economics for leaders lesson 2: opportunity cost, incentives & markets
TRANSCRIPT
Economics for Leaders
Economics for Leaders
Lesson 2: Opportunity Cost, Incentives & Markets
Joke Of The Day
An economist and an accountant are walking along a large pond and see a frog jumping on the mud.
The economist says: "If you eat the frog I'll give you $20,000!"
The accountant checks his budget and figures out he's better off eating it, so he does and collects money.
Continuing along they see another frog. The accountant says: "Now, if you eat this frog I'll give you $20,000."
After evaluating the proposal the economist eats the frog and gets the money.
Joke Of The Day
They go on. The accountant starts thinking:
"Listen, we both have the same amount of money we had before, but we both ate frogs. I don't see us being better off."
The economist says:
Joke Of The Day
"Well, that's true, but you overlooked the fact that we've just been involved in $40,000 of trade."
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True or
False?
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Economic Reasoning Principle #1: People choose, and individual choices are the source of social outcomes.
Scarcity necessitates choices: 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.
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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.
What did you give up to be here?
Should you go to college?
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choices → TRADE-OFFS → forgone alternatives
OPPORTUNITY COST!
choosing is REFUSING!the cost of something is what you give up.
OPPORTUNITY COST!
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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.
People do what makes them better off.
Marginal Cost, Marginal Benefit
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Drive or drive & ride the ferry?
What matters for this choice?
People do what makes them better off.
Marginal Cost, Marginal Benefit
Eau Claire to MuskegonSummer 2009
Price of gasoline $2.79/gal
The price of gasoline is $4.09/gal
What About 2008?
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The Cost of Something Is What You Give Up to Get It
Should Tiger Woods do his own yard work?Should Roger Federer do his own house-work?What else could they do? …
The Cost of Something Is What You Give Up to Get It
Should Kobe Bryant, Lebron James and Dwight Howard have gone to college?
What about you?What else could they/you do? …
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More ExamplesWhy attend college right after high school?Getting bumped from a flight?Another Rolo, a second washing machineMore oranges, more automobiles and buildings
auto industry bailout?financial industry bailout?health care reform?Afghanistan/Iraq wars?BP oil spill?Bush era tax cuts?Free Dave Matthews concert?
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Policy Conundrum
There are no SOLUTIONS.There are just TRADE-OFFS.
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Should We Ration?
Given that we MUST ration, what is the best mechanism?
Let’s do an activity!
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Rationing Scarce Goods
How much do you like it?
Rank how much you value the item.
1 to 10
10 = TOTALLY AWESOME :>)
1 = PATHETIC :<(
Rationing STUFF!
Item 1 for Allocation/Raffle
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Rationing Scarce Goods
How much do you like it?
Rank how much you value the item.
1 to 10
10 = TOTALLY AWESOME :>)
1 = PATHETIC :<(
Rationing STUFF!
Item 2 for Allocation/Raffle
Rationing Scarce Goods
How much do you like it?
Rank how much you value the item.
1 to 10
10 = TOTALLY AWESOME :>)
1 = PATHETIC :<(
Rationing STUFF!
Item 3 for Allocation/Raffle
Rationing Scarce Goods
How much do you like it?
Rank how much you value the item.
1 to 10
10 = TOTALLY AWESOME :>)
1 = PATHETIC :<(
Rationing STUFF!
Item 4 for Allocation/Raffle
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Methods of Allocation
Given the method of allocation just used to ration the STUFF…
How could we improve this outcome?
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Methods of AllocationAllow Trade Set up a market
Voluntary Trade Creates Wealth!
Rationing STUFF!Do you want to trade?
Rationing STUFF!Do you want to trade?
Rationing STUFF!
Do you
want to
trade?
Insert Trade Item
Rationing STUFF!
Do you
want to
trade?
Insert Trade Item
Rationing STUFF!
Do you
want to
trade?
Insert Trade Item
Rationing STUFF!Do you want to trade?
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Methods of AllocationLotteryContestArbitrary criteriaForceShare equallyFirst-come, first serveNeedMerit
Market Transactions (exchange/prices)
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Markets Typically Do A Good Job Of Rationing
Goods go to those with the highest value.
Goods are produced by those with the lowest opportunity cost.
Voluntary trade increases well-being.– It makes people better off!
What do markets look like?
What is a Market?
Buyers Sellers
specific productinformationproperty rights
competitionvoluntary tradeswell-being
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Markets: Circular Flow
Households
Develop resources to their fullest potential and offer them for sale in factor markets.
Earn income from sale of resources and purchase goods & services to maximize well-being (utility).
Firms
Employ resources in their most useful capacity to produce goods and services.
Sell goods and services to maximize well-being (profit).
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How Do Markets Work?
Buyers and sellers each perform cost/benefit analysis.
Price is a measure of relative scarcity.
Price represents opportunity cost.
Price sends signals/incentives to players.
Buyers
Sellers
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Markets: Supply & Demand
D = MB = WTP (value)Diminishing marginal benefitRolos, washing machine
S = MC = WTS (opportunity cost)Rising marginal costwheat/oranges
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Big Ideas
choices → TRADE-OFFS → forgone alternatives
OPPORTUNITY COST!
choosing is REFUSING!the cost of something is what you give up.
OPPORTUNITY COST!
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Big Ideas
People do things that make them better off.
People respond to incentives in predictable ways.
The rules of the game shape how decisions are made.
Decisions determine outcomes.
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Big Ideas
Voluntary trade creates well-being.
Markets do a good job of allocating scarce resources to meet society’s many and often competing wants/desires.
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Policy Conundrum
There are no SOLUTIONS.There are just TRADE-OFFS.
Fire Department Auction