Learning Objectives LO 1 Define economics microeconomics and

Learning Objectives LO 1: Define economics, microeconomics, and macroeconomics. LO 2: Identify John Maynard Keynes, Alfred Marshall, and Adam Smith, and their influence in economics. LO 3: State and explain the problem of scarcity and its relation to opportunity cost. LO 4: Explain how a rational decision maker applies the cost–benefit principle. LO 5: State how three pitfalls can undermine rational economic decisions. LO 6: Explain how data are used to evaluate economic theories. LO 7: Distinguish positive economics from welfare economics. LO 8: Define an economic naturalist. © 2012 Mc. Graw-Hill Ryerson Limited Ch 1 -1

LO 5: State how three pitfalls can undermine rational economic decisions PITFALL 1: Ignoring Opportunity Costs Many people make flawed decisions because they tend to ignore the value of foregone opportunities. A notebook computer costs $1, 020 at the nearby campus store and the same computer is on sale at a downtown store for $1, 010. If the downtown store is half an hour’s walk away, where will you, as a rational decision maker, buy the computer? © 2012 Mc. Graw-Hill Ryerson Limited LO 5: Three Common Pitfalls Ch 1 -2

LO 5: State how three pitfalls can undermine rational economic decisions PITFALL 1: Ignoring Opportunity Costs Assuming that the notebook is light enough to carry without effort, the structure of this example is exactly the same as that of the earlier example about the computer game—the only difference is that the price of the notebook is dramatically higher than the price of the computer game. So if you are perfectly rational, you will make the same decision in both cases. Yet when real people are asked what they would do in these situations, the overwhelming majority says they would walk downtown to buy the game but buy the notebook at the campus store. © 2012 Mc. Graw-Hill Ryerson Limited LO 5: Three Common Pitfalls Ch 1 -3

LO 5: State how three pitfalls can undermine rational economic decisions PITFALL 1: Ignoring Opportunity Costs When asked to explain, most of them say something like, the trip was worth it for the game because you save 40 per- cent, but not worth it for the notebook because you save only $10 out of $1, 020. This is faulty reasoning. The benefit of the trip downtown is not the proportion you save on the original price. Rather, it is the absolute dollar amount you save. A rational decision maker should make the same decision in both cases. Yet, as noted, most people choose differently. © 2012 Mc. Graw-Hill Ryerson Limited LO 5: Three Common Pitfalls Ch 1 -4

LO 5: State how three pitfalls can undermine rational economic decisions PITFALL 2: Failure to Ignore Sunk Costs Sunk costs are those costs that will be incurred whether or not an action is taken § E. g. , money that you cannot recover Therefore irrelevant to decision on whether to take an action § Should NOT be counted for decision-making purposes Rational decision makers compare benefits to only the additional costs that must be incurred © 2012 Mc. Graw-Hill Ryerson Limited LO 5: Three Common Pitfalls Ch 1 -5

LO 5: State how three pitfalls can undermine rational economic decisions PITFALL 2: Failure to Ignore Sunk Costs Suppose, for example, that you have invested $300, 000 in a small manufacturing shop that is still incomplete and worthless in its current state. Things have not gone well, and it will cost another $290, 000 to finish the job. But due to a new technological development, you could start a new, equally valuable manufacturing shop from scratch for only $275, 000. If one of the two options—finishing off the original shop or starting a new shop from scratch—is rational, which one is it? The key to this decision is that the original $300, 000 has already been spent. That money is gone; it is a sunk cost. For the same return, you can either invest an additional $290, 000 or invest an additional $275, 000. Starting a new shop from scratch is the rational choice. © 2012 Mc. Graw-Hill Ryerson Limited LO 5: Three Common Pitfalls Ch 1 -6

LO 5: State how three pitfalls can undermine rational economic decisions PITFALL 3: Failure to Understand the Average– Marginal Distinction Marginal cost: The increase in total cost that results from carrying out one additional unit of an activity Marginal benefit: The increase in total benefit that results from carrying out one more unit of an activity Average cost: Total cost of undertaking n units of an activity divided by n Average benefit: Total benefit of undertaking n units of an activity divided by n © 2012 Mc. Graw-Hill Ryerson Limited LO 5: Three Common Pitfalls Ch 1 -7

LO 5: State how three pitfalls can undermine rational economic decisions PITFALL 3: Failure to Understand the Average– Marginal Distinction Decision makers often have ready information about the total cost and benefit of an activity, and from these it is easy to calculate the activity’s average cost and benefit. However, it is a mistake to increase an activity simply because its average benefit is greater than its average cost. Likewise, it is a mistake to decrease an activity simply because its average benefit is less than its average cost. © 2012 Mc. Graw-Hill Ryerson Limited LO 5: Three Common Pitfalls Ch 1 -8

LO 5: State how three pitfalls can undermine rational economic decisions PITFALL 3: Failure to Understand the Average– Marginal Distinction The cost–benefit principle states that total benefit can be increased by increasing the amount of an activity if, and only if, the benefit of one more unit of the activity is greater than its cost. Likewise, total benefit can be increased by decreasing the activity if, and only if, its marginal benefit is less than its marginal cost. © 2012 Mc. Graw-Hill Ryerson Limited LO 5: Three Common Pitfalls Ch 1 -9