1. ECON 100 Lecture 4
Wednesday, February 13

2. Announcements
The first problem set will be posted on course webpage later this week. (if not then next week for sure) Course webpage Lecture notes and participation records are posted.

3. Class participation
10-point BONUS; in class experiments and activities
Please bring a pen/pencil and a piece of paper to each class.
During the lectures please turn off laptops tablets mobile phones etc
Avoid behavior like
always coming to class late;
keeping steady conversation with neighbors during lecture,
doing coursework for other classes, etc.
Ask questions, if I ask a question to you make an effort to answer it; pay attention to the lecture (most of the time)
If you are registered in the 9 30 section, you cannot attend the section.

4. Now the lecture

5. Monday’s “find the opportunity cost, and do activity x if B(x) > C(x)” question

6. A difficult opportunity cost question
You won a free ticket to see an Eric Clapton concert (which you can sell for $35, that means the resale value is $35). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. You would be willing to pay up to $50 to see Dylan. There are no other costs of seeing either performer. Based on this information, what is the minimum amount (in dollars) you would have to value seeing Eric Clapton for you to choose his concert? Give a short explanation.

7. $45. Why?
What net benefit is given up when you go to the Clapton concert? The $50 of benefits of the Dylan concert. But the Dylan concert costs $40 (ticket price). The net benefit given up is $10. You also give up the opportunity to earn $35 by selling your Clapton ticket. Total amount given up is $35+$10 = $45. The opportunity cost of the Clapton concert is $45, the money costs is 0. Rational person goes to Clapton if B ≥ C, C = $45, so B must be at least $45 for the rational person to choose the Clapton concert.

8. People respond to incentives Rational people think at the margin
Two main ideas today:
People respond to incentives
Rational people think at the margin

9. People respond to incentives

10. Implication of Rationality
People compare costs and benefits when they decide what to do. [do activity x if B(x) ≥ C(x)]
So, if the costs or the benefits of an action change, rational people change their behavior.
Economists capture this point by saying that “people respond to incentives”.

11. Incentive: definition
An incentive is something
that induces a person to act.
such as the fear of punishment or the expectation of reward, that induces action or motivates effort.

12. People respond to many different types of incentives, some altruistic, most, not so much. People are motivated by a sense of duty or community in how they live their lives or the choices that they make. People are also motivated (some say primarily) by financial/monetary incentives.

13. The standard economic rationality assumption is that individuals are self-interested.
But, in addition to their own material gains, people care about fairness and reciprocity.
People are willing to
change the distribution of material outcomes at personal cost;
reward those who act in a cooperative manner while punishing those who do not even when these actions are costly to the individual.

14. Simple story
The price of an apple rises… People decide to eat fewer apples (and possibly more pears), because …

15. Simple story
The price of an apple rises… People decide to eat fewer apples (and possibly more pears), because the cost of buying an apple is higher.

16. Simple story
The price of an apple rises… People decide to eat fewer apples (and possibly more pears), because the cost of buying an apple is higher. At the same time, apple orchards decide to hire more workers and harvest more apples, because…

17. Simple story
The price of an apple rises… People decide to eat fewer apples (and possibly more pears), because the cost of buying an apple is higher. At the same time, apple orchards decide to hire more workers and harvest more apples, because the benefit of selling an apple is higher.

18. Now something completely different: Traffic safety
How does a mandatory seat belt law affect auto safety? The direct effect is obvious. With seat belts in all cars the chances of surviving a major auto accident rises. In this sense, seat belts save lives.

19. But that's not the end of the story
But that's not the end of the story. To fully understand the effects of this law, we must recognize that people change their behavior in response to the incentives they face.

20. The relevant behavior here is the speed and care with which drivers operate their cars. Driving slowly and carefully is costly because it uses the driver's time and energy. Benefits are: lower probability of having an accident. When deciding how safely to drive, rational people compare the benefit from safer driving to the cost.

21. How does the seat belt law changes the cost-benefit calculation of the rational driver? Seat belts make accidents less costly for the driver because they reduce the probability of injury or death. Thus, the seat belt law reduces the benefits to slow and careful driving. When the benefit of an activity is lower, rational people do less of that activity. Seatbelts, or safety features such as airbags, make rational drivers drive less carefully.

22. So, can we say that
to eliminate all traffic accidents we should build cars that have a spear mounted on the steering wheel, pointing directly at the driver's heart?
Armen Alchian of the University of California at Los Angeles has suggested this and said there will be a lot less tailgating.

23. The law of unintended consequences or Bad things happen to good people

24. When policymakers fail to consider how their policies affect incentives, they can end up with results that they did not intend.
For example, consider public policy regarding auto safety. Today all cars have seat belts, but that was not true 40 years ago. In the late 1960s, Ralph Nader's book Unsafe at Any Speed generated much public concern over auto safety. Congress responded with laws requiring car companies to make various safety features, including seat belts, standard equipment on all new cars.

