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ECO100Y1-Pesando-Notes edited by Eva Wu

Topic 1 - The Economic Way of Thinking

(Week One Sep 13
Sep 17

Sep 13
Scarcity & Opportunity Cost
Scarcity: Individual: limited budget; limited time
Society: limited resources to produce goods
Economics: the study of how rational people make choices;
the study of how society managers its scarce resources;
Scarcity leads to Choices leads to Economics (the study of making choices).
1. Opportunity Cost:
what one forgoes by not taking the best next alternative;
whatever must be given up to obtain some item;
a. The question Should I do X should be replaced by
Should I do X or Y where Y is the most highly valued alternative to X
b. Includes Time Cost as well as money cost

e.g.1. What is the OC of attending University for one year ($8,000) if the next best alternative is working
full-time at $20,000/yr?
Opportunity Cost = Tuitions/Books + Forgone Earnings = $8000+$20,000
The Opportunity Cost of spending $1 is $1 (you could use the same dollar to buy other goods or services);

e.g.2 What is the OC of attending a 2-hr movie (ticket $12) if:
a). the next best alternative is working a P/T job at $10/hr
OC=Ticket Price + Forgone Earnings = $12 + $20 = $32;
b). the next best alternative is going for a walk
OC=Ticket Price + the Satisfaction from the walk (no monetary value)
(but the satisfaction from the walk apparently exceeds $20.00, by implication);

e.g.3 someone operates a hotdog stand with:
a. Revenue from an 8-hr day: 100 hotdogs x $2.5/hotdog = $250;
b. Cost of an 8-hr day: Rent-$75; Profit = $100
buns, hotdogs = $25; Total Cost = $100;
NOW should one continues operating the hotdog stand if:
a). The next best alternative is working at $15/hr?
No, $15 X 8 = $120 greater than $100;
b). The next best alternative is working at $10/hr?
Yes, $10 X 8 = $80 less than $100.
c).Why do few medical doctors operate hot dog stands?
Since medical doctors are the highest-earning professions in Canada, the opportunity cost of their time is
too high for them operate hotdog stands.

ECO100Y1-Pesando-Notes edited by Eva Wu

Application 1: Enrollment Rate
In Dec 1990, an Ontario University predicts its first year enrollment to be 25,000;
In spring 1991, the economy enters a deep recession, and employment drops greatly;
In Sep 1991, What is the actual enrollment going to be? Greater or Less than 25,000?

The OC of attending university (e.g.1) is Tuition/books + Forgone Earnings.
In this case, the unemployment increased greatly, prospective students are much less likely to get a job as
they used to expect. Their Forgone earning decreases greatly. The OC as a whole decreases greatly.
Therefore, there is a huge increase in the actual enrollment.

a). What is the OC of going to a free concert (2-hr) if the next best alternative is dinner at your favorite
restaurant? (the dinner is valued by you at $100; dinner cost $75;)
0; $25; $100; $175
You receive a satisfaction from the dinner which is valued by you at $100. For the dinner you spend $75.
Therefore if you do not go to the dinner, you are giving up $25 in value ($100-$75). And the concert is for
free, so there is no direct cost. Therefore the OC is $25.
b). What if the meal is for free?
The OC increases to $100 (your satisfaction for the dinner is $100 with no cost;)

Always in mind: WHAT DID YOU GIVE UP?

a). You decided to go to a concert which you value at $400. The concert costs you $200. Your next best
choice is having dinner at your favorite restaurant which you value at $150 and costs you $100. What is
the OC of going to the concert?
OC= $200+($150-$100) = $250
b).What if the value of the Concert goes up?
The OC is unchanged.

The value of the concert DOES NOT impact OC, but rather impact your decision of going to the concert. If
the value you assign to the concert is greater than the cost, you make the decision of going to the concert,
and vice versa. Once the decision is made, the value of the concert no longer impacts on the OC; only the
direct cost of the concert, the value and cost of your next best choice will impact on the OC, because

ECO100Y1-Pesando-Notes edited by Eva Wu

Measuring OC
Action Taken (1
Direct Cost
(because each $1 spent
has an OC of $1)

Why do we not include satisfaction of the 1
It does not impact on the OC but rather on the decision-making at the first place.

We have the following:
Choice cost; 1
choice satisfaction;
choice cost 2
choice satisfaction

Our objective is to obtain the 1
choice satisfaction.
To obtain the 1
choice satisfaction, we have to give up 1
choice cost, 2
choice satisfaction.
But 2
choice satisfaction comes with a 2
choice cost.
So the OC of the 1
choice satisfaction will be:
choice cost + (2
choice satisfaction 2
choice cost)

a). What is the OC of a dinner ($100) if your next best alternative is taking a walk in a park? (the walk is
valued at $50; taxi to and from the park is $20);
OC = $100 + ($50-20) = $130
b). What if the cost of the meal is $300?
Then OC = $300 + ($50-20) = $330. OC increases.

e.g.7. You bought a wine at $20. You have a choice of drinking the wine or selling the wine at the current
market price of $100. What is your OC of drinking the wine?
OC = nil + $100 = $100
OC= $20 + ($100-$20) = $100
($20 can be viewed as a sunk cost ;)

Application 2 Gun Registry
The federal government of Canada regulates guns for the purpose of saving lives. For the federal
government, the cost of gun registry every year is $ 1 billion. Policy Debate goes as follows:
Pros: the gun registry saves 200 lives/ yr;
Cons: the gun registry saves only 5 lives/yr
But this debate is only an illusion and the public is wrongly directed. This is not the real issue that people
should debate over; its not an economic way of thinking.

