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Lecture 2

Lecture 2 on The Economic Way of Thinking

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James Pesando

Opp. Cost of taking an action: what you forgo (give up) by not taking the next best alternative Q:You decide to attend a concert, which costs $200. You value the concert at $400. Your next best alternative is to go to a restaurant, which you value at $150 and which costs $100. What is the opp. cost? A: $200 + ($150-$100) = $250 How does the opp. cost change if the satisfaction you get from going to the concert increases from $400 to $500? A: Not at all, since opp. cost does not depend on the value to you of the action taken. Benefit of attending university for one year Individual A: $275,000 B: $150,000 C: $30,000 If opp. cost increases from $15,000 (sept 2012) to $45,000 (sept. 2013), individual C will choose NOT to attend university Observations 1. Opp cost is the SAME for A, B ,and C 2. Because of individuals like C, enrolment declined in Sept. 2013 Measuring Opportunity Costs Action Taken Next Best Alternative Direct Costs PLUS Dollar amount or value assigned by you LESS Direct Costs (each dollar spent has opp. cost of one dollar) Rational Decision Making Undertake activity if marginal (additional) benefit exceeds marginal (additional) cost Insights 1. Include all opportunity costs 2. Ignore sunk costs Sunk Costs ("Fixed" Costs) Costs which are incurred whether or not action is taken Insights Only relevant costs are those which can be avoided if action is not taken Examples: Marginal benefit of attending sports event: $100 (both Jack and Jill) Ticket Price: $50 1. Jack buys one week in advance 2. Jill plans to buy on day of event Subway breaks down on day of event, and Jack and Jill face unexpected cost: $75 for taxis Should Jack attend event? Should Jill attend event? Answer Jack should attend: MB= 100 MC=75 therefore, MB>MC (ticket price is a sunk cost) Jill should not attend: MB= 100 MC=75+50=125 therefore, MB < MC You buy a truck from a junkyard for $3,000. You plan to spend $2,000 to get it running, so you can resell it for $6,000. If the truck does not run, its market value is nil. Unfortunately, you discover that it will cost $5,000 to repair the truck. Q: Do you repair the truck? A: Marginal benefit: $6,000 Marginal cost : $5,000 MB>MC, so repair the truck (the 3,000 is the sunk cost as it is already spent) Profit: $6,000 - $8,000 = ($2,000) If do not repair truck, profit = $0 - $3,
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