c ost and p rices opportunity cost & incentives. h ow d o y ou k now w hen scarcity forces you...
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COST AND COST AND PRICES PRICES
Opportunity Cost & Incentives
HOW DO YOU KNOW WHEN
Scarcity Forces You to CHOOSE
Something Is Scarce?
SCARCITY CHOICE
OPPORTUNITY COST: THE VALUE OF THE NEXT BEST OR FOREGONE ALTERNATIVE
Think: “next-best”
OPPORTUNITY COST ANALYSIS
What was the 1st decision you made this morning?
OPPORTUNITY COST ANALYSIS
Alternatives: Get Up Now Don’t Get Up Now
Perceived Benefits
ChoiceOpp. Cost
Benefits Refused
Decision Maker: YOU
OPPORTUNITY COST ANALYSIS
Alternatives: Get Up Now Don’t Get Up Now
Perceived Benefits
Shower Breakfast don’t rushOn time Starbucks
ChoiceOpp. Cost
Benefits Refused
Decision Maker: YOU
More sleep
OPPORTUNITY COST ANALYSIS
Alternatives: Get Up Now Don’t Get Up Now
Perceived Benefits
Shower Breakfast don’t rushOn time Starbucks
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.
Who got up this morning and had breakfast? What was the opportunity cost you paid in order
to get one?
CHARACTERISTICS OF COST
Costs are the results of ACTIONSAll costs lie in the FUTURE (past costs are
“sunk” costs)Sunk costs are costs that have already been
incurred and which cannot be recovered. They should not be considered when making decisions.
Costs can be monetary ($) or non-monetary, but are frequently non-monetary (although we may value them in dollar terms)
WHAT DETERMINES YOUROPPORTUNITY COST?
Alternatives Tastes and
preferences (values)
Utility – usefulness of a product
Utility can vary from person to person
Rules of the Game: Institutions
DO GOV’T ACTIONS HAVE OPPORTUNITY COSTS?
Government Debt Economic Stimulus Package War in Afghanistan Limiting Carbon Emissions Universal Healthcare
All alternatives have cost and benefitsIndividuals perceive the value of costs and benefits
differently
SHOULD WESHOULD WEALLOCATE?ALLOCATE? RATION? RATION?
Given that we MUST ration, what is the best mechanism?
Back to Scarcity:
ALLOCATING/RATIONING ICE CREAM:
What Determines YourOpportunity Cost?
• Alternatives• Tastes and
preferences (values)
• Rules of the Game: Institutions
WHAT ARE THE METHODS OF RATIONING WHAT ARE THE METHODS OF RATIONING SCARCE GOODS AND SERVICES?SCARCE GOODS 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
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 clear2.2. Individuals can affect the outcome based Individuals can affect the outcome based
on their desire for the producton their desire for the product3.3. It directs resources to their most highly It directs resources to their most highly
valued usesvalued uses4.4. Individuals’ power and freedom is Individuals’ power and freedom is
enhancedenhanced5.5. It provides incentives for both consumers It provides incentives for both consumers
and producers to reduce scarcity.and producers to reduce scarcity.
WHERE DO PRICES COME FROM? The market interaction of buyers and sellers
in open and competitive markets!
PRICES: POWERFUL INCENTIVES
When prices change, opportunity costs change –that’s an incentive!
Both consumers and producers react to prices in ways that help us to deal with scarcity.
WHEN INCENTIVES (PRICES) CHANGE, BEHAVIOR CHANGES IN PREDICTABLE WAYS.
When prices go up, consumers demand a larger or smaller quantity?
Demand
The willingness and ability to purchase goods and services at various prices.
WHEN INCENTIVES (PRICES) CHANGE, BEHAVIOR CHANGES IN PREDICTABLE WAYS. When prices go up, consumers demand
a larger or smaller quantity? Smaller
When prices go down consumers demand a larger or smaller quantity?
Larger Always?Law of Demand P QD
WHEN INCENTIVES (PRICES) CHANGE, BEHAVIOR CHANGES IN PREDICTABLE WAYS.
When prices go up producers supply a larger or smaller quantity?
Supply
Producers willingness and ability to produce goods and services at various prices.
WHEN INCENTIVES (PRICES) CHANGE, BEHAVIOR CHANGES IN PREDICTABLE WAYS. When prices go up, producers supply a
larger or smaller quantity? Larger
When prices go down, producers supply a larger or smaller quantity?
Smaller
Always?Law of Supply P QS
WHAT DOES OPPORTUNITY COST HAVE TO DO WITH SUPPLY AND DEMAND?
Everything!
CHOICES ARE MADE AT THE MARGINOur only choice is the next choiceOur only choice is the next choice
Marginal = additional, next, a little more or a Marginal = additional, next, a little more or a little lesslittle less
Remember: Sunk costs are costs that have already been incurred and which cannot be recovered. They should not be considered when making decisions.
* * Economics of Seinfeld: The opposite: Look Economics of Seinfeld: The opposite: Look for the sunk cost and thinking on the for the sunk cost and thinking on the margin: margin:
HOW MUCH SHOULD WE DO?
Work Play Study Sleep Buy Sell
CHOICES ARE MADE AT THE MARGIN
Our only choice is the next Our only choice is the next choicechoice
Marginal = additional, next, a little Marginal = additional, next, a little more or a little lessmore or a little less
MARGINAL COST = COST OF NEXT ACTION, CHOICE, UNIT OF PRODUCTION
Marginal Benefit = benefit of the next
Action, Choice, Unit of production
As long as the marginal benefit is greater than the marginal cost you should continue the activity
MB=MCMB=MC
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.
Another way of putting it…
THE “BIG IDEAS” FROM LESSON 2:1. Scarcity forces us to choose and every choice has
an opportunity cost.2. When opportunity costs change, incentives change,
and choices change.3. Because costs lie in the future, the important costs
and benefits occur at the margin. (Think Elaine and her jujubes
4. Money price ($) rations goods in markets.5. Consumers and producers respond to changes in
price in predictable ways.
I have with me at this EFL program a new Dell Vostro 13 Notebook computer. It has 13” screen, 650 GB hard drive, 4 GB Ram, i7 processor, windows 7, internal wireless, etc.Questions:
It is mine. How much money would you give me for the computer? (You have until the end of the week to come up with the cash) ________
I have applied for a grant to study cigarette tax policies across the different states of the United States. To perform this project punctually, I will probably have to hire some research assistants. This work will have to be performed during the next 30 days. (at your home) The work will include data collection, research, and data coding.Questions:
2.How many hours would you work total over that time period?(next 30 days) if I paid you $35 per hour
3. I will probably undertake the project even if I do not get thegrant. How many hours would you be willing to work if I paid you $10 per hour?