An economist would consider: What is the OC of spending this $1 billion on gun registry if the next best
alternative is spending this $1 billion in another industry (e.g. Policing; Traffic; Healthcare)? Would it be
more effective and save more lives than putting that money in gun registry?
Next Best Alternative (2
($amount or value assigned by you)
Direct Cost of that alternative
ECO100Y1-Pesando-Notes edited by Eva Wu

Sep 15
- Rational Decision Making & Marginal Analysis & Incentives
Why think on the margins?
Decisions in life are rarely black and white, but usually involve shades of gray. When we make decision what
we really have to consider are the small incremental adjustments around the edge of what we are doing, i.e.
marginal changes.

Marginal changes: small incremental adjustments to a plan of action;
one undertakes the activity if marginal benefit exceeds marginal cost.

Insights: a).Include all OC;

Sunk Cost (Fixed Costs): costs which are incurred whether or not the action is taken;

Insight: when making decisions, sunk costs are ignored because they are incurred anyway.
Relevant costs are those which can be avoided if action is not taken.

e.g.8: Restaurant: Should it stay open for lunch
Lease payment: $12,000/mo. = $400/day
Dinner: 150 meals sold; Lunch: 25meals sold;
Marginal Revenue (revenue per day): 25 meals x $20/meal = $500/day
Marginal Costs (costs per day): Chef: 3hrs at $30/hr = $90
Waiters: 6hrs at $10/hr =$60
Food: 25 meals at $5 = $75 Total: $275/day
Conclusion: $500- $275 = $225 --- profitable to stay open.
The lease payment $400/day is ignored because no matter the restaurant stays open for lunch or not, the
owner still has to pay the lease.

e.g.9 Marginal benefit of attending sports events
Jack and Jill both value a game at $100. The ticket price is $50. Jack buys the ticket in advance, while Jill
plans to buy the ticket at the event. On the day of the event the subway breaks down, so Jack and Jill
encounter an unexpected taxi cost of $75. Should they attend the event?
Jack: MB = $100; MC = $75
(ticket cost $50 is ignored as sunk cost because he has already bought it);
MB is greater than MC, therefore Jack should go;
Jill: MB = $100; MC = $50+$75 = $125
(ticket cost $50 is a relevant cost because it can be avoided if he doesnt go);
MB is less than MC. Jill should not go.

e.g.10 You decide to go to a concert and buy the ticket at a discounted price of $50. You plan to take
public transit there, which will cost you $2. But on the day the concert the public transit breaks down
and cost of a taxi is $30. Its too late to sell the ticket.
a). Should you go to the concert?
MB (value of the concert) is at least greater than $52 (thats why you made the decision of going);
MC = $30. MB is greater than MC, therefore you should go.
ECO100Y1-Pesando-Notes edited by Eva Wu

b). Suppose you are going to the concert, but when you get there by taxi you find that you left the ticket
at home. New ticket to be purchased at the door is $60. Should you buy a new ticket and go to the
MB is greater than $52.
MC = $60. ($50+$30 the old ticket and the taxi costs are sunk cost)
The decision is uncertain.
If you value the concert at greater than $60, then you should buy a new ticket, and vice versa.

Incentive: something that induces a person to act;
Incentive alters MB/MC thus alters Decisions of an action.

Application 3-1: Incentives: unintended consequences of Public Policy
a). Policy: To help low-paid workers Province of Ontario raise the minimum wage to $10/hr.
Response: employers choose to hire fewer workers thus reducing the opportunity of unskilled workers to
gain experiences.
b).Policy: To protect workers, Province of Ontario requires firms to make a large severance payment to
workers if the plant is shut down;
Response: firms can choose where to locate plants; and fewer plants may be opened in the Province,
reducing revenue and job opportunities.
Application 3-2: Seat Belt Legislation
a). Policy: Province of Ontario requires the use of seatbelts to reduce car injuries.
Response: Drivers choose the degree of driving care by weighing its MB and MC.
MB of driving carefully: the value of drivers care;
MC of driving carefully: the value of drivers time and energy (driving slower)

With the seatbelt legislation, the MC of driving carefully is unchanged. But since seatbelts reduce the
likelihood of series injury or death, the VAULE of drivers attention and care also gets reduced. Thus
seatbelt reduce the benefit of driving more carefully. Therefore MB decreases, and driver drive with less
care. In other words, Drivers respond to seat belts as they would to an improved road conditions faster
and less careful driving.
Conclusion: the number of serious injuries and death drops, but the number of injuries increases.

b). If you have a ticket to a concert but you are running late. How do you decide on your level of care when
you drive?
MB of driving carefully: the value of drives care;
MC of driving carefully: the value of drivers time and energy driving slower
MB is unchanged. Since you have a concert to catch, your time values more now, therefore MC increases.
Therefore you will drive faster with less care.

c). If an economist were to propose a legislation to reduce the number of car accidents, he would probably
suggest the auto manufactures to put sharp spikes one inch to drivers throats when they drive.
MB of driving carefully: the value of drives care;
MC of driving carefully: the value of drivers time and energy driving slower
MB is now greatly increased because the value of drivers care is very high --- its valued at the expenses of
their lives. MC stays unchanged.
In this way drivers will drive with much more care.