Choice involves the loss of foregone alternatives. OPPORTUNITY COST is the highest valued alternative that must be sacrificed when one chooses. (Choosing between A and B, if you choose A the OPP COST of A is B).
Costs are always subjective and exist in the mind of the decision maker. Costs and benefits are highly individual, and can only really be evaluated with 100% accuracy by the decisionmaker. Costs being subjective allows trade to take place and re-allocates goods to the people who value them most highly.
Example - classified ads for used goods.
Cost has a MONETARY cost and a NON-MONETARY cost. Think of the TOTAL COST of getting a college degree. What is the largest cost of a B.A. degree?
Example - Greyhound bus to Miami for $50 each way. 2-3 days on the road each way is a non-monetary cost. Explains why Bill Gates/Oprah/Michael Jordan don't take the Greyhound bus - they have a very high OPP COST in terms of the next highest valued alternative. Their time is very expensive/valuable. Unemployed person, or a college student would be more likely to take the bus, they have a lower opp. cost in terms of the sacrificed alternatives. Their time is not worth as much.
Book example: Round trip airline ticket costs $150 and a bus ticket costs $110. Bus - 10 hours, Airplane-2 hours. Bus is 8 hours longer and $40 cheaper, or a savings of $5/hour. If the opp. cost of your time is less than $5, you should take the bus. If the opp. cost of your time is greater than $5, you should fly.
Example: labor market.
The cost of hiring someone if the opp. cost of the next highest paying job available. If you want to hire a lawyer to teach or be a univ administrator, you will have to compensate them for the next highest valued alternative - private law practice. Variation in college professors' salaries reflect OPP COST.
Or, a univ professor can either teach during the summer or work doing consulting project. To do the consulting project, they have to be paid at least as much as summer teaching. Employers have to bid away workers from other employment opportunities.
Example - retirees watch more daytime TV than working professionals. Why? It is more costly for a stockbroker or real estate agent to take time away from work during the day to watch TV. Retirees have a low opp. cost.
Example - the opp. cost of taking time off from
studying to go to the movies is higher during exam time. Study time becomes
more valuable during exam time and recreation time is more costly. Choosing
recreation would be much more costly during exam time than the first week
of the semester.
TRADE CREATES VALUE
Value/preferences are subjective, and differ among individuals. Trade actually creates wealth because it reallocates goods/service to those who value them most highly. Again, think of the wants ads. Goods are redistributed from those who don't value them to those who do value them. Or stated differently, people who sell used goods value money more highly than the goods, and people who buy used goods value the goods more highly than they value the money.
Grocery store example - $100 of worth of groceries.
What people gain in an exchange is worth more to them
to what they give up. Pos sum game. Not even zero sum(+/-) or neg. sum
game (-/-). In voluntary exchange, both parties are made better off. WIN-WIN
situation. see p. 47
TRANSACTION COSTS - a potential barrier to trade.
Transaction costs (frictions) - time, effort, monetary cost to search out, negotiate and consummate an exchange. Can also be commissions, fees, taxes, tariffs, etc for exchange.
Another way of saying that info is costly and we live in an imperfect universe, and we have to make compromises.
Example: you are looking for a job. Perhaps there are ideal jobs available in Arizona or Alaska, but it may be hard for you to find them. Transaction costs may prevent the ideal candidate getting matched up with the ideal position. "Friction-free capitalism" is an unreachable ideal, although we are moving towards it all the time, due to what???
POINT: transaction costs (frictions) prevent all potentially valuable trades from taking place, explains some of the unemployment in the economy.
Example, you are trying to sell your house for full price - $100,000. You get offers for $95k or $98k, perhaps there is someone in the universe willing to pay you $100k, but it is too costly to find them, in terms of the time required to wait. Cost of perfection is too high.
the optimal no of bad loans for a bank is not zero.
The optimal amt of pollution is NOT zero.
The optimal amt of tax audits is NOT zero.
The optimal amt of missed airplanes is NOT zero.
"Perfection might be too costly to achieve."
MIDDLEMAN AS COST REDUCER
Middleman as a cost reducer - Middlemen bring together buyers and sellers, create a market and reduce overall transaction costs. For a fee, middlemen reduce trans. costs.
Example: Real estate agents, Prop. mgmt agencies,
Stock brokers, Grocers, Auto dealers, Shopping Malls
Want Ads, Jewelry District in NYC, Yellow Pages, Ebay, etc.
