C OST AND P RICES Opportunity Cost & Incentives

H OW D O Y OU K NOW W HEN Scarcity Forces You to CHOOSE Something Is Scarce? SCARCITY CHOICE

O PPORTUNITY C OST : THE VALUE OF THE NEXT BEST OR FOREGONE ALTERNATIVE Think: “next-best”

O PPORTUNITY C OST A NALYSIS What was the 1 st decision you made this morning?

O PPORTUNITY C OST A NALYSIS Alternatives:Get Up NowDon’t Get Up Now Perceived Benefits Choice Opp. Cost Benefits Refused Decision Maker: YOU

O PPORTUNITY C OST A NALYSIS Alternatives:Get Up NowDon’t Get Up Now Perceived Benefits Shower Breakfast don’t rush On time Starbucks Choice Opp. Cost Benefits Refused Decision Maker: YOU More sleep

O PPORTUNITY C OST A NALYSIS Alternatives:Get Up NowDon’t Get Up Now Perceived Benefits Shower Breakfast don’t rush On time Starbucks Choice X Opp. Cost Benefits Refused Decision Maker: YOU More sleep X

C HOOSING IS R EFUSING Every time we choose we pay a cost.

P EOPLE ’ S C HOICES 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.

Who got up this morning and had breakfast? What was the opportunity cost you paid in order to get one?

C HARACTERISTICS OF C OST Costs are the results of ACTIONS All costs lie in the FUTURE (past costs are “sunk” costs) Sunk costs are costs that have already been incurred and which cannot be recovered. They should not be considered when making decisions. Costs can be monetary ($) or non- monetary, but are frequently non- monetary (although we may value them in dollar terms)

W HAT D ETERMINES Y OUR O PPORTUNITY C OST ? Alternatives Tastes and preferences (values) Utility – usefulness of a product Utility can vary from person to person Rules of the Game: Institutions

D O G OV ’ T ACTIONS HAVE OPPORTUNITY COSTS ? Government Debt Economic Stimulus Package War in Afghanistan Limiting Carbon Emissions Universal Healthcare All alternatives have cost and benefits Individuals perceive the value of costs and benefits differently

S HOULD WE A LLOCATE ? RATION ? Given that we MUST ration, what is the best mechanism? Back to Scarcity:

A LLOCATING / RATIONING I CE C REAM : What Determines Your Opportunity Cost? Alternatives Tastes and preferences (values) Rules of the Game: Institutions

W HAT ARE THE M ETHODS OF R ATIONING S CARCE G OODS AND S ERVICES ? prices command (someone decides) majority rule contests by force voting first-come-first-served sharing equally lottery personal characteristics need or merit

W HY IS $ PRICE RATIONING THE MOST COMMON METHOD OF ALLOCATING SCARCE GOODS, SERVICES, AND RESOURCES IN OUR ECONOMY ? 1. The outcome is clear 2. Individuals can affect the outcome based on their desire for the product 3. It directs resources to their most highly valued uses 4. Individuals’ power and freedom is enhanced 5. It provides incentives for both consumers and producers to reduce scarcity.

W HERE DO P RICES C OME F ROM ? The market interaction of buyers and sellers in open and competitive markets!

P RICES : POWERFUL I NCENTIVES When prices change, opportunity costs change – that’s an incentive! Both consumers and producers react to prices in ways that help us to deal with scarcity.

W HEN INCENTIVES (P RICES ) CHANGE, BEHAVIOR CHANGES IN PREDICTABLE WAYS. When prices go up, consumers demand a larger or smaller quantity? Demand The willingness and ability to purchase goods and services at various prices.

W HEN INCENTIVES (P RICES ) CHANGE, BEHAVIOR CHANGES IN PREDICTABLE WAYS. When prices go up, consumers demand a larger or smaller quantity? Smaller When prices go down consumers demand a larger or smaller quantity? Larger Always? Law of Demand P QD

W HEN INCENTIVES (P RICES ) CHANGE, BEHAVIOR CHANGES IN PREDICTABLE WAYS. When prices go up producers supply a larger or smaller quantity? Supply Producers willingness and ability to produce goods and services at various prices.

W HEN INCENTIVES (P RICES ) CHANGE, BEHAVIOR CHANGES IN PREDICTABLE WAYS. When prices go up, producers supply a larger or smaller quantity? Larger When prices go down, producers supply a larger or smaller quantity? Smaller Always? Law of Supply P QS

W HAT DOES O PPORTUNITY C OST HAVE TO DO WITH SUPPLY AND DEMAND ? Everything!

C HOICES ARE MADE AT THE M ARGIN Our only choice is the next choice Marginal = additional, next, a little more or a little less Remember: Sunk costs are costs that have already been incurred and which cannot be recovered. They should not be considered when making decisions. * Economics of Seinfeld: The opposite: Look for the sunk cost and thinking on the margin:

H OW MUCH SHOULD WE DO ? Work Play Study Sleep Buy Sell

C HOICES ARE MADE AT THE M ARGIN Our only choice is the next choice Marginal = additional, next, a little more or a little less

M ARGINAL C OST = COST OF NEXT A CTION, C HOICE, U NIT OF PRODUCTION Marginal Benefit = benefit of the next Action, Choice, Unit of production

As long as the marginal benefit is greater than the marginal cost you should continue the activityMB=MC

P EOPLE ’ S C HOICES 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. Another way of putting it…

T HE “B IG I DEAS ” FROM L ESSON 2: 1. Scarcity forces us to choose and every choice has an opportunity cost. 2. When opportunity costs change, incentives change, and choices change. 3. Because costs lie in the future, the important costs and benefits occur at the margin. (Think Elaine and her jujubes 4. Money price ($) rations goods in markets. 5. Consumers and producers respond to changes in price in predictable ways.

I have with me at this EFL program a new Dell Vostro 13 Notebook computer. It has 13” screen, 650 GB hard drive, 4 GB Ram, i7 processor, windows 7, internal wireless, etc. Questions: It is mine. How much money would you give me for the computer? (You have until the end of the week to come up with the cash) ________ I have applied for a grant to study cigarette tax policies across the different states of the United States. To perform this project punctually, I will probably have to hire some research assistants. This work will have to be performed during the next 30 days. (at your home) The work will include data collection, research, and data coding. Questions: 2.How many hours would you work total over that time period? (next 30 days) if I paid you $35 per hour 3. I will probably undertake the project even if I do not get the grant. How many hours would you be willing to work if I paid you $10 per hour?