Economics for Leaders Lesson 2: Opportunity Cost & Incentives

Economics for Leaders


Lesson 2: Opportunity Cost & Incentives


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InstructionsEat the Reese’s one at a time

Each time you finish one, write down your overall level of satisfaction from eating that cup– use a scale of 1 – 10

• 10 = highest; 1 = lowest

You may eat as many as you like,– once you stop eating, you may not

consume any more


Begin Eating

&

Record Level of Satisfaction

(1-10)


Control AIDS

Control malaria

Guest-worker programs for unskilled

Improve infant/child nutrition

Improve health benefits

Kyoto Protocol for environmental protection

Lower cost of starting new business

Lower barriers to migration of skilled workers

U.N. Identified World Challenges


World Challenges (continued)

Micronutrients

New agricultural technologies

Reduce low birth weight

Small-scale water technology

Sanitation

Trade liberalization

Water productivity in food production


Copenhagen Consensus

List of global challenges identified by U.N.

8 top economists in world• three Nobel Laureates in Economic Science

Task: rank order in terms of benefits & costs

• where should world spend $ most productively?


• Why not do all?

• Scarcity

Choice

All $50B spent


Key Economic Proposition

Scarcity necessitates choice


Economic Reasoning Principle #1: People choose, and individual choices are the source of social outcomes.

Scarcity necessitates choices


The poverty of some nations and the wealth of others is not an accident; it is the result of

choices


How Do You Know When

Scarcity Forces You to CHOOSE

Something Is Scarce?

SCARCITY CHOICE


Economic Reasoning Principle # 2: Choices impose costs; people receive benefits and incur costs when they make decisions.

The cost of a choice is the value of the next-best alternative foregone.


Opportunity Cost =the value of

the Next-Best Alternative– What are the considered alternatives?

• What would you choose – not what could you choose?

• What does the decision-maker perceive to be the benefits of each alternative?


The Cost of Something Is What You Give Up to Get It

Should Tiger Woods do his own yard work?Should Yao Ming do his own house-work?What else could they do? …


Opportunity Cost Analysis

What was the 1st decision you made this morning?



Alternatives: Get Up Now Don’t Get Up Now

Perceived Benefits

ChoiceOpp. Cost

Benefits Refused

Decision Maker: YOU




Perceived Benefits

Shower bkfst don’t rushOn time coffee

ChoiceOpp. Cost

Benefits Refused

Decision Maker: YOU

More sleep




Perceived Benefits

Shower bkfst don’t rushOn time coffee

Choice X

Opp. Cost

Benefits Refused

Decision Maker: YOU

More sleep

X


Choosing is Refusing

Every time we choose we pay a cost.


People’s Choices are always RATIONAL

Rational choice = choosing the alternative that has the greatest excess of benefits over costs.If ALL choices are rational, then the challenge is to understand the decision-maker’s perception of costs and benefits.



Characteristics of Cost:Costs are “to” someone.Costs are the results of actions.Costs relevant to decision making lie in the future.– Past costs (also known as “sunk” costs)

are not important to decisions– Example: Do you consider the cost of a

movie ticket in whether you sit though to the end of a really bad movie?

Costs are frequently not monetary (although we may value them in dollar terms)


What Determines YourOpportunity Cost?

AlternativesTastes and preferences (values)Rules of the Game--Institutions


Do Gov’t actions have opportunity costs?

Government DebtEconomic Stimulus PackageWar in IraqLimiting Carbon EmissionsUniversal Healthcare

All alternatives have cost and benefitsIndividuals perceive the value of costs and benefits differently


Once, after giving a talk, I was confronted by a lady in the audience who asked what some people regard as the ultimate question:

"What is YOUR solution?“

"There are no solutions," I said. "There are only trade-offs.“

"The people DEMAND solutions!" she shot back angrily.

The people can demand square circles if they want. But that doesn't mean that they will get them.

Quote From Thomas Sowell

Opportunity Cost!


Because costs lie in the future, choices are made at

the MARGIN


Choices are made at the “margin”

Marginal: additional, next, a little more or a little lessSometimes the “margin” is large & lumpy– Come to EFL or not

Sometimes the “margin” is small & smooth– Eat one more Butterfinger or not


A simple exampleWhen the price of gas went from $2/gal. to $4/gal, almost no one stopped driving– “To drive or not to drive” was not the question

Does this mean the price of gas has no influence over driving decisions?NO! Almost everyone made any of a series of small adjustments at the margin– Fewer trips, more buses, bikes, & car-pooling,

slower acceleration, more coasting, etc.

“All or nothing” is almost never the margin


All-or-Nothing vs. MarginalSuppose you must clean your room– What do you clean first?

• Clothes and other “stuff”– under the bed, in the closet,– or in the clothes hamper?

– What’s next?• Make the bed• Vacuum

– under the bed and dresser?– under the carpet?

• Dust– where? – over the door ledge?


A Dollar Auction GameYou are about to participate in an ascending price, (oral) auction for a one-dollar bill. The person with the highest bid will win the dollar and pay the price bid. The second-highest bidder will pay the amount of his or her final bid. Only the highest bidder receives the dollar.


