Class #7, 2/9/12

• Today in class, we worked a lot with supply/demand curves and the areas under curves (see notes for examples).
• Embedded in our values is our income and what we can afford. Income is a reasonable way to decide who gets what good.
• Prof. Rizzo gave us a curve about apples. Let's say there is a rich guy (Income= $1 million) and a poor guy (Income= $1,000). Sure, the poor guy would enjoy the apple, but if both men want the apple, the rich guy would always outbid the poor guy.
• If you just give the apple to the poor guy because you feel bad that he is poor, he knows that he can resell the apple. Because of his rational self-interest, he'd take the apply and sell it right back to someone else, even if the rich guy really wanted it, simply because the poor guy values the money for the apple more than the apple itself. 
• The free market is great because it allows you to do what is in your best interest. If a rich man values an apple at $500 and poor guy values it at $2. If rich guy buys the apple for $1, society is $499 wealthier because now he can spend his money on other things and society is richer by $1 for the apple that was bought. If it is sold to the poor person, society is $1 richer because that is all the poor man valued it at.
• If we give the apple to the poor, we are wasting charity/effort for society because we are just making an apple to give away. Instead of producing this apple, we could be making something else that could be of more value to society, such as medicine, etc.
• See curves in notes to see about area under curves.
• Total welfare a person gains from trade = total value - total cost
• Net benefit you get from making a transaction = benefit - cost
• For producers -----> price- cost = how much better off you are by participating in a certain market over doing something else
• Allocative Role of Prices = price is a signal if something is worth it for a consumer to buy something. For a producer, prices helps them know if they should make another unit
• Producers- only those who can make a good below the market price would make it
• Prices don't matter when it comes to economic welfare.
• Consumer surplus = Total value - PQ
• Producer Surplus = PQ - Total Cost
• Total Value - Total Cost -----> see, prices don't end up in calculation
• Gain in trade comes from taking a resource and moving it from a low value state to a high value state, such as oil in the ground. Using it in ways we can make use of it.
• Dead weight loss = any decrease in a gain from trade. So if for whatever reason, a person doesn't make a transaction, this could lead to dead weight loss on the Supply/Demand curve.

Class #6, 2/7/12

• Today, we learned a lot about the area under curves.
• The area beneath the demand curve= not a precise measurement, but nonetheless a measurement of how much value a person gets by doing something
• Key things to know when analyzing a curve/problem set in ECON 207:
• How much of something you start with and how much I'm going to get/takeaway.
• How much you get of something is contingent upon how much you already have.
• Marginal Value- any particular point on someone's demand curve, how much pleasure you get from consuming the very next unit
• Total Value- Approximated by the area below the demand curve- or in other words, how much pleasure you get from consuming a particular quantity of a good
• (See demand/supply curves from class)
• In class, Prof. Rizzo gave us examples of supply/demand curves of soda. By doing this, he explained to us how we can maximize value. So we have 1 soda- who wants it more? To maximize value, you should give it to the person who values it the most. If we then have a 2nd soda, we should give it to the person who has the next most value for the soda, and so on (keep in mind that as we move down the demand curve, people will value the next soda at a lower price. If I value my first soda at $15, I might value a second soda at $12, etc. So, if Joe values his first soda at $14 and 2nd soda at $11, I should get the first soda and Joe should get the second soda.) By doing this, we can accumulate a greater total value.
• The area below the supply curve = total cost a firm would endure when producing a certain amount of units (Q) of a good.
• By combining the supply and demand curves, and looking at the area beneath the curves, we see cost structure- for a firm, they would not sell a good if it costs more to make a good than they could make trying to sell it. If they did do this, that would be irrational!
• Pareto Efficient means to make everyone better off, at least one person has to be worse off. Pareto Efficient means that all possible improvements to a market have occurred.
• The willingness of someone to pay= the ability to pay and how much you value that something
• One final example: Let's say we produce 28 apples and we decide to make the 29th. Is this a good or bad idea? Well, this all depends on the total value society as a whole has on the next apple being produced compared to the cost of making it. But if making the 29th apple costs more than the pleasure we get from it, this is a waste of production because we would've gotten more pleasure producing something else for society- opportunity cost. At the same time, the market allows us to not stop producing apples when society has a high value for them, a value for them that exceeds the cost. The market regulates this.

