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."

Economics for Leaders True or False?

Economics for Leaders 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.

Economics for Leaders 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?

Economics for Leaders choices → TRADE-OFFS → forgone alternatives OPPORTUNITY COST! choosing is REFUSING! the cost of something is what you give up. OPPORTUNITY COST!

Economics for Leaders 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

Economics for Leaders 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 Muskegon Summer 2009

Price of gasoline $2.79/gal

The price of gasoline is $4.09/gal What About 2008? xx

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? …

Economics for Leaders More Examples Why attend college right after high school? Getting bumped from a flight? Another Rolo, a second washing machine More 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?

Economics for Leaders Policy Conundrum There are no SOLUTIONS. There are just TRADE-OFFS.

Economics for Leaders Should We Ration? Given that we MUST ration, what is the best mechanism? Let’s do an activity!

Economics for Leaders Rationing Scarce Goods How much do you like it? Rank how much you value the item. 1 to = TOTALLY AWESOME :>) 1 = PATHETIC :<(

Item 1 for Allocation/Raffle

Economics for Leaders Rationing Scarce Goods How much do you like it? Rank how much you value the item. 1 to = TOTALLY AWESOME :>) 1 = PATHETIC :<(

Item 2 for Allocation/Raffle

Rationing Scarce Goods How much do you like it? Rank how much you value the item. 1 to = TOTALLY AWESOME :>) 1 = PATHETIC :<(

Item 3 for Allocation/Raffle

Rationing Scarce Goods How much do you like it? Rank how much you value the item. 1 to = TOTALLY AWESOME :>) 1 = PATHETIC :<(

Item 4 for Allocation/Raffle

Economics for Leaders Methods of Allocation Given the method of allocation just used to ration the STUFF… How could we improve this outcome?

Economics for Leaders Methods of Allocation Allow Trade Set up a market Voluntary Trade Creates Wealth!

Do you want to trade?

Do you want to trade? Insert Trade Item

Do you want to trade? Insert Trade Item

Do you want to trade? Insert Trade Item

Do you want to trade?

Economics for Leaders Methods of Allocation Lottery Contest Arbitrary criteria Force Share equally First-come, first serve Need Merit Market Transactions (exchange/prices)

Economics for Leaders 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? BuyersSellers specific product information property rights competition voluntary trades well-being

Economics for Leaders 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).

Economics for Leaders 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

Economics for Leaders Markets: Supply & Demand D = MB = WTP (value) Diminishing marginal benefit Rolos, washing machine S = MC = WTS (opportunity cost) Rising marginal cost wheat/oranges

Economics for Leaders Big Ideas choices → TRADE-OFFS → forgone alternatives OPPORTUNITY COST! choosing is REFUSING! the cost of something is what you give up. OPPORTUNITY COST!

Economics for Leaders 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.

Economics for Leaders 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.

Economics for Leaders Policy Conundrum There are no SOLUTIONS. There are just TRADE-OFFS.

Fire Department Auction