Principles of Microeconomics

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ECON1001E,F Introduction Part II
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Introduction

• Scarcity and Competition
• Opportunity Cost
• Cost and Benefit Analysis
• Some Common Pitfalls for Decision Makers
• Positive Vs. Normative Economics

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What is Economics?

• Studies allocation of scarce resources among
  competing ends
• for most goods, wants (desires) exceed what is
  available (limited resources).
• Thus, having more of one thing usually means
  having less of another. People have to make
  choices.
• Studies how agents respond to incentive
• Is what economists study

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Economics studying choice in a world of scarcity

• The Scarcity Principle, a.k.a., the No-free-lunch
  Principle
• Although we have boundless needs and wants, the
  resources available to us are limited. So having
  more of one good thing usually means having less
  of another.
• The Cost-Benefit Principle An individual (or a
  firm or a society) should take an action if, and
  only if, the extra benefits from taking the
  action are at least as great as the extra costs

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Opportunity Costs

• For economists, costs mean opportunity costs or
  alternative costs.
• Opportunity Costs are the best foregone
  opportunities (or best alternative you otherwise
  would have chosen)
• Cost is important for decision making in
  economics
• Costs and choices are twin (You cant have one
  without the other)

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Example 1 Opportunity Costs

• If you are given a choice of the following three
  candies free of charge
• I) MM (0.5)
• II) Snicker (0.7)
• III) Nestle Crunch (1.0)
• What is your opportunity cost if you choose MM
  (with no resale option)? (a) 0.7, (b) 1, (c)
  Snicker, (d) Nestle Crunch, or (e) not enough
  information.

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Example 2 Opportunity Costs

• You have three job offers, they are indifferent
  to you except for their pay. Here are the
  offers
• Goldman Sachs 100,000
• Merrill Lynch 90,000
• Morgan Stanley 80,000
• What is your opportunity cost if you take the job
  at Merrill Lynch? (a) 10,000, (b) 100,000 (c)
  80,000, or (d) Not enough information.

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Example 3 Opportunity Costs

• You won a free ticket to see an Eason Chan
  concert (which has no resale value).
• Andy Lau is performing on the same night and is
  your next-best alternative activity. Tickets to
  see Andy cost 40/ticket.
• On any given day, you would be willing to pay up
  to 50 to see Andy.
• Assume there are no other costs of seeing either
  performer. Based on this information, what is the
  opportunity cost of seeing the Eason Chan
  concert? (a) 0, (b) 10, (c) 40, or (d) 50.
• (Source http//www.marginalrevolution.com/margina
  lrevolution/2005/09/opportunity_cos.html)

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Example 4 Opportunity Costs

• Paul is a house painter whose roof needs
  replacing. Ron is a roofer whose house needs
  painting.
• Although Paul is a painter, he also knows how to
  install roofing. Ron, for his part, knows how to
  paint houses.
• Should Paul roof his own house? Should Ron paint
  his own house?

Paul
Ron
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Example 4 Opportunity Costs
Time required by each to complete each type of
job
Painting Roofing
Paul 300 hrs 400 hrs
Ron 200 hrs 100 hrs
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Example 4. Opportunity Costs
Painting Roofing
Paul 300 hrs 400 hrs
Ron 200 hrs 100 hrs
Opp. Cost for 1 Painting Opp. Cost for 1 Roofing
Paul 0.75 Roofing 1.25 Painting
Ron 2 Roofing 0.5 Painting

• For Paul, the o.c. of painting one house the
  number of roofing jobs he could do during the
  same time.
• So Pauls o.c. of painting a house is .75 roofing
  jobs (300 hrs per painting/400 hrs per roofing).

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Cost and Benefit of New Drug Approval

• Food and Drug Administration (FDA) decides
  whether new medicines should be allowed to go on
  sale in the U.S.
• Pregnant mothers that took a sleeping pill called
  thalidomide caused the birth of 12,000 deformed
  infants.
• 1962 Kefauver-Harris Amendment passed
• Radically increased the drug approval process
• Average time between filing and approval of a new
  drug 7 months before 1962 and 8-10 years in
  1970s.

