Chapter 1 Thinking Like An Economist

Chapter 1, Opportunity Cost Q.1Edmond, Gary and Eason are your classmate in Economics class. On Valentine’s Day, each one of them ask you out at the same time. You are now facing 3 choices: 1) watch an opera with Edmond, 2) watch a concert with Gary or 3) dine out with Eason. Your choice of dating depending on the degree of handsomeness among the three. From your point of view, Edmond is very handsome; Gary is average; Eason is ugly. Obviously, you prefer 1) than 2) and 2) than 3). Your opportunity cost to go out with Edmond is,a. Watch a concert with Garyb. Dine out with Easonc. Watch a concert with Gary and Dine

out with Eason

• Opportunity cost: the dollar value of your next best alternative forgo in order to take certain activity

• It is not the combined value of all possible activities, only the value of your next best alternative

• It depends on how individual rank their choices, based on their preferences

Chapter 1, Opportunity Cost (Q.1)

Chapter 1, Opportunity Cost (Q.1)Edmond, Gary and Eason are your classmate in Economics class. On Valentine’s Day, each one of them ask you out at the same time. You are now facing 3 choices: 1) watch an opera with Edmond, 2) watch a concert with Gary or 3) dine out with Eason. Your choice of dating depending on the degree of handsomeness among the three. From your point of view, Edmond is very handsome; Gary is average; Eason is ugly. Obviously, you prefer 1) than 2) and 2) than 3). Your opportunity cost to go out with Edmond is,a. Watch a concert with Garyb. Dine out with Easonc. Watch a concert with Gary and Dine

out with Eason

• You won a free ticket to see an Eason Chan concert (which has no resale value).

• Andy Lau is performing on the same night and is your next-best alternative activity. Ticket to see Andy costs $40/ticket.

• On any given day, you would be willing to pay up to $50 to see Andy.

• Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing the Eason Chan concert? (a) $0, (b) $10, (c) $40, or (d) $50.

Chapter 1, Opportunity Cost (Q.2)

• Opportunity cost, by definition, the opportunity cost of an activity is the value of what must be forgone in order to undertake the activity.

• In other words, the opportunity cost to watch Eason’s concert is to forgo the “net benefit” you will get by watching Andy’s.

What is the “net benefit” of watching Andy’s?

“On any given day, you would be willing to pay up to $50 to see Andy.”

• Willingness to pay reflects how much you could benefit from the action or how much does it worth to you express in dollar term

• In this case, by watching Andy’s concert will give you $50 worth of enjoyment

• “Ticket to see Andy costs $40/ticket.”

• Therefore, the “net benefit” is $50 - $40 = $10• This is your opportunity cost must be forgone by watching Eason

Chan concert• Ans. (b)

Chapter 1, Opportunity Cost (Q.2)

• You won a free ticket to see an Eason Chan concert (which has no resale value).

• Andy Lau is performing on the same night and is your next-best alternative activity.

• On any given day, you would be willing to pay up to $50 to see Andy.

• Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing the Eason Chan concert? (a) $0, (b) $10, (c) $40, or (d) $50.

Chapter 1, Opportunity Cost (Q.3)

Ans: (d)

• You won a free ticket to see an Eason Chan concert (which has no resale value).

• Andy Lau is performing on the same night and is your next-best alternative activity.

• Ticket to see Andy costs $50.• On any given day, you would be willing to pay up to $50 to

see Andy. • Assume there are no other costs of seeing either performer.

Based on this information, what is the opportunity cost of seeing the Eason Chan concert? (a) $0, (b) $10, (c) $40, or (d) $50.

Chapter 1, Opportunity Cost (Q.4)

Ans: (a)

• You own and manage your own fruit stand. You can grow your own apples to sell as shown in the following table, or you can buy apples to sell at $0.2 per pound. For every hour you work growing apples, you must pay someone $6 per hour to run the fruit stand.

• How much time will you spend growing apples?

Chapter 1, Additional Question 1

Hours worked Total Pounds of Apple0 0

5 200

10 400

15 500

20 620

25 680

30 700

35 720

40 730

• To find the answer, you will need to apply the ‘Cost-Benefit’ Principle.

• To determine how many hours to work on growing apples, find i) MARGINAL COST of each ‘5 Hour’ unit spent on growing applesii) MARGINAL BENEFIT of each ‘5 Hour’ unit

• The optimal amount of hours to work on growing apples is at the point when MB>MC

• That is, we continue to spend the extra 5 hours as long as MB > MC. Stop otherwise

Solution to Chapter 1, Additional Question

• Calculating Marginal Cost of growing apples.• Bear in mind that the timescale on growing apples is

calculated in ‘5 hour’ units. • So to find MC is to calculate the extra cost incurred in 1 more

‘5 hour’ unit of growing apples.• In this case, when you work on the farm for 5 hours, you have

to pay someone $6/hr, you are giving up $6 x 5hrs, which is $30.

• In this question, MC is the same for all ‘5 hour’ units.• Adding this to the table…

Solution to Chapter 1, Additional Question

Hours worked

Total Pounds of Apple Marginal Cost

($)

0 0 -

5 200 30

10 400 30

15 500 30

20 620 30

25 680 30

30 700 30

35 720 30

40 730 30

Solution to Chapter 1, Additional Question

• Calculate the MARGINAL BENEFIT of each ‘5 hour’ unit.

• The benefit from growing apples is the $.20 per pound of apples saved by growing them rather than purchasing them.

• For each extra unit of work, there is an extra number of apples grown.