25. Safer cars reduce the number of driver deaths by making it easier to survive an accident. At the same time, they increase the number of driver deaths by encouraging reckless behavior.
Which effect is the greater? Will the number of driver deaths decrease or increase?  
In 1975 Sam Peltzman (University of Chicago) researched this issue. He found that
The two effects cancel each other out. There are more accidents and fewer driver deaths per accident, but the total number of driver deaths is unchanged.
The number of pedestrian deaths also increase because pedestrians do not benefit from safer cars.

26. The Effects of Automobile Safety Regulation by Sam Peltzman published in 1975 in the Journal of Political Economy
Abstract: Technological studies imply that annual highway deaths would be 20 percent greater without legally mandated installation of various safety devices on automobiles. However, this literature ignores offsetting effects of non- regulatory demand for safety and driver response to the devices. This article indicates that these offsets are virtually complete, so that regulation has not decreased highway deaths. Time-series (but not cross-section) data imply some saving of auto occupants' lives at the expense of more pedestrian deaths and more nonfatal accidents, a pattern consistent with optimal driver response to regulation.

27. Almost 30 years later, Peltzman’s results were overturned

28. The Effects of Mandatory Seat Belt Laws on Driving Behavior and Traffic Fatalities by Alma Cohen & Liran Einav. published in 2003 in the Review of Economics and Statistics
Abstract: This paper investigates the effects of mandatory seat belt laws on driver behavior and traffic fatalities. Using a unique panel data set on seat belt usage rates in all U.S. jurisdictions, we analyze how such laws, by influencing seat belt use, affect traffic fatalities. Controlling for the endogeneity of seat belt usage, we find that it decreases overall traffic fatalities. The magnitude of this effect, however, is significantly smaller than the estimate used by the National Highway Traffic Safety Administration. Testing the compensating behavior theory, which suggests that seat belt use also has an adverse effect on fatalities by encouraging careless driving, we find that this theory is not supported by the data. Finally, we identify factors, especially the type of enforcement used, that make seat belt laws more effective in increasing seat belt usage.

29. (Monetary) incentives can backfire

30. People respond to incentives*
The problem with this principle* isn’t the text itself – people do respond to incentives – but the naiveté with which we often assume people respond. We assume (based on rational people models) that if you pay people more to do something, they will do more of it, and if you tax something or raise its price, people will do it less. Of course, this is not always how thing are.

31. Two examples
A day care center in Haifa, Israel, begins fining parents for late pickups. This is to reduce the number of late pickups of children. Initially, there was no specific punishment attached to picking up children late, simply an admonition not to do so. The provider instituted a small fee (about $3).

32. How did the parent respond. The number of late parents doubled. Why
How did the parent respond? The number of late parents doubled. Why? The fine reduces the parents’ ethical obligation to avoid inconveniencing the teachers and makes them think of lateness as simply a commodity they can purchase.

33. Letting them contribute the payment to charity reverses the effect.
A very influential book by Richard Titmuss (1970), "Gift Relationship: From Human Blood to Social Policy“
Offering to pay women for donating blood decreases the number willing to donate by almost half.
Letting them contribute the payment to charity reverses the effect.
Both examples from Samuel Bowles Harvard Business Review | March 2009 | hbr.org
A large experiment in Switzerland in 2008 found that offering lottery tickets increased turnout at blood drives.

34. A short article highly recommended
Uri Gneezy, Stephan Meier and Pedro Rey-Biel “When and Why Incentives (Don’t) Work to Modify Behavior.”
Journal of Economic Perspectives: Vol. 25 No. 4 (Fall 2011)

35. From that article
The tradeoff between intrinsic and extrinsic motivation shows up frequently in studies where students are paid for their performance or attendance in school. Depending on the circumstances, the size of payments, and what they are tied to (attendance, completion of assignments, grades, etc.) the effect can vary substantially. Usually, if the payments are large enough, the short run effect is as expected: kids do more work, show up more often, etc. But, worryingly, these short run effects are sometimes outweighed by long-run negative effects on intrinsic motivation, especially if the incentive program is eliminated (or simply stops after a certain grade).

36. Now on to the next topic

37. Rational people think at the margin!

38. Do an activity if B > C is not helpful for decisions like “how many hours should I study for Econ100?” What does the rational person do when deciding on the level of an activity (how much/many?)

39. Example
How many units of compost* Heather should use to produce tomatoes?
*Decayed organic material used as a plant fertilizer

40. Heather’s Problem
Compost
(bags)
Tomatoes
(kg) 50 1 60 2 68 3 74 4 78 5 80
How many bags of compost should Heather use to produce tomatoes? What is her goal? We assume that she wants have the highest possible amount of profit.

