1. 1 ECONOMICS Marginal Benefits Versus Marginal Costs

2. 2 I. Marginal Analysis - Definitions Marginal Benefit –the change in total benefits arising from a given choice. Marginal Cost –the change in total costs arising from a given choice.

3. 3 Marginal Analysis for Profit Maximizing Firm Note first that firms maximize Economic Profits not Accounting Profits Accounting Profits= Total Revenue- Accounting Costs Economic Profits= Total Revenue- Economic Costs where Economic Costs include opportunity costs

4. 4 Opportunity Cost - Definition The cost of the explicit and implicit resources that are foregone when a decision is made OR the cost of using resources for a certain purpose in terms of the benefit given up by using them in their best alternative way.

5. 5 Marginal Analysis for Profit Maximizing Firm Marginal Benefit of a firm’s decision is the change in Total Revenue attributable to that decision. Marginal Cost of a firm’s decision is the change in Economic Costs attributable to that decision.

6. 6 Example 1: Coffee Shop Steve Mason works as a lawyer in Chicago and owns a two-story Brownstone. He currently lives on the second story of his Brownstone and leases the first floor out to a travel agency. Steve makes $60,000 per year as a lawyer, pays $80,000 per year in mortgage payments on the Brownstone and leases the first floor for $100,000 per year.

7. 7 Example 1 (cont.): Coffee Shop Steve is deciding whether to quit is job and open a coffee shop on the first floor of his Brownstone (instead of leasing the space to the travel agency). Steve expects the coffee shop’s labor costs to be $40,000 per year and supplies to cost $50,000 per year. What is the minimum expected revenue the coffee shop must generate in order for Steve to quit his job as a lawyer? What assumptions do you need to make?

8. 8 Example 2: 2015 Cotton Bowl Suppose you attended the Cotton Bowl at AT&T Stadium in Dallas Texas – MSU versus Baylor. You purchased a plane ticket for $600, bought a ticket for $300 and booked a hotel room for $500. You are standing in the parking lot of the Cotton Bowl right before kickoff and a scalper offers you $1200 for your ticket. Do you take it? What does it depend on?

9. COTTON BOWL 9 ScalperHere you are.

10. 10 Time Value of Money Suppose the interest rate (i) is 10%=0.10 What is $100 in a year worth today? OR What is the Present Value (PV) of $100 in a year?  Let PV be the Present Value … PV(1+0.10) = 100 PV= 100/(1+0.10) PV=$90.90 FV=PV (1+i) T so PV=FV/(1+i) T

11. 11 Time Value of Money Suppose the interest rate (i) is 10%=0.10 What is the PV of $100 in 2 years? Let PV be the Present Value… PV(1+0.10) 2 =100 PV=100/(1+0.10) 2 PV=100/1.21 PV=$82.64 FV=PV (1+i) T so PV=FV/(1+i) T

12. 12 Time Value of Money Generally, what is the PV of $100 in T years if the interest rate is i? PV=100/(1+i) T What is the PV of $100 in T years and $150 in Z years if the interest rate is i? PV=100/(1+i) T +150/(1+i) Z

13. 13 III. Marginal Analysis and the Time Value of Money Often, some of the benefits and costs associated with a given decision/action occur in the future.

14. 14 Example 3: Skaneateles Bar Sherwood Inn is a bar on Skaneateles Lake (one of the Finger Lakes in Upstate New York). The manager of Sherwood is deciding whether to buy a large tent for the 4 th of July (when the town has fireworks over the lake). The manager would use the tent each 4 th of July for a beer garden and expects the tent to last three years. The manager also expects that he would be able to increase the number of drinks sold each July 4 th by 2,000. Suppose the price of a drink is $3, the cost of the ingredients in each drink is $1 and that the manager would have $1,000 more in labor costs if he has the beer garden. If the annual interest rate is 10%, what is the maximum the manager is willing to pay for the tent?

15. 15 Example 4: Renovated Kitchen About two years ago, my wife and I (OK, primarily my wife) renovated our kitchen. Immediately after the kitchen was completed, my brother-in-law visited and stated that we would definitely “get our money” out of the kitchen. He was speculating that the kitchen was a good investment for us because it would increase the amount we could sell the house for. On a later visit, this same brother-in-law visited and said that because of what has recently happened in the housing market, he did not know if the kitchen was a good decision. What are your thoughts in terms of how the housing market changes affected whether renovating the kitchen was a good investment? Just to make things concrete, suppose we paid V for the house in 2005. Suppose two years ago, we could have sold our house for W if we did not renovate the kitchen and X if we did. Suppose today, we could sell our house for Y if we did not renovate the kitchen and Z if we did.

16. 16 Example 5: My Mom My mom owns a house in the Chicago suburbs which is currently worth $200,000. If she sells the house, she would rent another place in the suburbs for $15,000 a year which she has to pay at the beginning of the year. Suppose that the expected appreciation on the house is 5% annually. Let the interest rate be 10% annually and assume my mom is indifferent between living in her current house or renting (except for the cost issue). What is the maximum annual maintenance cost on the house my mom should be willing to pay? If the annual maintenance cost is greater than this amount, my mom would choose to rent. Assume the maintenance cost is paid at the end of the year.

17. 17 Example 6: When to retire? What if Social Security is Optional?

18. 18 Example 6: Decision to Retire at age 62 instead of age 65?

19. 19 Example 6: You’re 62. Should you retire now or at age 65? Primary Insurance Amount (PIA) = Life expectancy = birthday Real interest rate = 3% If you retire @ age 62 with a reduced benefit = of your PIA 1000 70% 72 nd i.e., die at 71 years and 364 days

20. 20 You’re 62. Should you retire now or at age 65? PIA = 1000 Life expectancy = 72 nd birthday Real interest rate = 3% If you retire @ age 62 with a reduced benefit = 70% of your PIA Monthly benefit = Annual Benefit = At age 62, what is the present discounted value of your future SS income (assume receive all benefit on b-day)? This year and 9 more =0.03 1000*0.70=$700 $700*12=$8,400 =$8,400+…+ $73,803

21. 21 You’re 62. Should you retire now or at age 65? PIA = 1000 Life expectancy = 72 nd birthday Real interest rate = 3% If you retire @ age 65 with 100% of your PIA Monthly benefit = Annual Benefit = At age 62, what is the present discounted value of your future SS income? =0.03 1000 $1000*12=$12,000 …+ $70,472

22. 22 You’re 62. Should you retire now or at age 65? If you retire @ age 62 with a reduced benefit = 70% of your PIA PDV of SS = $73,803 If you retire @ age 65 with 100% of your PIA PDV of SS =$70,472

23. 23 You’re 62. Should you retire now or at age 65? What if your life expectancy is longer? Life expectancy is 81 st birthday  If you retire @ age 62 with a reduced benefit = 70% of your PIA PDV of SS = $123,929  If you retire @ age 65 with 100% of your PIA PDV of SS =$142,080 Tradeoff, lower payment for longer time w/ higher payment for shorter time

24. 24 What does Social Security have to do with the annuities market? Is Adverse Selection in the Annuity Market a Big Problem? by Anthony Webb – Center for Retirement Research Introduction An annuity provides an individual or a household with insurance against living too long. In exchange for a one- time premium payment, the insurer agrees to make periodic payments to the insured for life. In theory, annuities seem like a valuable product for many retirees given an uncertain date of death. However, in practice, few people purchase annuities. Researchers who have studied this puzzle have concluded that annuities are not "actuarially fair," that is, for someone with average life expectancy they provide only about 74 to 85 cents in income for every dollar in premium payments...