1. Economics for Leaders Lesson 2: Opportunity Cost & Incentives

2. Economics for Leaders 1 Volunteer? Like these?

3. Economics for Leaders Instructions Eat the Reese’s one at a time Each time you finish one, write down your overall level of satisfaction from eating that cup – use a scale of 1 – 10 10 = highest; 1 = lowest You may eat as many as you like, – once you stop eating, you may not consume any more

4. Economics for Leaders Begin Eating & Record Level of Satisfaction (1-10)

5. Economics for Leaders Control AIDS Control malaria Guest-worker programs for unskilled Improve infant/child nutrition Improve health benefits Kyoto Protocol for environmental protection Lower cost of starting new business Lower barriers to migration of skilled workers U.N. Identified World Challenges

6. Economics for Leaders World Challenges (continued) Micronutrients New agricultural technologies Reduce low birth weight Small-scale water technology Sanitation Trade liberalization Water productivity in food production

7. Economics for Leaders Copenhagen Consensus List of global challenges identified by U.N. 8 top economists in world three Nobel Laureates in Economic Science Task: rank order in terms of benefits & costs where should world spend $ most productively?

8. Economics for Leaders Why not do all? Scarcity  Choice All $50B spent

9. Economics for Leaders Key Economic Proposition Scarcity necessitates choice

10. Economics for Leaders Economic Reasoning Principle #1: People choose, and individual choices are the source of social outcomes. Scarcity necessitates choices

11. Economics for Leaders The poverty of some nations and the wealth of others is not an accident; it is the result of choices

12. Economics for Leaders How Do You Know When Scarcity Forces You to CHOOSE Something Is Scarce? SCARCITY CHOICE

13. 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.

14. Economics for Leaders Opportunity Cost =the value of the Next-Best Alternative – What are the considered alternatives? What would you choose – not what could you choose? What does the decision-maker perceive to be the benefits of each alternative?

15. Economics for Leaders The Cost of Something Is What You Give Up to Get It Should Tiger Woods do his own yard work? Should Yao Ming do his own house-work? What else could they do? …

16. Economics for Leaders Opportunity Cost Analysis What was the 1 st decision you made this morning?

17. Economics for Leaders Opportunity Cost Analysis Alternatives:Get Up NowDon’t Get Up Now Perceived Benefits Choice Opp. Cost Benefits Refused Decision Maker: YOU

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

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

20. Economics for Leaders Choosing is Refusing Every time we choose we pay a cost.

21. Economics for Leaders 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.

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23. Characteristics of Cost: Costs are “to” someone. Costs are the results of actions. Costs relevant to decision making lie in the future. – Past costs (also known as “sunk” costs) are not important to decisions – Example: Do you consider the cost of a movie ticket in whether you sit though to the end of a really bad movie? Costs are frequently not monetary (although we may value them in dollar terms)

24. Economics for Leaders What Determines Your Opportunity Cost? Alternatives Tastes and preferences (values) Rules of the Game--Institutions

25. Economics for Leaders Do Gov’t actions have opportunity costs? Government Debt Economic Stimulus Package War in Iraq Limiting Carbon Emissions Universal Healthcare All alternatives have cost and benefits Individuals perceive the value of costs and benefits differently

26. Economics for Leaders Once, after giving a talk, I was confronted by a lady in the audience who asked what some people regard as the ultimate question: "What is YOUR solution?“ "There are no solutions," I said. "There are only trade-offs.“ "The people DEMAND solutions!" she shot back angrily. The people can demand square circles if they want. But that doesn't mean that they will get them. Quote From Thomas Sowell Opportunity Cost!

27. Economics for Leaders Because costs lie in the future, choices are made at the MARGIN

28. 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 Butterfinger or not

29. 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

30. Economics for Leaders All-or-Nothing vs. Marginal Suppose you must clean your room – What do you clean first? Clothes and other “stuff” –under the bed, in the closet, –or in the clothes hamper? – What’s next? Make the bed Vacuum –under the bed and dresser? –under the carpet? Dust –where? –over the door ledge?

31. Economics for Leaders A Dollar Auction Game You are about to participate in an ascending price, (oral) auction for a one-dollar bill. The person with the highest bid will win the dollar and pay the price bid. The second-highest bidder will pay the amount of his or her final bid. Only the highest bidder receives the dollar.

