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Lesson 2: Opportunity Cost and Incentives

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Key Terms

Opportunity Cost Marginal Benefit & Cost Supply
Incentives Rationing Sunk cost
Money Price Demand

National Content Standards Addressed

Standard 2: Marginal Decision Making

Effective decision making requires comparing the additional costs of alternatives with the additional benefits. Most choices involve doing a little more or a little less of something: few choices are “all or nothing” decisions.

  • Few choices are all-or-nothing decisions; they usually involve getting a little more or one thing by giving up a little of something else.
  • To determine the best level of consumption of a product, people must compare the additional benefits with the additional costs of consuming a little more or a little less.
  • Marginal benefit is the change in total benefit resulting from an action. Marginal cost is the change in total cost resulting from an action.
  • As long as the marginal benefit of an activity exceeds the marginal cost, people are better off doing more of it; when the marginal cost exceeds the marginal benefit, they are better off doing less of it.
  • To determine the optimal level of a public policy program, voters and government officials must compare the marginal benefits and marginal costs of providing a little more or a little less of the program’s services.

Standard 3: Allocation Mechanisms

Different methods can be used to allocate goods and services. People acting individually or collectively through government must choose which methods to use to allocate different kinds of goods and services.

  • No method of distributing goods and services can satisfy all wants.
  • There are different ways to distribute goods and services (by prices, command, majority rule, contests, force, first-come-first-served, sharing equally, lottery, personal characteristics, and others), and there are advantages and disadvantages to each.
  • Scarcity requires the use of some distribution method, whether the method is selected explicitly or not.
  • National economies vary in the extent to which they rely on government directives (central planning) and signals from private markets to allocate scarce goods, services, and productive resources.
  • Comparing the benefits and costs of different allocation methods in order to choose the method that is most appropriate for some specific problem can result in more effective allocations and a more effective overall allocation system.

Standard 4: Incentives

People respond predictably to positive and negative incentives.

  • Both positive and negative incentives affect people’s choices and behavior.
  • Changes in incentives cause people to change their behavior in predictable ways.
  • Incentives can be monetary or non-monetary.
  • Acting as consumers, producers, workers, savers, investors, and citizens, people respond to incentives in order to allocate their scarce resources in ways that provide the highest possible returns to them.

Standard 5: Gains from Voluntary Trade

Voluntary exchange occurs only when all participating parties expect to gain. This is true for trade among individuals or organizations within a nation, and among individuals or organizations in different nations.

  • People voluntarily exchange goods and services because they expect to be better off after the exchange.
  • Free trade increases worldwide material standards of living.

Key Ideas

1. Review:

  • Scarcity forces us to make choices.
  • People (not governments, nations, or societies) choose.

2. Every choice has an opportunity cost. The opportunity cost of choosing an alternative is the value of the “next-best” foregone alternative.

  • Relate opportunity cost to the choices students made in the “The Magic of Markets” trading game.

3. Because people make choices, all opportunity costs have the following characteristics:

  • All costs are costs to someone. Only people bear costs.
  • Costs are subjective. Individuals may value costs differently.
  • Opportunity costs result from actions. “Things” have no costs in and of themselves.
  • All costs relevant to decision making lie in the future. People can anticipate costs, but they occur only after a choice has been made.

4. Incentives are the rewards or punishments that shape people’s choices.

  • Incentives can be either monetary or non-monetary.
  • When opportunity costs change, incentives change, and people’s choices and behavior change.
  • Changes in incentives cause people to change their behavior in predictable ways.

5. Price acts as an incentive to consumers and producers.

  • Higher (lower) prices require consumers to give up more (fewer) resources to obtain goods.
  • Consumers react to changing price incentives by altering their consumption choices or the quantity demanded of goods.
  • The Law of Demand predicts an inverse or negative relationship between quantity demanded and the price of a good.
  • Prices affect producers of goods by offering them greater benefits from production when prices increase or lower benefits when prices decrease.
  • The Law of Supply predicts a positive relationship between quantity supplied and the price of a good.

6. All costs or benefits that affect decisions are marginal costs or marginal benefits.

  • As long as the marginal benefit of an activity exceeds the marginal cost, people are better off doing more of it. When the marginal cost exceeds the marginal benefit, they are better off doing less of it.
  • Past costs are called “sunk” costs. The sunk cost fallacy occurs when people fail to recognize that the relevant costs and benefits occur at the margin, which necessarily involves future costs and benefits.
  • Marginal analysis helps people to make more informed decisions.
    • Those who do not use marginal analysis are likely to reduce the total benefits available from the choices made.
  • In the whole economy, a lack of marginal decision making reduces income and growth.

7. Because of scarcity, all goods and services must be rationed. The question is: How are they rationed?

  • Economies must use rationing mechanisms to determine what is produced, how it’s produced, and who gets what is produced.
  • People’s choices are influenced by the incentives incorporated in rationing mechanisms.
  • The rationing mechanism may encourage or discourage economic growth. Rationing by money price has proven effective in addressing the allocation problem presented by scarcity, and in providing information that encourages economic growth.
  • Changes in price create incentives for predictable changes in people’s behavior that reduce the impact of scarcity.
    • A higher money price encourages more production (or a greater quantity supplied), while at the same time requiring buyers to give up more resources.
    • When buyers face higher opportunity costs to acquire a particular good or service, they react by seeking less costly substitutes; thereby reducing quantity demanded.
    • As production increases and quantity demanded decreases, quantities that people are willing to exchange come into balance. Thus, a changing money price causes the marketplace to reach equilibrium between quantity supplied and quantity demanded.
  • While we employ a variety of rationing mechanisms in the American economy, the advantages of money-price rationing mean that most goods and services are rationed in this way.

 

Ideas To Take Away From This Lesson

 

  • Scarcity forces us to choose and every choice has an opportunity cost.
  • Changing opportunity costs affect incentives and choices.
  • Because costs lie in the future, the relevant costs and benefits occur at the margin.
  • Money price acts effectively to balance quantity supplied with quantity demanded, and to ration goods in markets.
  • Decisions about quantity supplied and quantity demanded are affected by opportunity costs.
  • Price is a powerful incentive. The law of supply and the law of demand describe producers’ and consumers’ predictable reactions to changes in price.