Important concept in economics.
Who owns the Wash Monument/Lake Michigan/Grand Canyon
Private prop rights involves:
1. Exclusive control of prop.
2. Transferable rights - sell, rent, trade, give away, etc.
Goods, resources, assets, property have to be either owned privately or publicly.
Strong Difference in incentives created by who owns property.
"Tragedy of the commons" - If everybody owns a resource, no one has a stron incentive to take care of it.
Examples: Buffalos, elephants, commonly owned bicycles
at Berry College, grazing land, etc.
Incentives under private ownership:
1. Private owners gain by using their resources in ways that benefit others. Owners bear the cost of ignoring the wishes of others. In other words, private owners have a strong incentive to pay attention to what other people want. You can be selfish, but you will pay the cost.
Example - you own a house and you are concerned about resale value. You are going to do some decorating. You can paint the walls purple and put up wall paper with dogs playing cards and pave the front yard, but it would be very bad for resale value, because it is not what other people want. So in your decisions for redecorating, you are forced to be concerned about other peoples' tastes. If not, you pay the price of being selfish.
2. Private owners have strong incentives to take good care of their property. Example: you own a car and you will trade it in or sell it in three years. You have a strong incentive to change the oil and maintain the vehicle. Private owners are good stewards.
3. Private owners have an incentive to converse for the future. Example: owner of a house and future generations. Owner is forced to be concerned with future owners to enhance value of property, and will make repairs that will last longer than they plan to live their. Example: planting trees that will last for hundreds of years, putting on a new roof that will last for 30 years. Adding a garage or swimming pool that will last for many years......
4. With priv. prop rights, the owner is accountable for damage to others through misuse of prop. Example: factory that pollutes the water.....
Private prop rights provide powerful incentives for good stewardship....
Example: About 1% of the land in Russia is privately farmed. That 1% of the farm land produces about 40% of the produce grown in Russia.
Example: Water rights. Pollution.
PRODUCTION POSSIBILITIES CURVE
We now look at our first economic model - the Production Possibility Curve. It gives us insight into several of the econ guideposts we have talked about. It shows graphically the fact that resources are limited - universe of scarcity.
Example - we start with a student and graph their PPC for grades. Limited amount of study time - 10 hours per week. Allocated btwn. study for Econ and English. Given the limited study time and the ability of the student, the PPC on p. 40 shows the expected grade outcomes from different allocations of study time. If Susan spends 5 hours per week on both Eng and Econ, she can get a B in both classes, Point T (B, B). If she spends more time on Econ, she could get an A, but would only get a D in Eng, point S (A,D). If she spends more time on Eng, she can get an A, but would only get a D in Econ, Point U (D, A).
How could Susan try to get better grades in both classes????? (Shift out the PPC.)
PPC applied to entire simple economy - 2 good economy - Food and Clothing. Page 41. There is a limited amt of resources - land, labor and capital. If all resources are devoted to Clothing, then Amount S can be produced. If all resources to Food, amt T is produced. A, B, C are other possible combinations of both F and C. (S and T are corner solutions)
Point D is attainable, but is inefficient. Example: Epidemic or Plague, or War. Points outside the PPC are unattainable given the current resources available.
PPC could be flat or concave. If flat it means that resources can be easily and costlessly shifted from F to C or vice-versa. Example: farmer growing corn or soybeans.
In most cases, it would be realistic to assume that as resources starting getting shifted from one production process to the other, it becomes increasing costly to shift resources. Reason: labor, land and capital is not equally suited to both production. Intuition: as cloth workers get shifted to food, they are less and less able to produce food. Same for land and capital (machinery).
Economy can operate at full production (max output) in
SR as long as
1) resources are fixed
2) resources are used efficiently/full employment and
3) level of technology is constant.
How to get MORE output over time? How to INCREASE productivity? Shift OUT the PPC?
1. An increase in the economy's resources - discovery of oil, minerals. Investment in capital formation - machines, buildings, property, plant and equipment, human capital!
See graph page 42.
2. Advances in technology - Industrial revolution, Machine Age, Info Age. Computers, etc. Bar Codes, word processing, etc. Innovation/Entrepreneurs lead to inc. in output/productivity. They expand our production possibilities. See quote from T. Sowell, bottom page 43 about the cavemen.
Example: development of corporate law in 1800s reduced the cost of forming large companies, for example by providing limited liability to owners, and helped the Industrial Revolution which involved large, mass production type firms. We went from small craft guilds to large companies.