32. Economics for Leaders Dollar Auction continued s Bids must be given in 10-cent increments with the opening bid starting at 25 cents. s When all bidding stops, the auctioneer will give the dollar bill to the highest bidder for the amount bid. s The person with the second-highest bid will pay the auctioneer his or her highest bid, but does not receive the dollar.

33. Economics for Leaders s Do X (X = bid 10 cents)  Total Cost  $0.95  0.10  $1.05 s Not do X (X = bid 10 cents)  Total Cost  $0.95  0  $0.95 Suppose _____’s last bid is $0.95, but leading bidder is at $1.00 A Rational Approach to Bidding Sunk Cost MC = $0.10 Marginal benefit (MB) = chance at $1.00 If expected MB > $0.10 = MC, then rational person chooses to do X. Sunk cost correctly ignored.

34. Economics for Leaders How much should we do? Work Play Study Sleep Buy Sell

35. Economics for Leaders Choices Are Made At The MARGIN……More Soda? __________ Costs? Source: The Onion

36. Economics for Leaders As long as the marginal benefit is greater than the marginal cost you should continue the activity… MB>MC Do it!

37. Economics for Leaders Should we Allocate? ration? In a world of scarcity, wants exceed available resources… There is no alternative to rationing… The relevant question, what is the best mechanism? Back to Scarcity: What’s the Question?

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39. Allocating/Rationing?

40. Economics for Leaders 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 BEST?Depends…

41. Economics for Leaders Broad Social Goals What do we want your economy to provide for the citizens? What is it you want the economy to do for society? What criteria would you use in your evaluation economic systems?

42. Economics for Leaders Tradeoffs: Improve One Goal, May Reduce Another Example: Higher taxes to finance welfare programs for poor Promote economic equity B(X) Reduce economic freedom → reduce economic growth C(X)

43. Economics for Leaders Why Markets Voluntary Trade Creates Wealth!

44. Economics for Leaders Why 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.

45. Economics for Leaders Economic Reasoning Principle # 3: People respond to incentives in predictable ways. INCENTIVES the rewards or penalties that shape people’s behavior may be negative or positive. may be monetary or non-monetary

46. Economics for Leaders Intended Consequences If people respond to incentives... – then behavior can be altered in desired or intended ways –For example …

47. Economics for Leaders The Tax Man Cometh April 15, 1987... – IRS rule change: Instead of merely listing each dependent child, tax filers required to provide Social Security number. Result? 7 million children disappeared

48. Economics for Leaders However... Unintended Consequences If people respond to incentives... – then behavior may result in undesirable or unexpected outcomes –For example …

49. Economics for Leaders The Camel Race s Two Bedouins met in the desert, and fell into an argument over their camels, each claiming that his was the slowest, “stubbornest,” most useless camel in all of Arabia. The argument ended in a bet. They agreed to race to the oasis, two miles away, whichever camel arrived last would be proved slowest, and his owner would win ten dirham from the other.

50. Economics for Leaders Camel Race continued s... They got on their camels, and set off slowly toward the oasis. More slowly, still more slowly. After a while, it became clear that since each Bedouin was trying to win the bet, they were never going to make it to the oasis. s... After a while, a wise sheik rode up on a donkey and asked them why they and their camels were standing still, in the middle of the desert, on a hot day, with the oasis less than two miles away.

51. Economics for Leaders The Camel Race continued s They got off their camels, and all three sat down in the shade of a rock while the two Bedouins explained about their bet. The wise sheik whispered two words to them. The Bedouins immediately jumped on the camels and rode off as fast as they could towards the oasis.  What were the 2 words? ________ _________  Switch camels!

52. Economics for Leaders Consequences People respond to incentives causing… INTENDED consequences & UNINTENDED consequences. (can offset the intended benefits)

53. Economics for Leaders Ideas to Take Away from Lesson 2: Scarcity forces us to choose and every choice has an opportunity cost. Changing opportunity costs affect incentives and choices. Because costs lie in the future, the relevant costs and benefits occur at the margin. Open markets are a key institution for fostering economic growth and improving standards of living.

54. Economics for Leaders (cont.) Price is a powerful incentive. The law of supply and the law of demand describe producers’ and consumers’ predictable reactions to changes in price. Buyers’ and sellers’ decisions about quantity demanded and quantity supplied are affected by opportunity costs.

55. Economics for Leaders Negotiating with the Dentist