Dollar Auction continued

Bids must be given in 10-cent increments with the opening bid starting at 25 cents.

When all bidding stops, the auctioneer will give the dollar bill to the highest bidder for the amount bid.

The person with the second-highest bid will pay the auctioneer his or her highest bid, but does not receive the dollar.


Do X (X = bid 10 cents)

Total Cost $0.95 0.10 $1.05

Not do X (X = bid 10 cents)

Total Cost $0.95 0 $0.95

Suppose _____’s last bid is $0.95, but leading bidder is at $1.00

A Rational Approach to Bidding

Sunk Cost

MC = $0.10

Marginal benefit (MB) = chance at $1.00

If expected MB > $0.10 = MC, then rational person chooses to do X.

Sunk cost correctly ignored.


How much should we do?

WorkPlayStudySleepBuySell


Choices Are Made At The MARGIN……More Soda?

__________ Costs?

Source: The Onion


As long as the marginal benefit is greater than the marginal cost you should continue the activity…

MB>MCDo it!


Should weShould weAllocate?Allocate? ration? ration?

In a world of scarcity, wants exceed available resources…There is no alternative to rationing…The relevant question, what is the best mechanism?

Back to Scarcity: What’s the Question?



Allocating/Rationing?


Methods of Rationing Scarce Methods of Rationing Scarce Goods and ServicesGoods and Services

pricesprices

command command (someone decides)(someone decides)

majority rulemajority rule

contestscontests

by forceby force

votingvoting

first-come-first-first-come-first-servedserved

sharing equallysharing equally

lotterylottery

personal personal characteristicscharacteristics

need or meritneed or merit

BEST? Depends…


Broad Social Goals

What do we want your economy to provide for the citizens?

What is it you want the economy to do for society?

What criteria would you use in your evaluation economic systems?


Tradeoffs: Improve One Goal, May Reduce Another

Example: Higher taxes to finance welfare programs for poor

Promote economic equity

B(X)

Reduce economic freedom

→ reduce economic growth

C(X)


Why Markets

Voluntary TradeCreates Wealth!


Why is price rationing the most common method of allocating scarce goods, services, and resources in our

economy?1.1. The outcome is clearThe outcome is clear

2.2. Individuals can affect the outcome based Individuals can affect the outcome based on their desire for the producton their desire for the product

3.3. It directs resources to their most highly It directs resources to their most highly valued usesvalued uses

4.4. Individuals’ power and freedom is Individuals’ power and freedom is enhancedenhanced

5.5. It provides incentives for both consumers It provides incentives for both consumers and producers to reduce scarcity.and producers to reduce scarcity.


Economic Reasoning Principle # 3: People respond to incentives in predictable ways.

INCENTIVESthe rewards or penalties that shape people’s behaviormay be negative or positive.may be monetary or non-monetary


Intended Consequences

• If people respond to incentives . . .

– then behavior can be altered in desired or intended ways

– For example …


The Tax Man Cometh

April 15, 1987 . . . – IRS rule change:

• Instead of merely listing each dependent child, tax filers required to provide Social Security number.

Result?

7 million children disappeared


However . . . Unintended Consequences

• If people respond to incentives . . .

– then behavior may result in undesirable or unexpected outcomes

– For example …


The Camel Race

Two Bedouins met in the desert, and fell into an argument over their camels, each claiming that his was the slowest, “stubbornest,” most useless camel in all of Arabia. The argument ended in a bet. They agreed to race to the oasis, two miles away, whichever camel arrived last would be proved slowest, and his owner would win ten dirham from the other.


Camel Race continued

. . . They got on their camels, and set off slowly toward the oasis. More slowly, still more slowly. After a while, it became clear that since each Bedouin was trying to win the bet, they were never going to make it to the oasis.

. . . After a while, a wise sheik rode up on a donkey and asked them why they and their camels were standing still, in the middle of the desert, on a hot day, with the oasis less than two miles away.


The Camel Racecontinued

They got off their camels, and all three sat down in the shade of a rock while the two Bedouins explained about their bet. The wise sheik whispered two words to them. The Bedouins immediately jumped on the camels and rode off as fast as they could towards the oasis. What were the 2 words?

________ _________

Switch camels!


Consequences

People respond to incentives causing…INTENDED consequences &

UNINTENDED consequences.(can offset the intended benefits)


Ideas to Take Away from Lesson 2:

Scarcity forces us to choose and every choice has an opportunity cost.Changing opportunity costs affect incentives and choices.Because costs lie in the future, the relevant costs and benefits occur at the margin.Open markets are a key institution for fostering economic growth and improving standards of living.


(cont.)

Price is a powerful incentive. The law of supply and the law of demand describe producers’ and consumers’ predictable reactions to changes in price.Buyers’ and sellers’ decisions about quantity demanded and quantity supplied are affected by opportunity costs.


Negotiating with the Dentist

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Economics for Leaders Lesson 2: Opportunity Cost & Incentives