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Cost and Benefit of New Drug Approval

• Benefit Increase new drug safety
• Cost delay of new drug approval killed
  patients that could have benefited from the
  successful new drugs.
• Example 1 The five-year lag in introducing
  Septra (an antibacterial agent) to the US
  killed, 100,000, may be a million people.
• Example 2 Delay the introduction of a class of
  drugs called beta blockers for a decade (used to
  treat heart attack, high blood pressure) killed
  at least 250,000 Americans

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Some Common Pitfalls for Decision Makers

• Pitfall 1 Measuring cost and benefits as
  proportions rather than absolute dollar amounts

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Example Proportion vs. absolute

• Your employer has a travel discount voucher that
  can be redeemed on one of your next two business
  trips.
• You could use it to save 100 on a 2,000 plane
  ticket to Tokyo or you could save 90 on a 200
  plane ticket to Chicago?

• If your goal is to do what would be best for your
  company, for which trip should you use the
  coupon?
• 90 a savings of 45 (90/200)
• 100 a savings of 5 (100/2,000)

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Some Common Pitfalls for Decision Makers

• Pitfall 2 Ignoring Opportunity Costs
• If doing activity x means not being able to do
  activity y, then the value to you of doing y is
  an opportunity cost of doing x.
• Many people make bad decisions because they tend
  to ignore the value of such foregone
  opportunities.

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Example Opportunity cost when lending a friend
some money?

• Suppose a friend lends you 10,000 free of charge
  for a year.
• She could have put that money in the bank, where
  it would have earned a market interest rate of 5
  percent, or 500 each year.
• Thus, the opportunity cost of loaning you the
  money is 500 interest, the interest that could
  have been earned elsewhere.

If she didn't charge you any interest, it would
be the same as giving you a gift of 500/yr.
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Sunk cost

• Sunk costs are costs that have already been
  incurred and which cannot be recovered to any
  significant degree.

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Some Common Pitfalls for Decision Makers

• Pitfall 3 Failure To Ignore Sunk Costs
• An opportunity cost will often not seem like a
  relevant cost when in reality it is.
• Another pitfall in decision making is that
  sometimes an expenditure will seem like a
  relevant cost when in reality it is not.
• The only costs that should influence a decision
  about whether to take an action are those costs
  that we can avoid by not taking the action.
• Sunk cost is a cost that is beyond recovery at
  the moment a decision must be made, therefore it
  does not affect decision making

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Example The Pizza Experiment

• How much should you eat at an all-you-can-eat
  restaurant?
• A local pizza parlor offers an all-you-can-eat
  lunch for 80.
• You pay at the door, and then the waiter brings
  you as many slices of pizza as you like.
• The "waiter" selects half of the tables at random
  and gave everyone at those tables a 80 refund
  before taking orders.
• If all diners are rational, will there be any
  difference in the average quantity of food
  consumed by these two groups?

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Example The Pizza Experiment

• The 80 admission fee is a sunk cost, and should
  have no influence on the amount of pizza one
  eats.
• So the two groups should eat the same amount of
  pizza, on the average.
• In fact, however, the group that did not get the
  refund consumed substantially more pizza.
• Is it a pitfall for ignoring sunk cost?

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Some Common Pitfalls for Decision Makers

• Pitfall 4 Failure To Understand the
  Average-Marginal Distinction
• Marginal Benefit The increase in total benefit
  that results from carrying out one additional
  unit of an activity.
• Average Benefit The total benefit of undertaking
  n units of an activity divided by n.
• Marginal Cost The increase in total cost that
  results from carrying out one additional unit of
  an activity.
• Average Cost The total cost of undertaking n
  units of an activity divided by n.

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Example Should NASA expand the space shuttle
program?

