Opportunity Cost & Incentives EFL Lesson 2 Opportunity Cost & Incentives

Review: 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 these choices based on their perceptions of the expected costs and benefits of the alternatives.

Example: Venezuela Result? The poverty of some nations and the wealth of others is not an accident; it is the result of choices. Example: Venezuela President Hugo Chavez has nationalized (unilaterally stripped away) the Venezuelan oil holdings of Exxon Mobil Corporation and ConocoPhillips. By unilaterally stripping away the Venezuelan oil holdings of both Exxon Mobil Corp. and ConocoPhillips, Venezuela President Hugo Chavez has essentially bid adios to future investments by foreign corporations. Result?

Economic Freedom ranking: Venezuela Economic Freedom ranking: 148 / 157 Economic Freedom Rank: 148 in world Regional Rank: 28 of 29 Poverty: Increasing Since 1998, President Hugo Chávez has pursued a military buildup, hobbled political opponents through electoral manipulation, imposed foreign exchange controls, undermined speech and property rights, and politicized the state oil company that dominates the economy. Last year, Chávez confiscated control from private-sector oil companies and nationalized the largest electricity supplier and the biggest telephone company. . . . These policies hurt the lower-income groups. Venezuela has one of the world's highest inflation rates. Price controls on food, medicines, and basic services discourage private production and result in shortages. By unilaterally stripping away the Venezuelan oil holdings of both Exxon Mobil Corp. and ConocoPhillips, Venezuela President Hugo Chavez has essentially bid adios to future investments by foreign corporations. http://www.heritage.org/research/features/index/country.cfm?id=Venezuela%20

ERP-5: Understanding based on knowledge and evidence imparts value to opinions. Opinions matter and are of equal value at the ballot box. But on matters of rational deliberation the value of an opinion is determined by the knowledge and evidence on which it is based. Statements of opinion should initiate the quest for economic understanding, not end it.

ERP #3: People respond to incentives in predictable ways. Review: ERP #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 change, behavior changes in predictable ways. Incentives may be positive or negative. Incentives may be monetary or non-monetary.

NEW: ERP #2: Choices impose costs; people receive benefits and incur costs when they make decisions. The cost of a choice is the value of the next-best alternative foregone, measurable in time or money or some alternative activity given up.

SCARCITY CHOICE How Do You Know When Something Is Scarce? Scarcity Forces You to CHOOSE SCARCITY CHOICE

Opportunity Cost: the foregone alternative Think: “next-best”

Scarcity IS: Even in the face of abundance . . . What’s scarce when you’re in the Mall of America? at the all-you-can-eat buffet?

Opportunity Cost = the Next-Best Alternative Identifying Opportunity Cost: What are the considered alternatives? Prioritize the alternatives – What is the best and what is the “next-best”? What would you do – not what could you do? What does the decision-maker perceive to be the benefits of each alternative?

People’s Choices are always RATIONAL Rational choice = choosing the alternative that has the greatest excess of benefits over costs. If ALL choices are rational, then the challenge is to understand the decision-maker’s perception of costs and benefits.

Opportunity Cost Analysis What was the 1st decision you made this morning?

Opportunity Cost Analysis Decision Maker: YOU Alternatives: Get Up Now Don’t Get Up Now Perceived Benefits Choice Opp. Cost Benefits Refused

Opportunity Cost Analysis Decision Maker: YOU Alternatives: Get Up Now Don’t Get Up Now Perceived Benefits Shower bkfst don’t rush On time coffee Choice Opp. Cost Benefits Refused More sleep

Opportunity Cost Analysis Decision Maker: YOU Alternatives: Get Up Now Don’t Get Up Now Perceived Benefits Shower bkfst don’t rush On time coffee Choice X Opp. Cost Benefits Refused More sleep X

Opportunity Cost Analysis Decision Maker: YOU Alternatives: Get Up Now Don’t Get Up Now Perceived Benefits Shower bkfst Coffee don’t rush On time Choice X Opp. Cost Benefits Refused More sleep

Use the concept of opportunity cost to discuss the following questions: Who might choose to get bumped from a flight? Should Tiger Woods mow his own lawn? What is the cost of attending college? for LeBron James? for you?

Characteristics of Cost Costs are the results of ACTIONS (Remember that people choose, and choices impose costs.)

Characteristics of Cost Costs are the results of ACTIONS Costs are TO people; things have no cost People choose – so people bear costs. “governments,” “societies,” countries, nations don’t choose; people do. Don’t confuse cost and price

Characteristics of Cost Costs are the results of ACTIONS Costs are TO people; things have no cost All costs lie in the FUTURE The future is uncertain. When we choose, we anticipate costs, but we don’t know for sure until the act of deciding is complete. Cost ≠ Consequence

Characteristics of Cost Costs are the results of ACTIONS Costs are TO people; things have no cost All costs lie in the FUTURE Costs are frequently not monetary (although we may value them in dollar terms)

Opportunity Cost of Gov’t Policies Other Government programs that you could have done. What the resources used by government could have produced in the private sector.

Given that we MUST ration, what is the best mechanism? Back to Scarcity: What’s the Question? (And what does opportunity cost have to do with it?) Should we ration? Given that we MUST ration, what is the best mechanism?

Rationing DVDs

Methods of Rationing Scarce Goods and Services prices command (someone decides) majority rule contests by force voting first-come-first-served sharing equally lottery personal characteristics need or merit

Why is price rationing the most common method of allocating scarce goods, services, and resources in our economy? The outcome is clear Individuals can affect the outcome based on their desire for the product It directs resources to their most highly valued uses Individuals’ power and freedom is enhanced It provides incentives for both consumers and producers to reduce scarcity.

Prices: POWERFUL Incentives When prices change, opportunity costs change – and that’s an incentive! People react to changes in incentives in predictable ways. Both consumers and producers react to prices in ways that help us to deal with scarcity.

Choices are made at the Margin Steps in our economic way of thinking: Scarcity IS Because of scarcity; people must CHOOSE All choices bear COSTS – the value of the next-best alternative Very few choices are “all or nothing”: choices are made at the margin

Marginal Analysis: Do you want another one?

Choices are made on the margin The next one A little more or a little less

Making the Choice The Rule IF MB ≥ MC then DO IT; People will choose to do an activity so long as the Marginal Benefit is equal to or greater than the Marginal Cost: The Rule IF MB ≥ MC then DO IT; IF MB < MC then DO LESS

The “Big Ideas” from Lesson 2: Scarcity forces us to choose and every choice has an opportunity cost. When opportunity costs change, incentives change, and choices change. Because costs lie in the future, the important costs and benefits occur at the margin. Money price rations goods in markets.