Economics for Leaders

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

2. 1 Volunteer? Like these?

3. 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. Begin Eating&Record Level of Satisfaction(1-10)

5. U.N. Identified World Challenges • 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

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

7. 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. All $50B spent • Why not do all? • Scarcity •  Choice

9. Key Economic Proposition • Scarcity necessitates choice

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

11. The poverty of some nations and the wealth of others is not an accident; it is the result of choices Economic Freedom ranking: 144/144 (2012)

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

13. 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. 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. 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. Opportunity Cost Analysis What was the 1st decision you made this morning?

17. Opportunity Cost Analysis Decision Maker: YOU

18. Opportunity Cost Analysis Decision Maker: YOU More sleep

19. Opportunity Cost Analysis Decision Maker: YOU More sleep X

20. Choosing is Refusing • Every time we choose we pay a cost.

21. 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.

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. What Determines YourOpportunity Cost? • Alternatives • Tastes and preferences (values) • Rules of the Game--Institutions

25. 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. Quote From Thomas Sowell 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. Opportunity Cost!

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

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

33. Sunk Cost MC = $0.10 A Rational Approach to Bidding Suppose _____’s last bid is $0.95, but leading bidder is at $1.00 • Do X (X = bid 10 cents) • Total Cost • $0.95 • 0.10 • $1.05 • Not do X (X = bid 10 cents) • Total Cost • $0.95 • 0 • $0.95 • 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. How much should we do? • Work • Play • Study • Sleep • Buy • Sell

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

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

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

39. Allocating/Rationing?

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

43. Voluntary Trade Creates Wealth! Why Markets

44. Why is price rationing the most common method of allocating scarce goods, services, and resources in our economy? The outcome is clear Individuals can affect the outcome based on their desire for the product It directs resources to their most highly valued uses Individuals’ power and freedom is enhanced It provides incentives for both consumers and producers to reduce scarcity.

45. 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. Intended Consequences • If people respond to incentives . . . • then behavior can be altered in desired or intended ways • For example …

47. 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. However . . . Unintended Consequences • If people respond to incentives . . . • then behavior may result in undesirable or unexpected outcomes • For example …

49. The Camel Race • 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. Camel Race continued • . . . 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. • . . . 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.