ECON 100 Lecture 3 Monday, February 10

Announcements CASE Dean’s Office (Professor İnsan Tunalı) increased section sizes from 95 to 105. If you are still trying to add Econ 100 to your schedule, please talk to me after class. You can pick up your copy of the syllabus at the end of the lecture. Course webpage https://ais.ku.edu.tr/course/24055/Default.html

More announcements Time and classroom info for Problem Sessions. PS#1: SOS B08, TUB6 PS#2: SOS B08, FRB1 PS#3: SOS B08, FRB4 PS#4: SOS B07, FRB2 Problem sessions are optional. You can go to any session that fits your schedule. The first problem set will be posted on course webpage later this week. Study questions/problem sets are important for preparing for the exams.

of last week’s lectures A short summary of last week’s lectures

Economists assume that… people are rational — they have well-defined goals and try to achieve their goals as best as they can with available resources and information. Rational people behave according the following rule: “Take an action if and only if the benefits of taking the action are at least as great as the costs.” Do activity x if B(x) ≥ C(x)

The Cost-Benefit Principle Measuring the costs and benefits of an action is not always very easy. Stem-cell research Missile defense system Career choice Auto purchase

What are the problems? People sometimes ignore costs that should be counted. Opportunity cost People sometimes count costs that should be ignored. Sunk cost More on this second “problem” later in the lecture.

Do not ignore the opportunity costs Making a rational decision requires the recognition of opportunity cost. Opportunity cost of an action is the value of the next-best alternative that we must give up in order to engage in that action.

from Wednesday’s lecture Clapton vs. Dylan from Wednesday’s lecture

Who is older?

The question You have a free ticket to Clapton. Same night there is also a Dylan concert. Dylan is worth to you $50. Dylan tickets cost $40. Question #1: As a rational person, will you go to Clapton? ANSWER: “Not enough information to answer this question” Question #2: What is the opportunity cost of seeing Clapton? A. $0 B.$10 C. $40 D. $50

ANSWER: “B” $10 ( = 50 – 40) .

Why? Because “The cost of something is what you give up to get it.”

Why is B. $10 the correct answer? When you choose Clapton, you give up the net benefit of Dylan, which is your enjoyment (measured at $50) minus the ticket cost, which is $40. The value (net benefit) of the Dylan concert is $10. This ($10) is what you give up if you choose Clapton. One more time… The opportunity cost of Clapton is $10, the net benefit of the (next-best) alternative, which is Dylan.

Paul Ferraro and Laura Taylor, asked this very same question, which is taken from page 4 of Robert Frank and Ben Bernanke’s textbook, Introduction to Microeconomics, to PhD students and professors at the ASSA meeting, in 2005. ASSA: Allied Social Science Associations meeting organized by the American Economic Association

Mentioned in the New York Times Paul Ferraro and Laura Taylor, “Do Economists Recognize an Opportunity Cost When They See One? A Dismal Performance from the Dismal Science.” Mentioned in the New York Times The Dismal Science, Dismally Taught - New York Times www.nytimes.com/2007/08/12/business/yourmoney/12view.html

How did the PhD students and professors answer this question? http://www2.gsu.edu/~wwwcec/docs/ferrarotaylorbep.pdf Respondents spent, on average, close to five minutes answering the survey. $0 25.1% $10 21.6% $40 25.6% $50 27.6%

How did Econ100 students do? Much much better

Our results answer # of students % of students $0 5 3,5% $10 130 89,5% $40 3 2,0% $50 7 5,0%

Spring 2013 $0 4 6,8% 8 10,5% $10 41 69,5% 62 81,6% $40 12 20,3% 3 3,9% $50 2 3,4%

Spring 2012 $0 0% 1 2% $10 39 87% 46 81% $40 2 4% $50 5 11% 8 14%

Let’s do one more opportunity cost question Let’s do one more opportunity cost question. Because, as Prof Robert Frank says, “[…] the opportunity cost concept, so central to our understanding of what it means to think like an economist, is but one among hundreds of concepts that go by in a blur.” We don’t want that!

A difficult opportunity cost question #1 You have a free ticket to a Eric Clapton concert. You can sell it for $35. Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. Dylan is worth to you $50. There are no other costs of seeing either performer. You choose Clapton. If you are a rational person, we can conclude that Clapton is worth to you at least ….

