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The Do-Nothing Alternative March 16, 2015

Posted by tomflesher in Examples, Micro, Teaching.
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Consider the following situation: You are at a casino. You have a crisp new $100 bill in your pocket and an hour before your friend arrives. There are several options available: blackjack, poker, and slot machines. Each has its advantages and disadvantages. Blackjack offers a 45% probability that you will double your money over the next hour, but a 55% probability you will lose it all. Based on your understanding of statistics, you know this means you should expect to have about $90 at the end of the hour. Poker is a better proposition – since it is a game of skill, you have a 60% chance of earning an extra $50 (for a total of $150), but a 40% chance of losing all of your money. That means you can expect to have about $90 in your pocket at the end of the hour. Slot machines, to go to the other extreme, are a highly negative expected-value proposition. You stand a 1% chance of winning $1000, but a 99% chance of losing all of your money. As a result, you could expect to have about $1 in your pocket at the end of the hour.

Thinking like an economist, you quickly winnow your options down to blackjack or poker, since you cannot abide such a risky proposition. Then, however, you’re stuck – the expected values are the same. Which game is it rational to play?

Similarly, consider this problem raised in a freshman course on ethics: You are on your way out of a coffee shop carrying a double shot of espresso and a $1 bill you received as change. Two homeless people, one man and one woman, each step toward you and simultaneously ask you for the dollar. Since you don’t have any coins, you cannot split the value between the two people. Who should you give your dollar to?1

What do these two situations have in common? In each of them, you are attempting to choose between two options that result in negative consequences for you. In the gambling scenario, you have two options, each with the expectation of losing $10. In the coffee shop scenario, you have two people each asking for $1. In neither case is there a compelling reason to choose one option over the other. The underlying assumption, though, is that we must choose an option at all.

The do-nothing alternative is often (but not always) a hidden option when making choices. For example, in the gambling scenario, you have the option to literally do nothing for an hour until your friend arrives. This leaves you $100 with certainty. In the coffee shop scenario, you have the option to politely refuse each person’s request, leaving you free to keep your dollar. Not every situation allows a do-nothing option; for example, a baseball manager faced with the option of starting his worst starting pitcher or a pitcher who is usually used only in long relief cannot opt to simply start no pitcher. However, a voter who is disgusted with all available candidates may bemoan his “forced” vote for the lesser of two evils without acknowledging that he has the option simply not to vote at all. The do-nothing option is often low-cost but has low returns as well, making it a great way to avoid choosing the best of a bad lot, but a lousy choice for a firm seeking growth.

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1 This was met with considerable debate about the probability that the homeless woman had children.

Budgets and Opportunity Cost January 19, 2012

Posted by tomflesher in Finance, Micro, Teaching.
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In the previous entry, we talked a little about opportunity cost. In short, it’s what someone gives up in order to acquire something else. What does that have to do with budgeting?

Start with the plain-sense definition of a budget. Most people think of a budget – quite correctly – as a list of planned expenses by category. I might plan out my week’s spending as:

  • $30: gas
  • $200: planned monthly expenses (rent, insurance, utilities)
  • $50: groceries
  • $40: a meal out
  • $30: savings
  • $50: petty cash (Starbucks, forgot my lunch, that sort of thing)

That comes out to $400. What does that tell me? Well, for it to be a good budget, I’d better not make any less than $400 a week! Otherwise, I’m planning to spend more than I make, and that’s going to get me into trouble shortly. (If I spend myself into a deficit, I’ll need to plan to get out at some point.) It also tells me that I expect to make no MORE than $400 this week. After all, I have a spot for savings and a spot for petty cash, so I have places for overflow. Petty cash is what some people call slack,where anything “extra” would go.

Let’s simplify just a little. Let’s say I have that same $400 income, but I can only spend it on two things: coffee and sweaters. Sweaters cost $25 each, and coffee costs $2 per cup. I have a couple of choices – in fact, an infinite number of them – for how I can spend that money. For example, if I want to spend all my money on coffee, I can buy

\frac{400}{2} = 200

cups of coffee. If I want to spend all my money on sweaters, I can buy

\frac{400}{25} = 16

of them. Of course, there’s no reason to spend all my money on one of those two goods. I can buy any combination, subject to the budget constraint that I don’t create a deficit: that is, that

2*(cups\:of\:coffee) + 25*(sweaters) \le 400

Think back to when we talked about opportunity cost: if I have the same budget either way, then think about how many cups of coffee I have to give up to get a sweater. There are a couple of ways to do this, but the easiest is to compare the prices: for $25, I get one sweater or 12.5 cups of coffee, so the opportunity cost of one sweater is 12.5 cups of coffee. Similarly, for $2, I get one cup of coffee or 1/12.5 = .08 sweater, so my opportunity cost of buying a cup of coffee is 8% of a sweater. Note that this is the same as dividing the total quantities I can buy:

16\:sweaters = 200\:cups

1\:sweater = \frac{200}{16}\:cups

1\:cup = \frac{16}{200}\:sweaters

Basically, we can use a budget constraint to determine opportunity costs by imagining that we spend our entire budget on each of two goods and then comparing the quantities, or simply by comparing prices. Opportunity costs represent budgeting decisions on a much smaller – some might say marginal – scale.

Opportunities and What They Cost December 23, 2011

Posted by tomflesher in Finance, Micro, Teaching.
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One of the fundamental concepts in economics is that of opportunity cost. In order to understand opportunity cost, though, we need to take a step back and think about costs in a more general way.

