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2012-09-10 week - THE ECONOMIC WAY OF THINKING (opportunity cost) marginal rational decision making, sunk costs, incentive.docx

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James Pesando

Sept 10, 2012 ECO100 pesando Username: pesando Password: Windsor Tutorials start in 2 weeks – complete assignments by tutorial, TA explains answers Usually no Friday lectures WEEK #1 THE ECONOMIC WAY OF THINKING 1. The economic problem -> scarcity requires choices Economics: study of how people make decisions SCARCITY Individual - Limited budget - Limited time Society - Limited resources to produce goods CHOICES – scarcity forces us to make choices If you had unlimited resources/time, you wouldn’t need to make decisions because you could do/make everything ECONOMICS: study of how rational people make choices Opportunity Cost And Marginal Analysis Logical thinking in economic context OPPORTUNITY COST The opportunity cost of an action is what one forgoes (gives up) by not taking the best alternative action Insights: (1) The question “Should I do X?” should be replaces by “Should I do X or Y, where Y is the most highly valued alternative to X?” (if I didn’t do x, y would be the next on the list” (2) Opportunity cost includes time cost as well as money cost Opportunity Cost: BASIC EXAMPLES: Ex. #1: choose to go to a concert - $50 Next best alternative: work for 2 hours, earn $40 Opportunity cost (i.e. if u chose next best alt): $50 (didn’t spend on ticket)+ $40 (earned) = $90 Remember: opportunity cost of spending $1 is $1 (since you could spend it on other goods/services) Benefit of going to concert does not effect opportunity cost. Insight: if the benefit of attending concert was $100, $200, $10,000 the opportunity cost would not change. However, if the benefit is less than $50, you would never attend the concert Only look at what you forgo, not what you gain from choosing option X Ex. #2: concert - $50 Next best alt: nature walk, which you value as earning $25 Opportunity cost: $50+$25= $75 DIFFICULT EXAMPLES: Ex. #1: 2005: purchased bottle of rare wine for $50 2008: could have sold wine for $200 Today: could sell wine for $75 If you drink wine today, and the next best alternative is to sell it, what is the opportunity cost? - $0? - $50? - $200? - $75!!! --- what you paid in 2005 or what you could have sold it for in 2008 are NOT RELEVANT! Ex. #2 1. Receive free concert ticket (2 hrs) Next best alternative: dinner at fav restaurant, which you value as earning $100, but the actual monetary COST of the meal is $75 What is the opportunity cost of attending the concert? - $0? - $100? - $175? - $25!!!!!!! $100 monetary value (earned, you assigned) – $75 cost (meal cost) = $25 lost/missed out by going to the concert So it’s like you had a coupon for getting $100 worth of food at kelsey’s for $75. Going to the restaurant, you *technically* earn $25. Going to the concert, if you don’t value it at all, you earn $0. So you lost/missed out on $25 by going to the concert. *ask professor* if you had valued the concert at $25, would the opportunity cost be $0? MEASURING OPPORTUNITY COST Action Taken Next Best Alternative Direct costs Dollar amount or value (each dollar spent has +PLUS assigned by you Opportunity cost of one dollar) - LESS Direct cost of next best alternative Opportunity Cost: Applications December 1990: Ontario universities predict first year’s enrollment for Fall 1991 to be 25,000 Spring 1991: economy enters deep recession, employment drops, unemployment rises Sept 1991: is actual enrollment likely to be more than 25,000 or less? Answer: MORE Ex. opportunity cost of attending university for one year 1. If the best alternative (to attending uni) is full time work at $20,000 per year, the opportunity cost is: (Tuition/books: )$8000 + (Forgone earnings: ) $20,000 = $28,000 2. If the best alternative (to attending uni) is full time work at $40,000 (Tuition/books:) $8000 + (Forgone earnings: ) $40,000 = $48,000 Observe: Forgone earnings is the most import component of opportunity cost (and in 1991, explains the unexpectedly high enrollment) Cant find a high paying job -> go to uni instead Insight: if the opportunity cost of taking an action is high, the action is less likely to be taken Ex. Should this individual operate a hot dog stand? Revenue (per 8 hr day): 100 hot dogs @ $2.50 each = $250 Direct costs (per 8 hr day): Rent for stand ($75) + Hot dogs, buns ($75) = $150 Difference: $250-$150 = $100 Missing information: Opportunity cost of individual’s time (1) If I could earn $15/hr (make $120 in 8 hrs) opportunity cost is $120 for 8 hr day Question: why is the opportunity cost $120 and not $20? (120-100=20) Since $120 exceeds $100, you should not operate the stand What if opportunity cost is $10/hr? = $80 --- then you should operate the hot dog sand Q: why do so few doctors operate hot dog stands? A: the opportunity cost is so high ***end of Monday sept. 10 lecture *** September 12, 2012 Rational (economic) decision making Two key building blocks: 1) Opportunity Cost (what you forgo by not taking the next best alternative) 2) Marginal Analysis Rational Decis
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