Example - 18th century, patent law was developed. Intellectual property rights were established - copyrights (music), patents, trademarks, formulas, etc. Led to an increase in production.
Problem: China has not always followed our copyright laws - Bootleg tape/CDs
Problem: Poland - no way to record a mortgage or bankruptcy.
Problem: Peru - took 5 years to transfer title of car. 90% of the land is untitled.
4. Working longer hours could lead to an inc. in production.
Or increasing work force - more women are working, more two-earner households.
We have some control over how many hours we work and how many adults work.
DIVISION OF LABOR AND SPECIALIZATION
Division of labor and specialization allow us to produce much more as a society compared to each household being self-sufficient. Imagine if each family grew its own food, made their own clothes, chopped wood, made bread, made soap, milked cows, raised cattle, chickens, pigs, etc for meat, built their own house, etc.
Adam Smith example - pin-making. Compared output when one person produced a pin from start to finish vs. separating the various tasks associated with pin-making and implementing specialization. Workers now specialized in just one phase of pin-making. Specialization resulted in output of 4800 pins/worker/day vs. 20 per day working alone. Output increased by 240x by division of labor and specialization.
Why does specialization lead to inc. output?
TRADE AND COMPARATIVE ADVANTAGE
Economizing means getting the most output from the resources available. Maximizing behavior is evident in nature - grass coming up out of cement.
How do we reach maximum output and/or operate at max efficiency?
Insight: Comparative advantage increases output.
Law of comparative advantage - (David Ricardo, early 1800s) states that individuals, firms, regions, nations, planets can gain (increase total output) by specialization in what they are efficient at (low opp. cost) and trading for goods for which they are inefficient (high opp. cost) at producing. Even if a country has an Absolute Advantage (more efficient at everything), they will still benefit from trade because of Comparative Advantage.
Example: Lawyer who is also a very fast typist. 120 wpm. Considers hiring a sect/typist who can type 60 wpm to prepare some legal documents. The lawyer's time is worth $50/hr and the typist charges $7/hour. The lawyer has an absolute advantage in both typing and legal services. The lawyer can type the documents in 4 hours, the sect in 8 hours. The lawyer, has a very high OPP COST of typing, since he/she could be doing legal work if not typing. The cost of having the lawyer type the documents would be $200, the cost of having the typist would only be $56. Even though the lawyer is a better typist, his/her comparative advantage is in law. He/she should hire the typist and concentrate on law. He/She might be twice as efficient at typing, but might be 100x more efficient at practicing law, compared to typist.
Example: cars produced in Michigan, oranges produced in Florida. We are better off specializing and trading compared to Michigan trying to produce both cars and oranges, and Florida trying to produce cars and oranges. National output is increased by specialization and trade.
Example: coffee and Colombia. World output is increased by specialization and trade.
Difficult to exaggerate the gains from Specialization, Division of Labor and Trade According to Comparative Advantage. Our high standard of living is a result of these conditions. Allows us to escape the limits of household production and take advantage of other people's talents and gifts.
Low standard of living of third world countries can be explained by their failure to take advantage of Specialization, Division of Labor and Trade - production is still largely by household. Agricultural, rural economies.
Specialization and trade create mutual dependence. Trading
partners become mutually dependent-creates international cooperation. War
interrupts trade. "When goods can't cross boundaries, armies will."
THREE ECONOMIC QUESTION FOR AN ECONOMY/SOCIETY
ROLE of INFORMATION IN SOCIETY - How to communicate information to decision makers, as a buyer, seller, taxpayer, voter, ect., as a participant in the economy.
1. VOICE - The ability to communicate information (wants, desires, likes, dislikes, complaints, suggestions, etc) to decision makers in the Private sector and the Public Sector.
How do we as consumers transmit information to producers?
To politicans? Bureaucrats?
How do producers communicate information about the cost of production to consumers?
The market as a "virtual voting booth." We vote with our dollars.
2. EXIT - The ability to withdraw from an economic relationship. Very direct and effective method of communicating information/preferences in the market. "Vote with your feet." What if you don't like Wal Mart as a customer/shareholder/bondholder/employee? Exit strategy is very effective in market.
Political arena, exit option is more limited. What if you don't like the service at the Post Office, Dept of Motor Vehicles? What if you don't like taxes in MI as a taxpayer or business?
Questions 1-4, 8, 12-14