip class?• What does it cost to come to class?•How much does it cost to invest $1,000 in Coca-Cola?7Question: Should I go to college for 1 year?Benefits:1 year college educationCosts:Tuition: $11,600Books: $1,000Foregone earnings: $25,000Benefits:1 year earnings : $25,000Don’t have to pay tuition or booksCosts:1 year college education83Weighing your decision9BenefitsCostsOne year college education$12,600Benefits CostsOne year college education$37,600Wrong Way!!!!Correct FrameworkMedian Salary by MajorPetroleum EngineeringMechanical EngineeringCivil EngineeringBusiness EconomicsAccountingPolitical ScienceMarketingHistoryPhilosophySecondary EducationSociologyGeneral EducationSocial WorkCounseling Psychology10Source: What’s It Worth? The economic value of college majors; Decisions at the MarginMargin: means one more or the next one or one additionalMost decisions you make are small, incremental decisions…• How do I spend the next free hour?• Do I want to buy 1 more pair of shoes?• Do I want to take 12 or 15 hours this semester?We normally don’t measure the total benefits or costs, but instead marginal benefits and marginal costs of a decision•If Marginal benefit > Marginal cost Do it!!! (Say yes!)•If Marginal benefit < Marginal cost Don’t!!!! (Say no)11A. Your marginal benefit is $300,000; Agent’s is $9,000B. Your marginal benefit is $250,000; Agent’s is $7,500C. Your marginal benefit is $50,000; Agent’s is $1,500D. Your marginal benefit is $50,000; Agent’s is $9,000E. Your marginal benefit is $50,000; Agent’s is -$7,00012A. B. C. D. E.0%0%0%0%0%4Real Estate Agent and Incentives•Assume:• You hire a real estate agent to help show and sell your house• He makes 3% of the final sale• You could sell house now for $250,000• Agent earns $7,500• Or, with extra work, time & patience, could sell house in 4 months for $300,000• Agent earns $9,000 •What is the marginal benefit to you from waiting till Nov?• $50,000; The extra you make from waiting ($300,000 vs. $250,000)•What is the marginal benefit to your agent from waiting?• $1,500; The extra the agent makes from waiting ($7,500 vs. $9,000)13People Respond to IncentivesSince,• People behave rationally, and• People make small everyday decisions based on comparing small benefits against small costsThen,• Small changes can be enough to alter people’s decisions and their behavior•Examples• Cheating (on an exam)• Prices (small changes in price)14PRODUCTION POSSIBILITIES FRONTIER (PPF)PPF –• an economic model that shows the maximum combination of goods/services that can be produced given available resources and technology•Useful to show:• The consequences of scarcity• Tradeoffs from making decisions (benefits/costs when making a decision)15PPF Example #1Suppose that we have…• lots of O.J.• lots of Bloody Mary mix• a small bottle of vodka (enough for 6 drinks) and, • we like screwdrivers and Bloody MarysWhat can we do with these resources?1. What are our possibilities?2. What is the best we can do? (a better question)165664422Bloody MarysScrewdrivers17PPF example #1, (cont)What are our possibilities?There are an infinite number of possibilities…664422Bloody MarysScrewdrivers18PPF example #1, (cont)What’s the best we can do?Why have only 3 Bloody Marys when we can have 3 Bloody MarysAND 3 screwdrivers?PPF DefinitionsEfficient Points: All points on the PPF• We are using all of our available (fixed) resources to their best use• Level of technology is unchangedInefficient Points: All points inside the PPF• We are not using all of our available resources; resources are left idle; we can do better (MORE IS ALWAYS BETTER)Unattainable Points: All points outside the PPF• Because of scarcity