Suggested solution; a difficult opportunity cost question #1 As a rational person, you choose Clapton if B ≥ C. We first compute C of Clapton, and then choose the smallest B such that B ≥ C C = 10 + 35 Why? 10 = 50 – 40 is the net benefit of Dylan 35 is also part of the cost because you give up the opportunity to earn 35 when you choose Clapton So, B must be at least 45.

A difficult opportunity cost question #2 You have a free ticket to Clapton and also a free ticket to Dylan. You can sell Clapton for $35, Dylan for $20. These are your only options for tonight. Dylan is worth to you $50. There are no other costs of seeing either performer. You choose Clapton. If you are a rational person, we can conclude that Clapton is worth to you at least ….

Suggested solution; a difficult opportunity cost question #2 Clapton is worth to you BC, Dylan is worth to you $50. If you choose Clapton, you can’t sell the ticket, which means you give up the opportunity to earn $35 If you choose Dylan, you can’t sell the Dylan ticket, which means you give up the opportunity to earn $20. So, the rational person chooses Clapton if BC – 35 > 50 – 20 So, Clapton must be worth to you at least $65.

The scarcity principle The opportunity cost (fırsat maliyeti)

There is no such thing as a free lunch!

Herşeyin bir bedeli var!

There is no such thing as a free lunch! “Although we have boundless needs and wants the resources available to us are limited. As a consequence, having more of one good necessarily means having less of another.” Consider the following statement: “The citizens of Sweden are lucky because they have free health care while the citizens of the US have to pay for it.”

Our very first economic model The production possibilities frontier (PPF) Üretim İmkanları Eğrisi

Economic Models Economists use models to simplify reality in order to improve our understanding of the world. In constructing their models economists make many simplifying assumptions. One of the basic economic models is The Production Possibilities Frontier

The scarcity principle means that people face trade offs. How many goods do we need (minimum)? Two Imagine a country that produces only two goods

Cars vs. Computers  Quantity of Computers Produced 3,000  D C 2,200 3,000  D C 2,200 600 A 700 2,000 Production possibilities frontier 1,000 300 B  1,000 Quantity of Cars Produced

Cars vs. Computers  Quantity of Computers Produced 3,000  D C 2,200 Producing under the PPF (like at point B) means that the economy is not producing efficiently. Points outside the PPF (like D) are not attainable with the currently available amount of resources and level of technology. Quantity of Computers Produced 3,000  D C 2,200 600 A 700 2,000 Production possibilities frontier 1,000 300 B  1,000 Quantity of Cars Produced

The Production Possibility Frontier is... a graph that shows the combinations of goods (and services) that the economy can possibly produce given the available resources and the available production technology.

Finally, let’s go back to Sweden vs. the US healthcare question “Citizens of Sweden are lucky because they have free health care while the citizens of the US have to pay for it.”

Sweden vs. the US (healthcare) Cars US A B Sweden Healthcare

Measuring the costs and benefits of an action is not always very easy!

People sometimes count costs that should be ignored. Sunk costs

Example: Sunk costs A group has arranged a bus trip to Niagara Falls. The driver’s fee is $100, the bus rental is $500 and the fuel costs $75. The driver’s fee is not refundable. The bus rental may be canceled a week in advance but there is a cancellation fee of $100. At $25 a ticket, how many people must buy tickets a week before so that canceling the trip is definitely a bad idea?

Suppose that 20 people bought tickets. Should we cancel the trip or not? We have to make a decision because this is the last day for cancelling without paying the full amount of the bus rental.

Should we go or cancel? Compare costs and benefits! Benefit = number of tickets soldx$25 What is the cost of this trip? Driver’s fee $100 + the bus rental $500 + fuel costs $75 = $675 If we have sold $675/$25 = 27 tickets, benefits > costs  go. Sunk cost : driver’s fee + cancellation fee = $200 Ignore $200 Relevant costs are $475 If we have sold $475/$25 = 19 tickets, benefits > costs  go.

Failure to Ignore Sunk Costs Sunk cost: A cost that is beyond recovery at the moment a decision must be made. Sometimes people are influenced by sunk costs when they should be ignored. This is the reverse of ignoring opportunity costs.

Sunk Costs Sunk costs are borne whether or not an action is taken. It is an expenditure that you cannot recover. Therefore, they are irrelevant to a decision on whether to take an action.

People respond to incentives and Rational people think at the margin Next lecture: People respond to incentives and Rational people think at the margin