The Five Foundations of Economics Incentives matter Life is about trade-offs Opportunity costs Marginal thinking Trade creates value Lecture notes: The rest of this chapter will discuss each of the five foundations in detail.

1. Incentives Matter Incentives Positive incentives Factors that motivate you to act or exert effort People respond to incentives! Positive incentives Tax refund, pay raise, employee of the month award, sticker and a smiley face, extra credit Negative incentives Taxes, jail, fees, fines, spankings, getting grounded, getting fired, failing class Lecture tips: Instructors: Do you give attendance quizzes? If so, you can ask students why they come to class. Possible answers include getting a good grade, not wanting to fail, wanting to get easy attendance points, etc. If you DIDN’T offer attendance points, maybe your attendance in class would be lower!

Direct and Indirect Incentives Generally easy to recognize “Do my yard work and I’ll give you $40” “Get straight A’s and I’ll give you $500” Indirect incentives (using second example) Maybe the child now has been given an indirect incentive to cheat! Another indirect incentive: don’t get involved in extracurricular activities. Lecture notes: Direct incentives: “Here is what I want you to do, and here is what I am going to do in order to get you to do it.” Indirect incentives: You can think of an indirect incentive as a secondary change in behavior that was brought about by the original incentive. See the next slide about “unintended consequences.” Maybe the parents are trying to get the kid to study more, but they don’t necessarily want him to quit clubs and sports to do so. They certainly don’t want him cheating either!

Unintended Consequences An unplanned result (usually negative and unwanted) of an incentive Example: social safety net Most agree that we need a safety net for those without employment or low income However, what if the money from the safety net is higher than he can make at a job? Indirect incentive to stay on welfare rather than work! Lecture notes: Society has a direct incentive to alleviate poverty and suffering. Less poverty and suffering = lower crime, better health. However, does a safety net give people an incentive to stay on welfare rather than work? For example, imagine you are low-skilled and out of work: You could get a full-time low-wage job and get $400 per week. You could remain on welfare, and get $450 per week and not work.

Incentives and Innovation Patents and copyrights Incentives to innovate Why work hard, bear all costs (time and monetary) if someone could just steal your idea for profit? Result of a strong patent system? More innovation, since people are rewarded for new popular inventions Innovation  economic growth, higher standards of living But … those big, greedy pharmaceutical companies! Lecture notes: It’s not that new inventions are always the result of someone looking to get rich. Many times, it’s just people finding a better (or faster or cheaper) way to get things done, or someone making a great new product. However, we want to reward people when this happens. Rewarding innovation is a way to guarantee that innovation will continue to happen in the future. How would you like it if you spent years of your own money, blood, sweat, and tears on a great idea, only to have someone steal your ideas one month after you start selling it? You may never innovate again! Last bullet: It may take a lot of time, effort, and expense to develop new medicines. Sometimes, they have to have over 10,000 people in drug studies. If the drug really works, a company can enjoy a patent on the drug for 20 years before generics are made. Suppose a cure for cancer is finally discovered. Don’t you think we ought to reward the person or company that invented the cure? Or inversely, do you think that a possible monetary reward makes some people work harder to find a cure? The answer to both questions is probably yes.

2. Life is About Trade-offs With scarcity, decisions incur costs Individual examples Go to theater: do I watch the action movie or the romantic comedy? Go to food court: do I eat at Sbarro’s or Fuji Garden? After high school: do I attend Ohio State or Michigan? Which president do I vote for? Lecture notes: We can’t see both movies in the same night. We can’t go to both universities. We can’t vote for both candidates.

Trade-offs and Policy Governments face trade-offs as well Spend tax dollars on education or the highway system? Should we penalize polluting companies? Gain: cleaner air, better health Loss: less industry, higher prices in some sectors? Different cultures may have different values. Often depends on wealth. Lecture notes: In more developed countries, higher standards of living already exist, and the cost of pollution control will not cause the economy’s growth to slow down to unacceptable levels. People in these countries are much less likely to accept more pollution in order to raise the level of income even further. In less developed countries, where income is already very low, people are generally not willing to give up what little income they have in order to have cleaner air and water.

