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?