Economics for Leaders Lesson 2: Opportunity Cost & Incentives

Economics for Leaders Opportunity Cost Highest-valued foregone alternative – the value (to you!) of the next-best alternative that you sacrificed It is always subjective – You know your costs It is sometimes objective – Sometimes I can measure your costs in, say, dollars and cents

Economics for Leaders Economic Reasoning Principle-1: People choose, and individual choices are the source of social outcomes Scarcity implies we must choose: 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.

Economics for Leaders A simple example: TR Pops, anyone? Individual choices.... In the presence of scarcity.... Yield outcomes for society TR Pops: Group 1, Group 2, Group 3 – I will put a down coin & a TP Pop – You may have either, but not both – Pick up one leave the other for me – Do nothing until all in Group can choose

Economics for Leaders Economic Reasoning Principle-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.

Economics for Leaders Characteristics of Cost: Costs are “to” someone, i.e., people bear costs, not businesses or governments, etc Costs are the results of actions (choices) Costs relevant to decision making lie in the future, i.e. those not yet incurred – Past, inescapable, “sunk” costs are gone – Example: You sacrificed $X and two days to get here; these costs are sunk—inescapable – The costs relevant for staying are those that are avoidable It does include the opportunity of five more days But NOT what you sacrificed in the past

Economics for Leaders TR Pops, once more What was the cost of a TR Pop for each person the first group? Is the cost different for a person in the second group? Did anyone have to pull money out of his or her pocket to incur these costs?

Economics for Leaders 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 change, behavior changes in predictable ways.

Economics for Leaders Oh, those TR Pops Poor members of group #3: what was cost to each of them of choosing a TR Pop? Did they behave any differently than other individuals in the class? Do we think this difference applies to other people?... other goods?

Economics for Leaders Incentives The rewards or penalties that result from the choices people make – They may be negative or positive – They may be monetary or non-monetary But they are inescapable, and they help guide the choices we make

Economics for Leaders Objectives, incentives, and choice The choices people make depend on 1. Who they are, what they like and want to accomplish, their hopes, dreams, etc 2. The incentives they face Item 1 is known to each decision-maker—but often not to us, the outside observer-analysts Item 2 is observable to us, the outside observer- analysts The reason that we (and other economists) focus so much on Item 2 is because incentives are observable, not because Item 1 is unimportant

Economics for Leaders Choices are made at the “margin” Marginal: additional, next, a little more or a little less Sometimes the “margin” is large & lumpy – Come to EFL or not Sometimes the “margin” is small & smooth – Eat one more french fry or not The key to good analysis and decision- making is to identify the correct “margin”

Economics for Leaders A simple example When the price of gas went from $2/gal. to $4/gal, almost no one stopped driving – “To drive or not to drive” was not the question Does this mean the price of gas has no influence over driving decisions? NO! Almost everyone made any of a series of small adjustments at the margin – Fewer trips, more buses, bikes, & car-pooling, slower acceleration, more coasting, etc. “All or nothing” is almost never the margin

Economics for Leaders Paper for Sale 1.You are bidding for the right to DISPOSE of the contents of the bag. 2.Winning bidder must dispose of the CONTENTS by first removing it from the bag and then Putting it in the landfill (trashcan) OR Reusing it (put in pocket for later) OR Recycling it (eat it) 3.The baggie must be returned to me AFTER contents removed. 4.Cash only; I will keep what you bid

Economics for Leaders A different problem How do I get rid of this $25 gift card from Target? Does anyone want it? Is it scarce? Should we ration it (what is wrong with this question)?

Economics for Leaders Should we ration? In a world of scarcity, wants exceed available resources There is no alternative to rationing The relevant question: what is the “best” mechanism?

Economics for Leaders Methods of rationing scarce goods and services Prices Command (someone imposes) Contests Voting (e.g., majority rule) Force First-come-first- served Sharing equally Lottery Personal characteristics ‘Need’ or merit

Economics for Leaders Economic Reasoning Principle-4: Institutions are the “rules of the game” that influence choices Laws, customs, moral principles, superstitions, and cultural values influence people’s choices. These basic institutions controlling behavior establish the incentive structure and the basic design of the economic system.

Economics for Leaders Queries Do the outcomes of rationing differ if the rules are different? Is this true for – Grades in school Current method Alternative method – Pieces of paper sold at auction Current method Alternative method – Everything else?

Economics for Leaders Economic Reasoning Principle-5: Understanding based on knowledge and evidence imparts value to opinions Opinions matter and count equally 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.