The standard example goes like this: I like books, so I want to turn my passion into a job and open a bookstore. To do so, I need to rent a storefront and buy some inventory; for now, I’m going to run the bookstore myself. I’ll be open eight hours a day, so I’ll quit my current job at the box factory and do the bookstore job instead. Easy peasy, right? I even have $100,000 in the bank to get myself started.

Let’s look at the costs. The first thing to consider is the actual money I’m laying down to run this business. Say rent is $1,000 per month. If I don’t want to bother with discounting – and for now, I don’t – then that means I’ve spent $1,000 x 12 = $12,000 on rent this year. Then, imagine that in order to meet demand and still have a decent inventory, I need to spend $43,000 on books. That brings me up to $55,000 worth of cash that I’m laying out – my explicit costs, otherwise known as accounting costs, are $55,000.

But accounting costs don’t show that I had to give up my job at the box factory to do this, and I could have made $45,000. They also don’t account for the interest income I’m giving up by pulling my money out of the bank to live on it. Even if interest rates are only 1.25 APR (that’s annual percentage rate), I’m losing $1,250 in interest income. So, for simplicity (I don’t want to bother with compounding, either), let’s assume that in January I take out this year’s $45,000 in salary and keep it under my mattress. I buy my inventory and pay my rent. I’ve given up $1,250 in interest income and $45,000 in salary, so even though I haven’t laid out that cash, I have to count it as a cost. Accountants won’t write down what I gave up on a balance sheet, but my implicit costs, or opportunity costs, are $46,250.

Total costs are simple – just add implicit and explicit costs. My total costs for starting the business are $55,000 + $46,250 = $101,250.

The key to understanding opportunity cost is that it’s a measure of what you gave up to make a choice, and so it shows how much something is worth to you. If I offer you a free Pepsi, your opportunity cost is zero, so you might as well take it. If I offer you a Pepsi for your Dr. Pepper, we can infer two things:

  1. I value Dr. Pepper at least as much as Pepsi, and
  2. I can figure out how much you value Dr. Pepper, relatively, based on your decision. If you accept, then you must value Pepsi at least as much as Dr. Pepper; if not, you must value Dr. Pepper more (and would thus be rational, since Dr. Pepper is superior to Pepsi).

Opportunity cost is very useful for determining preferences. We’ll talk about that a little more later on. In the meantime, just remember this distinction:

  • Explicit costs are things you paid money for
  • Opportunity costs are how much you’d value your best alternative
  • Total costs are the sum of explicit and opportunity costs.

Comparative Advantage April 8, 2011

Posted by tomflesher in Macro, Teaching.
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So far, we’ve done a lot of discussion of macroeconomics where the economy is closed – that is, we assume all trade takes place in the country, or, in plain terms, there’s no importing and no exporting. Now, we can extend that idea into allowing international trade.

The first question, though, is why would we want to do any international trade at all? Why shouldn’t we – the United States – produce all the goods we need at home instead of sending money outside the country to buy things produced somewhere else?

The first thing to think about is called absolute advantage. In some cases, goods are just cheaper to produce in another country than here. An example might be labor-intensive goods (those are goods produced using more human input than machinery). A lot of clothes purchased in the US are produced in India and Bangladesh, for example, and that makes sense: there are many people, wages are relatively low, and so it’s cheaper to produce goods that can be made by people. On the other hand, the US is more adept at producing capital-intensive goods. An example might be circuitboards, which require a lot of machinery to produce right. It’s easier to substitute people for sewing machines than to substitute them for photoengraving equipment.

However, that ignores some possibilities. If we only took absolute advantage into account, we’d come to the conclusion that a few very smart, very productive nations should do just about everything. Breaking this down to individuals, imagine an economy where there are only two people: a writer and her teenage neighbor. The writer can produce 80 pages of quality material in eight hours and do her dishes in an hour. The teenager can produce 8 pages in eight hours and they aren’t very good, and it takes him two hours to do the dishes. (Not a very productive kid.) If the writer wants a novel, she should do it, and if the writer’s dishes need to be washed, then under the theory of absolute advantage, she should do them, since her absolute cost to do so is lower.

Still, that leaves her with two fewer hours to write, kicking her down to only seven hours and 70 pages. The kid has six pages written and one load of dishes. She’s had to give up 10 pages of production – that’s her opportunity cost, or the best thing she gave up to go mow the lawn. It’d be fair to say that doing the dishes cost her 10 pages of writing. The tally: 76 pages plus two set of dishes (70 + 1 from the writer, and 6 + 1 from the kid).

Suppose instead that the writer negotiates with the kid – she’ll do all his writing, and he’ll do all her dishes. She writes 80 pages. He does two loads of dishes. The total: 80 pages plus two loads of dishes, PLUS the kid has five hours free to put together another five pages of material. We have 85 pages and two loads of dishes. That’s an extra 9 pages. Everyone’s better off.

This is called comparative advantage. The kid isn’t faster than the writer at anything, but his opportunity cost to do a load of dishes – two hours of time – could only produce two pages of writing. The writer’s opportunity cost for a load of dishes is 10 pages. So, since his opportunity cost is lower, the teenager’s comparative advantage is in doing dishes. On the other hand, the opportunity cost to the writer of writing 10 pages is one load of dishes. The opportunity cost to the teenager of writing 10 pages is five loads of dishes. The writer’s opportunity cost is lower, so her comparative advantage is in writing.

You can extend that same idea to two different countries. In some, there are lower opportunity costs to produce goods. It’s correct in a quick and dirty way to say that the opportunity cost of producing labor-intensive goods in the US is higher than in India, and vice versa for capital-intensive goods. Basically, the theory of comparative advantage tells us that even if we have the capability to produce something good, we should allow another country to produce it and then import it if we can produce something better.