Scarcity  Choice  Opportunity Cost The highest-valued alternative that must be sacrificed in order to get something else Not all alternatives, just the next best choice In economics: The cost of something is what you give up to get it Scarcity  Choice  Opportunity Cost Lecture notes: Every time we make a choice, we experience an opportunity cost. The key to making the best possible decision is to minimize your opportunity cost by selecting the option that gives you the largest benefit.

4. Marginal Thinking Economic thinking Marginal thinking Systematically evaluating a course of action Requires a purposeful evaluation of available opportunities to make the best decision Marginal thinking Evaluate whether the benefit of one more unit of something is greater than the cost Margin examples: one more unit (slice of pizza), one more hour of activity (studying, sleeping) Lecture notes: Marginal thinking can be quite challenging, but understanding how to analyze decisions at the margin is essential to becoming a good economist. Think of marginal as examining decisions “one step at a time.” How much benefit will ONE more hour of sleep give me? What do I give up by sleeping one more hour? In other words, what are the costs of sleeping for one more hour?

Marginal Thinking Example Suppose you are vacuuming your living room. Will you move the couch and china cabinet to vacuum underneath them? Marginal benefits A small additional amount of carpet is cleaned Marginal costs Vacuuming now takes more time and effort Cost-benefit analysis at the margin Do the action (move furniture) only if the marginal benefits are greater than the marginal costs Depends on your valuation of the clean room and the time and effort it takes you to move the furniture Lecture notes: So what’s the answer? Should you move the furniture? Answer: It depends. Different people will have different answers! Perhaps a person with strong preferences for a spotless home will gain a large benefit from knowing that every square inch of the carpet is cleaned. Perhaps you are a strong individual (or have a friend), and the furniture can be moved at a low cost. Or, maybe the carpet is extremely dirty under the furniture, and the benefits of cleaning it would be large. In either of these cases, the decision could be rationally made to move the furniture. On the other side . . . Maybe you don’t care if there is a little dust under the couch. Maybe you don’t have a friend to help easily move the furniture. Maybe the carpet isn’t that dirty under the cabinet, so cleaning it would yield a low benefit. In either of these cases, the cost-benefit marginal analysis will rationally tell you to not move the furniture. The costs are greater than the benefits.

Is Going to College Worth It? Let’s examine a college education using opportunity costs and marginal thinking. We often hear people (especially politicians!) say phrases like the following: College graduates earn $1 million more in their lifetimes than high school grads. Everyone should go to college. College will benefit everyone. We expect all our nation’s children to go to college. “Beyond the Book” Slide The first statement is a statistic skewed from selection bias (beyond the scope of this course). The other statements are normative statements (see the next chapter). Ask your students if they’ve heard some of these statements (or something similar).

Is Going to College Worth It? Difficult question: Are the benefits of college greater than the costs of college for everybody? Think about this: some may have big direct costs or opportunity costs; others will have a small benefit. Answer: If the answer to the previous question is “no,” then not everyone should go to college. Economists would disagree with such blanket statements as “everyone will benefit from a college education.” “Beyond the Book” Slide Should Lebron James or Bill Gates have gone to college? No, they would have given up huge earnings. Not worth it for them. We’re not all superstars like Lebron or Bill Gates, but we all should make this choice; we all need to think of our OWN costs and benefits. Suppose you could take over a crab-fishing boat and earn $96,000 per year. Would you want to give up four years of that income to go to college? Could you earn more than that by doing a different career after college? Or, suppose you took some technical and shop classes in high school and got a job offer to be a welder making $65,000 per year. Does college still sound as appealing? For some people, college will just bring debt and heartache. Other people will greatly benefit, and college is right for them.

