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ECON 1001 E, F Introduction Part II 1

Introduction n Scarcity and Competition n Opportunity Cost n Cost and Benefit Analysis n Some Common Pitfalls for Decision Makers n Positive Vs. Normative Economics

What is Economics? n Studies allocation of scarce resources among competing ends n for most goods, wants (desires) exceed what is available (limited resources). n Thus, having more of one thing usually means having less of another. People have to make choices. n Studies how agents respond to incentive n Is what economists study

Economics: studying choice in a world of scarcity n The Scarcity Principle, a. k. a. , the No-free-lunch Principle: n Although we have boundless needs and wants, the resources available to us are limited. So having more of one good thing usually means having less of another. n The Cost-Benefit Principle: An individual (or a firm or a society) should take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs

Opportunity Costs n For economists, costs mean opportunity costs or alternative costs. n Opportunity Costs are the best foregone opportunities (or best alternative you otherwise would have chosen) n Cost is important for decision making in economics n Costs and choices are twin (You can’t have one without the other)

Example 1: Opportunity Costs n If you are given a choice of the following three candies free of charge: n I) M&M ($0. 5) n II) Snicker ($0. 7) n III) Nestle Crunch ($1. 0) n What is your opportunity cost if you choose M&M (with no resale option)? (a) $0. 7, (b) $1, (c) Snicker, (d) Nestle Crunch, or (e) not enough information.

Example 2: Opportunity Costs n You have three job offers, they are indifferent to you except for their pay. Here are the offers: n Goldman Sachs $100, 000 n Merrill Lynch $90, 000 n Morgan Stanley $80, 000 n What is your opportunity cost if you take the job at Merrill Lynch? (a) $10, 000, (b) $100, 000 (c) $80, 000, or (d) Not enough information.

Example 3: Opportunity Costs n You won a free ticket to see an Eason Chan concert (which has no resale value). n Andy Lau is performing on the same night and is your next-best alternative activity. Tickets to see Andy cost $40/ticket. n On any given day, you would be willing to pay up to $50 to see Andy. n 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. (Source: http: //www. marginalrevolution. com/marginalrevolution/2005/09/op portunity_cos. html)

Example 4 Opportunity Costs n Paul is a house painter whose roof needs replacing. Ron is a roofer whose house needs painting. n Although Paul is a painter, he also knows how to install roofing. Ron, for his part, knows how to paint houses. n Should Paul roof his own house? Should Ron paint his own house? Paul Ron

Example 4 Opportunity Costs Time required by each to complete each type of job: Painting Roofing Paul 300 hrs 400 hrs Ron 200 hrs 100 hrs

Example 4. Opportunity Costs Painting Roofing Paul 300 hrs 400 hrs Ron 200 hrs 100 hrs Opp. Cost for 1 Painting Opp. Cost for 1 Roofing Paul 0. 75 Roofing 1. 25 Painting Ron 2 Roofing 0. 5 Painting n For Paul, the o. c. of painting one house = the number of roofing jobs he could do during the same time. n So Paul’s o. c. of painting a house is. 75 roofing jobs (=300 hrs per painting/400 hrs per roofing). 11

Cost and Benefit of New Drug Approval n Food and Drug Administration (FDA) decides whether new medicines should be allowed to go on sale in the U. S. n Pregnant mothers that took a sleeping pill called thalidomide caused the birth of 12, 000 deformed infants. n 1962 Kefauver-Harris Amendment passed n Radically increased the drug approval process n Average time between filing and approval of a new drug: 7 months before 1962 and 8 -10 years in 1970 s.

Cost and Benefit of New Drug Approval n Benefit: Increase new drug safety n Cost: delay of new drug approval “killed” patients that could have benefited from the successful new drugs. n Example 1: The five-year lag in introducing Septra (an antibacterial agent) to the US “killed, 100, 000, may be a million people. ” n Example 2: Delay the introduction of a class of drugs called beta blockers for a decade (used to treat heart attack, high blood pressure) “killed” at least 250, 000 Americans

Some Common Pitfalls for Decision Makers Pitfall 1: Measuring cost and benefits as proportions rather than absolute dollar amounts 14

Example: Proportion vs. absolute n Your employer has a travel discount voucher that can be redeemed on one of your next two business trips. n You could use it to save $100 on a $2, 000 plane ticket to Tokyo; or you could save $90 on a $200 plane ticket to Chicago? If your goal is to do what would be best for your company, for which trip should you use the coupon? (a) $90 [a savings of 45% ($90/$200)] (b) $100 [a savings of 5% ($100/$2, 000)] 15

Some Common Pitfalls for Decision Makers Pitfall 2: Ignoring Opportunity Costs n If doing activity x means not being able to do activity y, then the value to you of doing y is an opportunity cost of doing x. n Many people make bad decisions because they tend to ignore the value of such foregone opportunities. 16

Example: Opportunity cost when lending a friend some money? n Suppose a friend lends you $10, 000 free of charge for a year. n She could have put that money in the bank, where it would have earned a market interest rate of 5 percent, or $500 each year. n Thus, the opportunity cost of loaning you the money is $500 interest, the interest that could have been earned elsewhere. If she didn't charge you any interest, it would be the same as giving you a “gift” of $500/yr. 17

Sunk cost n Sunk costs are costs that have already been incurred and which cannot be recovered to any significant degree. 18

