Economic Decision Making

The Economic Way of Thinking

• A rational choice is one that compares costs and benefits and achieves the greatest benefit over cost for the person making the choice.
• Only the wants of the person making a choice are relevant to determine its rationality.
• The idea of rational choice provides an answer to the first question: What goods and services will be produced and in what quantities? The answer is: Those that people rationally choose to buy!

Benefits and Costs

• The benefit of something is the gain or pleasure that it brings and is determined by preferences.
• Preferences are what a person likes and dislikes and the intensity of those feelings.
• The opportunity cost of something is the highest-valued alternative that must be given up to get it.
• Opportunity cost has two components: the things you can’t afford to buy and the things you can’t do with your time.

Choosing at the Margin

• A choice is not all or nothing, but you must decide how many minutes to allocate to each activity.
• To make a choice at the margin, you evaluate the consequences of making incremental changes in the use of your time.
• The benefit from pursuing an incremental increase in an activity is its marginal benefit.
• The opportunity cost of pursuing an incremental increase in an activity is its marginal cost.

Choices Respond to Incentives

• A change in marginal cost or a change in marginal benefit changes the incentives that we face and leads us to change our choice.
• Incentives are also the key to reconciling self-interest and the social interest.

Economics: A Social Science and Policy Tool

• Economists distinguish between two types of statement: positive statements and normative statements.
• A positive statement can be tested by checking it against facts.
• A normative statement expresses an opinion and cannot be tested.

Unscrambling Cause and Effect

• The task of economic science is to discover positive statements that are consistent with what we observe in the world and that enable us to understand how the economic world works.
• Economists create and test economic models.
• An economic model is a description of some aspect of the economic world that includes only those features that are needed for the purpose at hand.

Two Big Economic Questions

• Between 1993 and 2007, the U.S. and global economies expanded strongly, with incomes increasing by 30 percent in the United States and tripling in China.
• The choices of banks to borrow and lend and the choices of people and businesses to lend to and borrow from banks are made in self-interest.

The Six Key Ideas of the Economic Way of Thinking

• A choice is a tradeoff.
• People make rational choices by comparing benefits and costs.
• Benefit is what you gain from something.
• Cost is what you must give up to get something.
• Most choices are “how-much” choices made at the margin.
• Choices respond to incentives.