Is Going to College Worth It? Other non-monetary benefits of college Statistically not as likely to be hit by unemployment during rough economy 9.7% versus 5.2% for H.S. and Bachelor degree unemployment in 2009 College-grad jobs may have better hours, better working conditions Sense of accomplishment Education leads to positive externalities (benefits to others) “Beyond the Book” Slide Previously, we just looked at the monetary earning effects of college. Here are other benefits.

5. Trade Creates Value Markets Trade Bring buyers and sellers together to exchange goods and services Trade The voluntary exchange of goods and services between two or more parties Key word = voluntary You don’t engage in trade if it makes you worse off; therefore, trade only occurs if both parties feel they gain from the trade! Lecture notes: Markets bring trading partners together and help to create order out of chaos. Markets have grown from infrequent gatherings, where exchange was done by trading goods and services for other goods and services, into more sophisticated systems that use cash, credit, and other financial instruments. Markets don’t have to be a physical place: think Amazon, eBay, and Craigslist. Trade (from the text) Voluntary trade among rational individuals is beneficial to everyone involved. Imagine you are on your way home from class and you want to pick up a gallon of milk. You know that milk will be more expensive at a convenience store than it will be at the grocery store five miles away, but you are in a hurry to study for your economics exam and are willing to pay up to $5 for the convenience of getting it quickly. At the store, you find that the price is $4 and you happily purchase the milk. This ability to buy for less than the price you are willing to pay provides a positive incentive to make the purchase. But what about the seller? If the store owner paid $3 to buy the milk from a supplier, and you are willing to pay the $4 price that he has set in order to make a profit, the store owner has an incentive to sell. This simple voluntary transaction has made both sides better off.

Comparative Advantage Without trade, you would have to produce everything you consume. You would have to make your own food, clothing, housing, and electronics. You would have to do all your own services as well (hair-cutting, plumbing, dentistry, education) Comparative advantage The situation in which an individual, business, or country can produce at a lower opportunity cost than a competitor Allows gains from trade to occur Lecture notes: By fostering the exchange of goods, trade helps to create additional growth through specialization. Comparative advantage harnesses the power of specialization. As a result, it is possible to be a physician, teacher, or plumber and not worry about how to do everything yourself. The physician becomes proficient at dispensing medical advice, the teacher at helping students, and the plumber at fixing leaks. The physician and teacher call the plumber when they need work on their plumbing. The teacher and plumber see the doctor when they are sick. The physician and the plumber send their children to school to learn from the teacher. This trading of services increases the welfare of everyone in society. Trade creates gains for everyone involved.

Trade Specialization Trade controversies You go to Starbucks to get coffee. You go to the doctor when you’re sick. You don’t have to do everything yourself: people specialize in what they’re best at (lowest opportunity cost) and you can trade with them. Trade controversies India or China may have a comparative advantage (relative to USA) in labor-intensive goods. Result: outsourcing of jobs What if this causes an American worker to lose his job? Lecture notes: Some countries have highly developed workforces capable of managing and solving complex processes. Other countries have large pools of relatively unskilled labor. As a result, businesses that need skilled labor gravitate to countries where they can easily find the workers they need. Likewise, firms with production processes that rely on unskilled labor, look for employees in less developed countries. By harnessing the power of increased specialization, global companies and economies are able to increase production and growth.

Practice What You Know Which of the following situations illustrates an incentive? Dave snacks all afternoon and isn’t hungry for dinner. Dirk’s children misbehave during dinner. Lee gives his children candy if they behave during dinner. Jaime goes to a restaurant for dinner. Clicker Question Correct answer: C An incentive is a motivator to get someone to change their behavior. The children are given a positive incentive to behave.

Practice What You Know The governor decides to increase funding for education. However, this will mean decreasing funding for infrastructure. This situation illustrates trade-offs. comparative advantage. incentives. markets. Clicker Question Correct answer: A It also illustrates scarcity, choice, and opportunity cost.