41. How can we transform the simple rule (do action x if B(x) > C(x) ) into a rule that will tell us the right level or amount of some action, like choosing the right level of compost use for a small garden?

42. We start with zero units of compost and ask the question : “Should we us one more unit of compost?” Here we compare the cost and benefit of the first unit of compost. If the answer is yes, then we repeat the question: Here we compare the cost and benefit of the additional unit of compost. We keep going until the answer is “no”.

43. What information beside the table do we need to compare benefit and cost? We need prices. What is the price of tomatoes; what is the price of a bag of compost?

44. Heather’s Problem One bag of compost costs $10, tomatoes sell for $2/kg
(bags)
Tomatoes
(kg)
Total Revenue 50
100 1 60
120 2 68
136 3 74
148 4 78
156 5 80
160
Total revenue is price of tomatoes multiplied by the quantity of tomatoes sold.
What is the additional “benefit” (in $) of the first bag of compost?

45. Question: What is the additional cost of the first bag of compost?
Heather’s Problem One bag of compost costs $10, tomatoes sell for $2/kg
Compost
(bags)
Tomatoes
(kg)
Total Revenue 50
$100 1 60
$120
$20
The additional benefit of the 1st bag of compost 2 68
$136 3 74
$148 4 78
$156 5 80
$160
Question: What is the additional cost of the first bag of compost?
Answer: $10
Question: Should Heather use the first bag of compost?
Answer: YES, benefit = $20, cost $10; B > C, use the first bag.

46. Now, we repeat the process for the second bag and ask the same questions.

47. Heather’s Problem One bag of compost costs $10, tomatoes sell for $2/kg
(bags)
Tomatoes
(kg)
Total Revenue 50
100 1 60
120 20
The additional benefit of the 1st bag of compost 2 68
136 3 74
148 4 78
156 5 80
160
What is the additional “benefit” (in $) of the second bag of compost?

48. Heather’s Problem One bag of compost costs $10, tomatoes sell for $2/kg
(bags)
Tomatoes
(kg)
Total Revenue 50
100 1 60
120 20
The additional benefit of the 1st bag of compost 2 68
136 16
The additional benefit of the 2nd bag of compost 3 74
148 4 78
156 5 80
160
The cost of each additional bag of compost is $10. That doesn’t change.
Question: Should Heather use the second bag of compost?
Answer: YES, benefit = $16, cost $10; B > C, use the second bag.

49. Heather’s Problem One bag of compost costs $10, tomatoes sell for $2/kg
(bags)
Tomatoes
(kg)
Total Revenue 50
$100 1 60
$120
$20
The additional benefit of the 1st bag of compost 2 68
$136
$16
The additional benefit of the 2nd bag of compost 3 74
$148
$12
The additional benefit of the 3rd bag of compost 4 78
$156 $8
The additional benefit of the 4th bag of compost 5 80
$160 $4
The additional benefit of the 5th bag of compost

50. Heather’s Problem (Price of compost $10/bag, price of tomatoes $2/kg)
For bag #1, #2, and #3 the additional benefit > the additional cost.
For the 4th bag of compost the additional benefit is $8, smaller than the additional cost of $10.
Solution to Heather’s Problem: Use 3 bags of compost

51. Positive Net Gain
Comparing the marginal cost to the marginal benefit of the next unit tells whether or not there is a net gain.
If the net gain is positive, then the next unit should be undertaken.
Heather’s optimal level is four units of compost.

52. Deciding on the Level of an Activity
Rational decision makers compare
The additional benefits against additional costs.
also called marginal analysis.
Marginal Benefit:
The increase in total benefit that results from carrying out one additional unit of the activity.
Marginal Cost:
The increase in total cost that results from carrying out one additional unit of the activity.

53. Finding the Optimal Level
At a given level, if the marginal benefit is greater than marginal cost:
Increase level of the activity
If the marginal benefit is less than the marginal cost:
Decrease the level of the activity.
Optimal level of activity is where marginal benefit (MB) equals marginal cost (MC)
MB = MC

54. Summary Benefit-cost principle
The level of an activity should be increased if, and only if, the marginal benefit exceeds the marginal cost.

55. Your turn
Units of Pollution Eliminated
Total Financial Benefit to Farmers 1
78,000 2
126,000 3
154,000 4
170,000 5
178,000 6
181,000
You are in charge of the environmental cleanliness department of your city. You know that your air is being polluted by industry, and you know the dollar value of the damage being done to farmers' production as a result. The financial benefit to farmers from having pollution reduced is shown in the table. You also know that the cost of reducing the pollution is constant, and equal to $12,000 per unit of pollution.