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Cost-benefit Principle
evaluate ALL costs and benefits for any choice you face, and pursue the choice if the benefits are at least as large as the costs
What are the four core principles?
Cost-benefit principle 2.Opportunity cost principle 3. Marginal Principles 4. Independence principle
How do we determine the benefit of something?
Measuring benefit is often hard, we can ask: “What is my willingness to pay”(most you are willing to pay”
Are costs easy to quantify?
No, Ex: Free donut but have to listen to a 1-hour lecture, to quantify the cost of listening to the lecture you could pay to avoid it.
Economic Surplus
Benefit-Cost >= 0, measures changes in our well-being, surplus>0, then our well-being goes up, can never be negative or zero so we will be better off
Does following cost-benefit principles increase our well-being?
Yes
Example of Economic Surplus
Benefit of a pizza= 4$ Cost of a pizza= 3$, Economic surplus is 1$
Example of No economic surplus
Benefit of a pizza-$4 Cost of a pizza=5$, we will not buy so economic surplus =0,
Both buyers and sellers benefit from voluntary exchange
Buyers:Willingness to pay- 7000$ Sellers: Willingness to except: 5000$ Seller: Least Willingness to Accept : 4000$
Suppose car sellers for price :5000$
Buyer benefit=$7000 Buyer Cost=5000$ Economic surplus: 2000$
Seller benefit=$5000 Cost=4000$ Economic Surplus=1000$
Takeaway: Price serves different functions for the buyer and seller To buyer, price=cost, To seller: price=benefit
Opportunity Cost
principle of the true cost of something( the value of) the next best alternative you have to give up to get it, your decisions should reflect opportunity cost, rather than simple out of pocket dollar costs, the relevant cost in economics
Example question of opportunity cost
Should you invest in the stock market? Ask what you could be doing with this limited resource?
Types of limited resources?
limited time-limited money, social or political capital
Example of opportunity cost
what to buy for lunch,
$10 will spend it all on lunch
Price/cost of 1 pizza=10$ price/cost of
1 burger=5$ 2 burgers=$10
Opportunity cost of 1 pizza=2 burgers
Opportunity cost of 1 burgers= ½ pizza
Suppose benefit of 1 pizza= $12 and one benefit of one burger=$7, so benefits of 2 burgers=$14
What is the opportunity cost of two burgers?
1 pizza=12$
Should we buy two burgers?
Compare benefit to cost:
Benefit 14 >= 12 so Buy
Should we buy the pizza?
Compare benefit to cost = 12>10
So you should want to buy the pizza
Opportunity costs should be broadly:
If I did the alternative, what benefits would I get? What additional costs would linger? How much (if any would) save?
Example of concert opportunity cost
Situation: Going to a concert, the tickets you have not yet purchased are 20$. the next best alternative is to study for class. This would give $15 of benefit if you studied.
Opportunity cost: Studying gives you 15$ worth of benefit AND you save the 20 cost of the ticket so the OC is 35$
You should go to the cost if Benefit >= Cost or Benefit >= 35$
example of college opportunity cost
Benefits of college: Higher income in future
Next best alternative: work
costs: tuition -foregone income for job
Costs under either alternative: -time(8hour/day) -rent/food
Costs of college - Cost of Work = Opportunity Cost
Tuition: 20k No tuition -20K
No job forgone income, 50K 50 K
Rent/food Rent/Food 0
8hr/day 8hr/day 0
70K/Year
Total Cost of College=
4 X 70K =280K
You should attend college if benefits >= 280K
-Benefits are coming throughout their lifetime
sunk cost
a cost that has already been incurred and cannot be reversed Ex: Tutition -should not affect your decisions and are NOT, part of opportunity costs
Example of concert example revisited- Sunk Cost
-assume you HAVE bought the concert ticket, for $20, cannot return or sell it so it is a sunk cost, recalled benefits of studying is 15$? the opportunity cost is now 15$ because the 20$ has been spent either way
Some examples of sunk costs
-Movie, the 15$ affect whether or not you leave the movie if you already bought the ticket -Shoes, cannot return the shoes, you keep wearing them should not be affected by how much you spent