OPPORTUNITY COST & INCENTIVESEconomics for Leaders: Lesson 2

Review 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.

Venezuela President Hugo Chavez has nationalized

(unilaterally stripped away) the Venezuelan oil holdings of Exxon Mobile Corporation and Conoco Phillips.

Result?

The poverty of some nations and the wealth of others is not an accident; it is the result of choices.

Economic Freedom ranking: 148 / 157

Venezuela Economic Freedom

Rank: 148 in the world Regional Rank: 28 of 29 Poverty: Increasing

Since 1998, President Chavez has pursued a military buildup, hobbled political opponents through electoral manipulation, imposed foreign exchange controls, undermined speech and property rights, and politicized the state oil company that dominates the economy.

Last year, Chavez confiscated control from private sector oil companies and nationalized the largest electricity superior and the biggest telephone company….. These policies hurt the lower- income groups.

Venezuela has one of the world’s highest inflation rates. Prices controls on food, medicines, and basic services discourage private production and result in shortages.

Economic Reasoning Principle #5:

Understanding based on knowledge and evidence imparts value to opinions.

Opinions matter and are of equal value at the ballot box. But on matters of rational deliberation the value of an opinion is determined by the knowledge and evidence on which it is based. Statements of opinion should initiate the quest for economic understanding, not end it.

Review: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.

New: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.

How Do You Know When Something Is Scarce?

Scarcity Forces You to CHOOSE

SCARCITY CHOICE

Opportunity Cost: The foregone Alternative

Think: “next- best”

Scarcity Is: Even in the face of abundance…..

What’s scarce when you’re In the Mall of America? At the all-you-can-eat buffet?

Opportunity Cost= the Next Best Alternative

Identifying Opportunity Cost: What are the considered alternatives? Prioritize the alternatives- what is the best

and what is the “next- best”? What would you do- not what could you do? What does the decision- maker perceive to be

the benefits of each alternative?

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.

Opportunity Cost Analysis

What was the 1st decision you made this morning?

Opportunity Cost Analysis

Alternatives: Get Up Now Don’t Get Up Now

Perceived Benefits

Choice

Opp. Cost

Benefits Refused

Decision Maker: YOU

Opportunity Cost Analysis Decision Maker: YOUAlternatives: Get Up Now Don’t Get Up Now

Perceived Benefits Shower, breakfast, don’t rush, on time, coffee

More Sleep!

Choice

Opp. Cost

Benefits Refused

Opportunity Cost Analysis Decision Maker: YOUAlternatives: Get Up Now Don’t Get Up Now

Perceived Benefits Shower, breakfast, don’t rush, on time, coffee

More Sleep!

Choice XOpp. Cost XBenefits Refused

Opportunity Cost Analysis Decision Maker: YOUAlternatives: Get Up Now Don’t Get Up Now

Perceived Benefits Shower, breakfast, don’t rush, on time, coffee

More Sleep!

Choice XOpp. Cost XBenefits Refused More Sleep

Use the concept of opportunity cost to discuss the following questions:

Who might choose to get bumped from a flight?

Should Tiger Woods mow his own lawn? What is the cost of attending college?

For LeBron James? For You?

Characteristics of CostCosts are the result of ACTIONS Remember that people choose, and choices impose costs.

Characteristics of Cost Costs are the results of ACTIONS Costs are TO people; things have

no cost “governments,” ”societies,”

countries, nations don’t choose; people do.

Don’t confuse cost and price.

Characteristics of Cost Costs are the results of ACTIONS Costs are TO people; things have no cost All costs lie in the FUTURE

The future is uncertain. When we choose, we anticipate costs, but we don’t know for sure until the act of deciding is complete.

Costs Consequences

Characteristics of Cost Costs are the results of ACTIONS Costs are TO people; things have no cost All costs lie in the FUTURE Costs are frequently not monetary (although

we may value them in dollars terms). 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?

Opportunity Cost of Gov’t Policies Other government programs that you

could have done. What the resources used by government

could have produced in the private sector.

Back to Scarcity: What the Question?(And what does opportunity cost have to do with it?)

Should we ration?

Given that we MUST ration, what is the best mechanism?

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

Why is price rationing the most common method of allocating scarce goods, services, and resources in our economy? The outcome in 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.

Prices: POWERFUL Incentives When prices change, opportunity costs

change- and that is an incentive! People react to changes in incentives in

predictable ways. Both consumers and producers react to

prices in ways that help us to deal with scarcity.

Incentives the rewards or penalties that shape

people’s behavior Incentives may be negative or positive. Incentives may be monetary or non-

monetary

Choices are made at the Margin Steps in our economic way of thinking:

Scarcity IS Because of scarcity; people must choose All choices bear COSTS- the value of the

next- best alternative. Very few choices are “all or nothing”:

choices are made at the margin.

Marginal Analysis:Do you want another one?

Choices are made on the Margin

Margin The next one A little more or a little

less

An Area man forces self to drink another Free Refill!

Making the Choice People will choose to do an activity so

long as the Marginal Benefit is equal to or greater than the Marginal Cost: The Rule

If MB > MC then DO IT; If MB < MC the DO LESS

Economic Reasoning Principle # 4:

Institutions are the “rules of the game” that influence choices.

Laws, customs, moral principles, superstitions, and cultural values influence people’s choices. These basic institutions controlling behavior set out and establish the incentive structure and the basic design of the economic system.

The “Big Ideas” from Lesson 2: Scarcity forces us to choose and every

choice has an opportunity cost. When opportunity cost change,

incentives change, and choices change. Because costs lie in the future, the

important costs and benefits occur at the margin.

Money price rations goods in markets.