Lesson 2: Opportunity Cost & Incentives

Joke Of The Day An economist and an accountant are walking along a large pond and see a frog jumping on the mud. The economist says: "If you eat the frog I'll give you $20,000!" The accountant checks his budget and figures out he's better off eating it, so he does and collects money. Continuing along they see another frog.   The accountant says: "Now, if you eat this frog I'll give you $20,000." After evaluating the proposal the economist eats the frog and gets the money.

Joke Of The Day They go on. The accountant starts thinking: "Listen, we both have the same amount of money we had before, but we both ate frogs.   I don't see us being better off." The economist says:

Joke Of The Day "Well, that's true, but you overlooked the fact that we've just been involved in $40,000 of trade."

True or False?

Economic Reasoning Principle #1: People choose, and individual choices are the source of social outcomes. Scarcity necessitates choices: not all of our desires can be satisfied. People make choices based on their perceptions of the expected costs and benefits of the alternatives.

Economic Reasoning Principle # 2: Choices impose costs Economic Reasoning Principle # 2: Choices impose costs. People receive benefits as they make decisions, but they also incur costs. The cost of a choice is the value of the next best alternative foregone, measurable in time, money or some alternative value. What did you give up to be here? Should you go to college?

choices → TRADE-OFFS → forgone alternatives OPPORTUNITY COST! choosing is REFUSING! the cost of something is what you give up

Economic Reasoning Principle # 3: People respond to incentives in predictable ways. Choices are influenced by incentives, the rewards that encourage and the punishments that discourage actions. When incentives are altered, behavior changes in predictable ways. People do what makes them better off Marginal Benefit > Marginal Cost (MB > MC)

Choices & Opportunity Cost Decisions require comparing costs and benefits of alternatives Whether to go to college or to work Whether to study or go out on a date Whether to go to class or sleep in The opportunity cost of an item is what you give up to obtain that item 10

Choices & Opportunity Cost Should Jordan Spieth or Novak Djokovic do their own yard-work, house-work? What else could they do? What about me? 10

Choices & Opportunity Cost What is the cost of attending college? LeBron James, Kobe Bryant, Dwight Howard Jackie Chan You What is given up? 10

More Examples A free Dave Matthews concert Getting bumped from a flight Why attend college right after high school? Another Rolo, a second washing machine More oranges More automobiles More buildings More roads More Examples

More Examples Auto industry bailout Financial industry bailout Afghanistan/Iraq wars BP oil spill Bush era tax cuts The war on terror Health care for all College for all More Examples

There are only trade-offs and OPPORTUNITY COSTS Policy Conundrum There are no solutions. There are only trade-offs and OPPORTUNITY COSTS

Should We Ration? (Scarcity) Given that we MUST ration, what is the best mechanism? Let’s do an activity!

Rationing Scarce Goods How much do you like it? Rank how much you value the item. 1 to 10 10 = TOTALLY AWESOME :>) 1 = PATHETIC :<(

Scarcity & Rationing How much do you like it? Rank from 1 to 10 $10 Rationing STUFF! How much do you like it? Rank from 1 to 10 $10 Gift Card

Scarcity & Rationing How much do you like it? Rank from 1 to 10 Rationing STUFF! How much do you like it? Rank from 1 to 10

Scarcity & Rationing How much do you like it? Rank from 1 to 10 Rationing STUFF! How much do you like it? Rank from 1 to 10

How could we improve this outcome? Methods of Allocation Given the method of allocation just used to ration the STUFF… How could we improve this outcome?

Voluntary Trade Creates Wealth! Methods of Allocation Allow Trade Set up a market Voluntary Trade Creates Wealth!

Rationing STUFF! Do you want to trade?

Rationing STUFF! Do you want to trade?

Rationing STUFF! Do you want to trade?

Rationing STUFF! Do you want to trade?

Rationing STUFF! Do you want to trade? $10 Gift Card

Rationing STUFF! Do you want to trade? $10 Gift Card

Methods of Allocation Lottery Contest Arbitrary criteria Force Share equally First-come, first serve Need Merit Market Transactions (exchange/prices)

Markets Typically Do A Good Job Of Rationing Goods go to those with the highest value. Goods are produced by those with the lowest opportunity cost. Voluntary trade increases well-being. It makes people better off! What do markets look like?

What is a Market? Buyers Sellers specific product information property rights competition voluntary trades well-being

Markets: Circular Flow Households Develop resources to their fullest potential and offer them for sale in factor markets. Earn income from sale of resources and purchase goods & services to maximize well-being (utility). Firms Employ resources in their most useful capacity to produce goods and services. Sell goods and services to maximize well-being (profit).

How Do Markets Work? Buyers and sellers each perform cost/benefit analysis Price is a measure of relative scarcity Price represents opportunity cost Price sends signals/incentives to players Buyers Sellers

Markets: Supply & Demand D = MB = WTP (value) Diminishing marginal benefit Rolos, washing machine S = MC = WTS (opportunity cost) Rising marginal cost wheat/oranges

Big Ideas choices → TRADE-OFFS → forgone alternatives OPPORTUNITY COST! choosing is REFUSING! the cost of something is what you give up.

Big Ideas People do things that make them better off People respond to incentives in predictable ways The rules of the game (institutions) shape how decisions are made Decisions determine outcomes

Big Ideas Voluntary trade creates well-being Markets do a good job of allocating scarce resources to meet society’s many competing wants/desires

There are only trade-offs and OPPORTUNITY COSTS Policy Conundrum There are no solutions. There are only trade-offs and OPPORTUNITY COSTS

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