• NASA currently makes four launches per year.
• Should NASA expand the space shuttle program from
  four launches per year to five?
• Benefits
• Total of 24 billion
• Average of 6 billion/launch
• Costs
• Total of 20 billion
• Average of 5 billion/launch

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Example Should NASA expand the space shuttle
program?
of Launches Total Cost Average
Cost Marginal Cost
( billion) ( billion/launch) (
billion/launch)
What is the optimal number of launches?
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Rules for allocating resources

• The general rule for allocating a resource
  efficiently across different production
  activities is
• Allocate each unit of the resource to the
  production activity where its marginal benefit is
  highest.
• For a resource that is perfectly divisible, and
  for activities for which the marginal product of
  the resource is not always higher in one than in
  the others, the rule is
• Allocate the resource so that its marginal
  benefit is the same in every activity.

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Example Fishing boat allocation

• Suppose you own a fishing fleet consisting of a
  given number of boats, and can send your boats in
  whatever numbers you wish to either of two ends
  of an extremely wide lake, east or west.
• Where should you send your boats?

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Example 1.16. Fishing boat allocation

• Under your current allocation of boats, the ones
  fishing at the east end return daily with 100
  pounds of fish each, while those in the west
  return daily with 120 pounds each.
• The fish populations at each end of the lake are
  completely independent, and your current yields
  can be sustained indefinitely.
• Average CatchWest End 120 lbs/boatEast End
  100 lbs/boat

True or False If you shift some of your boats
from the east end to the west end, you will catch
more fish.
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Example 1.17. Should you move one of your boats
from the east end to the west end?
Currently two boats are sent to the east end and
two to the west end.
Average output per boat Average output per boat
Number of boats East end West end
1 100 lbs/boat 130 lbs/boat
2 100 lbs/boat 120 lbs/boat
3 100 lbs/boat 110 lbs/boat
4 100 lbs/boat 100 lbs/boat
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Example 1.17. Should you move one of your boats
from the east end to the west end?
Average output per boat Average output per boat
Number of boats East end West end
1 100 lbs/boat 130 lbs/boat
2 100 lbs/boat 120 lbs/boat
3 100 lbs/boat 110 lbs/boat
4 100 lbs/boat 100 lbs/boat
Number of boats Number of boats
East end West end Total output
2 2 440 lbs
3 1 430 lbs
1 3 430 lbs
4 0 400 lbs
0 4 400 lbs
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Example 1.17. Should you move one of your boats
from the east end to the west end?
Average output per boat Average output per boat
Number of boats East end West end
1 100 lbs/boat 130 lbs/boat
2 100 lbs/boat 120 lbs/boat
3 100 lbs/boat 110 lbs/boat
4 100 lbs/boat 100 lbs/boat
Marginal output per boat Marginal output per boat
The n-th boat East end West end
1 100 lbs 130 lbs
2 100 lbs 110 lbs ( 240-130)
3 100 lbs 90 lbs (330-240)
4 100 lbs 70 lbs (400-330)
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Rules for allocating resources

• The general rule for allocating a resource
  efficiently across different production
  activities is
• Allocate each unit of the resource to the
  production activity where its marginal benefit is
  highest.
• For a resource that is perfectly divisible, and
  for activities for which the marginal product of
  the resource is not always higher in one than in
  the others, the rule is
• Allocate the resource so that its marginal
  benefit is the same in every activity.

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Positive Economics

• Positive statements are statements that can be
  classified as either true or false
• Offer TESTABLE implications (or refutable
  hypotheses) If A, then B
• If A and not B, then reject the null hypothesis
  
• Positive Economics addresses question likes If
  this, then that form of analysis
• Increase the minimum wage raises unemployment
  rate among young and unskilled workers
• Three strikes and you are out reduces crime

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Positive Economics

• It involves NO value judgments.
• It does not comment on the result of the
  analysis. Whether the result is good or bad
  to the society is none of the business of
  positive economics analysis.
• Do not let your own values direct your analysis
  in positive economics.

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Normative Economics

• Normative economics address questions likes
  what should be done or what ought to be done
• Contains basis for deciding what is good or bad
  (value judgment).
• Examples
• The distribution of income should be more equal
• Antitrust laws should be used vigorously to
  reduce monopoly.