• For the first ‘5 hours’ of work, we get 200 apples. Total amount saved 200 apples x $.20 per pound

• For the second ‘5 hours’ of work, number of apples increases by 400 – 200 = 200.Total amount saved 200 apples x $.20 per pound

• Adding to the table…

Solution to Chapter 1, Additional Question

Hours worked

Total Pounds of Apple

Marginal Benefit

($)

Marginal Cost

($)

0 0 - -

5 200 40 30

10 400 40 30

15 500 20 30

20 620 24 30

25 680 12 30

30 700 4 30

35 720 4 30

40 730 2 30

Solution to Chapter 1, Additional Question

• The optimal time on growing apples is at the point where MB > MC.

• The optimal amount of time is therefore working 10 hours on apples.

• Because the 10th – 15th unit will result in a loss (MC > MB)

Solution to Chapter 1, Additional Question

Chapter 1, Problem 3

Residents of your city are charged a fixed weekly fee of $6 for garbage collection. They are allowed to put out as many cans as they wish. The average household disposes of three cans of garbage per week under this plan.

Now suppose that your city changes to a “tag” system. Each can of refuse to be collected must have a tag affixed to it. The tags cost $2 each and are not reusable.

What effect do you think the introduction of the tag system will have on the total quantity of garbage collected in your city? Explain briefly.

Solution to Problem 3 (1)• Initially the city has imposed a lump-sum fee of $6 per week for

garbage collection– No garbage = $6– 1 bag of garbage = $6– 2 bags of garbage =$6…– Pay $6 regardless the number of garbage bag disposes– Extra cost of an additional bag of garbage =$0

• Now the city imposes a pay-as-you-go fee for garbage collection called “tag system.” $2 for each tag.– No garbage =$0– 1 bag of garbage =$2– 2 bags of garbage =$4…– Extra cost of an additional tag (bag of garbage) =$2

Solution to Problem 3 (2)

• The initial plan is more favourable to residents who have so much garbage

• The current plan is more favourable to residents who have less garbage

Initial plan (lump-sum)

Current Plan(Pay-as-you-

go)

2 bags = $6 2 bags = $4

3 bags = $6 3 bags = $6

4 bags = $6 4 bags = $8

5 bags = $6 5 bags = $10

6 bags = $6 6 bags = $12

Solution to Problem 3 (3)

• Suppose now the pay-as-you-go plan is effective, residents who discharge less garbage are favoured

• All residents are now induced to reducing their garbage so as to avoid the marginal cost of disposal of $2 for which it was initially zero

• The total quantity of garbage collected will decrease• The new garbage disposal system functions well in

reducing amount of garbage which in turn produces a positive impact on the environment

You and your friend Joe have identical tastes. At 2pm, you go to the local Ticketmaster outlet and buy a $30 ticket to a basketball game to be played that night in Syracuse, 50 miles north of your home in Ithaca.

Joe plans to attend the same game, but because he cannot get to the Ticketmaster outlet, he plans to buy his ticket at the game. Tickets sold at the game cost only $25, because they carry no Ticketmaster surcharge. (Many people nonetheless pay the higher price at Ticketmaster, to be sure of getting good seats.) At 4pm, an unexpected snowstorm begins, making the prospect of the drive to Syracuse much less attractive than before (but assuring the availability of good seats). If both you and Joe are rational, is one of you more likely to attend the game than the other?

Chapter 1, Problem 8

• You:- You buy the ticket from Ticketmaster outlet, so $30 is sunk cost. You have already paid this price and cannot recover. You should not consider this as your cost of not going to the game.

- In deciding whether to see the game, you should compare the benefit to see the game with the additional cost to attend this game.

- That is, the opportunity cost of your time and whatever cost you assign to driving through the snowstorm.

Solution to Problem 8 (1)

• Joe:-The opportunity cost to attend the game is,-The opportunity cost of Joe’s time and whatever cost Joe assigns to driving through the snowstorm PLUS the ticket price. Since, he buys the ticket at door and he needs to spend $25 if he attends the game.- Therefore, the costs to Joe to attend the game is $25 higher than your cost to attend the game.

- the benefit to attend the games are the same for the two. Thus, Joe is more likely not to attend the game.

- Note: You may think the cost of seeing the game is higher for you since your ticket costs is $30 and only $25 for Joe. However, when deciding whether to make the drive, the $25 is a relevant cost for Joe, whereas your $30 is a sunk cost and is irrelevant to you.

Solution to Problem 8 (2)

Chapter 1, Problem 9• For each long-distance call anywhere in the

continental United States, a new phone service will charge users 30 cents per minute for the first 2 minutes and 2 cents per minute for additional minutes in each call.

• Tom’s current phone service charges 10 cents per minute for all calls, and his calls are never shorter than 7 minutes. If Tom’s dorm switches to the new phone service, what will happen to the average length of his calls?

Solution to Problem 9 (1)

• If Tom talks exactly 7 minutes, -- Both service plans charge exactly the same amount - $0.70 for seven minutes

• If Tom talks beyond 7 minutes,– Under the current service plan, the marginal cost is $0.10 per

minute– Under the new service plan, the marginal cost is only $0.02 per

minute• Since Tom never talks on phone shorter than seven

minutes, he will be benefited from a new lower marginal cost under the new service plan

New Plan Current Plan

1st two minutes $0.30 per minute $0.10 per minute

Next two minutes $0.02 per minute $0.10 per minute

Solution to Problem 9 (2)

• Suppose the new service plan is now effective. Will Tom change his behaviour?– A lower marginal cost will encourage Tom to talk

longer under the new phone service plan.

End of Chapter 1