Some Common Pitfalls for Decision Makers Pitfall 3: Failure To Ignore Sunk Costs n An opportunity cost will often not seem like a relevant cost when in reality it is. n Another pitfall in decision making is that sometimes an expenditure will seem like a relevant cost when in reality it is not. n The only costs that should influence a decision about whether to take an action are those costs that we can avoid by not taking the action. n Sunk cost is a cost that is beyond recovery at the moment a decision must be made, therefore it does not affect decision making 19

Example: The Pizza Experiment How much should you eat at an all-you-can-eat restaurant? n A local pizza parlor offers an all-you-can-eat lunch for $80. n You pay at the door, and then the waiter brings you as many slices of pizza as you like. n The "waiter" selects half of the tables at random and gave everyone at those tables a $80 refund before taking orders. n If all diners are rational, will there be any difference in the average quantity of food consumed by these two groups? 20

Example: The Pizza Experiment n The $80 admission fee is a sunk cost, and should have no influence on the amount of pizza one eats. n So the two groups should eat the same amount of pizza, on the average. n In fact, however, the group that did not get the refund consumed substantially more pizza. n Is it a pitfall for ignoring sunk cost? 21

Some Common Pitfalls for Decision Makers Pitfall 4: Failure To Understand the Average. Marginal Distinction n Marginal Benefit: The increase in total benefit that results from carrying out one additional unit of an activity. n Average Benefit: The total benefit of undertaking n units of an activity divided by n. n Marginal Cost: The increase in total cost that results from carrying out one additional unit of an activity. n Average Cost: The total cost of undertaking n units of an activity divided by n. 22

Example: Should NASA expand the space shuttle program? n NASA currently makes four launches per year. n Should NASA expand the space shuttle program from four launches per year to five? n Benefits n Total of $24 billion n Average of $6 billion/launch n Costs n Total of $20 billion n Average of $5 billion/launch 23

Example: Should NASA expand the space shuttle program? # of Launches Total Cost Average Cost Marginal Cost ($ billion) ($ billion/launch) 0 0 0 1 3 3 3 4 5 2 3 4 7 12 3. 5 4 8 12 What is the optimal number of launches? 20 5 Assume: Average Benefit = Marginal Benefit = $6 billion 5 32 6. 4 24

Rules for allocating resources n The general rule for allocating a resource efficiently across different production activities is: n Allocate each unit of the resource to the production activity where its marginal benefit is highest. n For a resource that is perfectly divisible, and for activities for which the marginal product of the resource is not always higher in one than in the others, the rule is: n Allocate the resource so that its marginal benefit is the same in every activity. 25

Example Fishing boat allocation n Suppose you own a fishing fleet consisting of a given number of boats, and can send your boats in whatever numbers you wish to either of two ends of an extremely wide lake, east or west. n Where should you send your boats?

Example 1. 16. Fishing boat allocation n Under your current allocation of boats, the ones fishing at the east end return daily with 100 pounds of fish each, while those in the west return daily with 120 pounds each. n The fish populations at each end of the lake are completely independent, and your current yields can be sustained indefinitely. n Average Catch: West End: 120 lbs/boat East End: 100 lbs/boat True or False: If you shift some of your boats from the east end to the west end, you will catch more fish.

Example 1. 17. Should you move one of your boats from the east end to the west end? Currently two boats are sent to the east end and two to the west end. Average output per boat Number of boats East end West end 1 100 lbs/boat 130 lbs/boat 2 100 lbs/boat 120 lbs/boat 3 100 lbs/boat 110 lbs/boat 4 100 lbs/boat

Example 1. 17. Should you move one of your boats from the east end to the west end? Average output per boat Number of boats East end West end 1 100 lbs/boat 130 lbs/boat 2 100 lbs/boat 120 lbs/boat 3 100 lbs/boat 110 lbs/boat 4 100 lbs/boat Number of boats East end West end Total output 2 2 440 lbs 3 1 430 lbs 1 3 430 lbs 4 0 400 lbs 0 4 400 lbs

Example 1. 17. Should you move one of your boats from the east end to the west end? Average output per boat Number of boats East end West end 1 100 lbs/boat 130 lbs/boat 2 100 lbs/boat 120 lbs/boat 3 100 lbs/boat 110 lbs/boat 4 100 lbs/boat Marginal output per boat The n-th boat East end West end 1 100 lbs 130 lbs 2 100 lbs 110 lbs (= 240 -130) 3 100 lbs 90 lbs (=330 -240) 4 100 lbs 70 lbs (400 -330)

Rules for allocating resources n The general rule for allocating a resource efficiently across different production activities is: n Allocate each unit of the resource to the production activity where its marginal benefit is highest. n For a resource that is perfectly divisible, and for activities for which the marginal product of the resource is not always higher in one than in the others, the rule is: n Allocate the resource so that its marginal benefit is the same in every activity.

Positive Economics n Positive statements are statements that can be classified as either true or false n Offer TESTABLE implications (or refutable hypotheses): If A, then B n If “A and not B”, then reject the null hypothesis n Positive Economics addresses question likes “If this, then that” form of analysis n Increase the minimum wage raises unemployment rate among young and unskilled workers n “Three strikes and you are out” reduces crime

Positive Economics n It involves NO value judgments. n It does not comment on the result of the analysis. Whether the result is “good” or “bad” to the society is none of the business of positive economics analysis. n Do not let your own values direct your analysis in positive economics.

Normative Economics n Normative economics address questions likes “what should be done” or “what ought to be done” n Contains basis for deciding what is good or bad (value judgment). n Examples n. The distribution of income should be more equal n. Antitrust laws should be used vigorously to reduce monopoly.