Class #5, 2/2/12

• You love the environment, should you necessarily buy a fuel-efficient car?
• Two choices:
• Rent a used Buick: $600 and 20 mpg
• Rent used Toyota: $400 and 40 mpg
• We need to know annual driving costs. Suppose the price of gas =$3.00/gallon. So the annual cost= rental cost + fuel cost
• Buick cost= $600 +miles*$3 gallon/20mpg
• Toyota cost = 1400+ 3/40M
• If we set these equations equal to one another, we get: 600 +3/20M = 1400+/40M
• This equals M= 10,667 Miles. So, the Toyota would be cheaper if we drive more than this. The Buick would be cheaper if we drive less.
• The moral of this? When I make a choice, I'm changing everyone's budget constraints. If I buy a Toyota, there is 1 less Toyota for someone else to buy, etc.
• If we are talking about homo-economics here, you need to buy the cheapest car. But cheapest car has a different meaning for different people. You need to do what's in your homo-economicus self-interest. By doing this, we are all better off.
• For example, let's say grandpa has a Toyota. This is dumb if he never drives because now he might make someone else who could make better use of the car not be able to get the car. Thus, that person is forced to buy a less fuel efficient car.
• Also, remember the rules of scarcity. If everyone is buying Buick because the price seems cheaper, the price will eventually go up. This will in result knock people out of the market. In the meantime, the Toyota price would go down until an equilibrium with the Buick sales is met.
• Keep in mind: What might be efficient for you might not be efficient to everyone else due to opportunity costs. In the example of the grandpa, it might be more useful to give a certain car to someone else, but by the grandpa buying the Toyota, he is preventing that from happening.
• We also talked about littering policies. If there is a stiff penalty for littering, this makes the cost of committing an even worse crime lower. For example, lets say the government enacts the penalty that for anyone who litters, they will be killed by the death penalty. Well, not if someone does litter, and someone witnesses the littering, the litterer might be coerced to physically harm/kill the witness so as to prevent himself from being given the death penalty. Think about it- if he is going to be killed anyway, his best chance of survival is to eliminate the witness. Thus, the cost of killing someone else has lowered dramatically all because of a stiff penalty on littering. 

Class #4, 1/31/12

• Positive statements= statements about how the world looks
• Normative= how you think the world ought to be
• Elastic equals more horizontal demand curve
• Inelastic equals more vertical demand curve
• In class, Rizzo showed us a demand curve. In short, people would respond much more to a change in law for a policy when the demand curve is more elastic/horizontal because when the demand curve is horizontal, the less someone does of something, the greater reduction in cost there is.
• We talked about the implications and situations surround aggressive driving.
• When there is an airbag in the car, there is a lower cost to drive aggressively even if a person is not doing so intentionally. Thus, because of the airbag, people almost always drive more aggressively because the cost of doing so is lower than if there were no airbag (you have a better chance of surviving a crash).
• If we were making a policy, let's say, to put airbags in a car to reduce car-related deaths, we'd want to be dealing with a demand curve that is more inelastic (or vertical) because the cost would lower, yes, but since the curve is inelastic, it won't be effected as much as an elastic curve would, and therefore, deaths might increase but not nearly as much as if the demand curve was elastic (more sensitive to change).
• Let's say we find out that there are not less deaths even with airbags. This still could be a positive (unintended consequences). Because of airbags, maybe we can now drive faster and be more efficient in travel because we are technically safer in the car and thus can make better use of our time by driving faster.
• Thus, we are taking the gift of more efficiency.
• Then, we learned about absolute vs. relative prices.
• In this class, when Rizzo says price, he is referring to the relative price of something. Keep in mind that in a world without money, people would still exchange and trade.
• When we talk about wanting money, we don't really want money. What we want is purchasing power to buy what we want. In other words, we need to consider what we are trading off of one good to get another good.
• Money measures how much things cost. Money helps us compare how valuable things are to people.
• But money prices don't always convey all the information about a good (consider inflation). Once again, what matters is what the money can buy you.
• Then, Rizzo explained to us a very interesting concept about The Orange Market.

                                  Florida                NY

Good Oranges:         $1    TC=0.50                $1.50

Bad Oranges:            0.50                 1.00

TC=transaction cost

So according to the above table, the price of a good orange in Florida= 2 bad oranges. Thus, here is the tradeoff. If you are in Florida and you buy a good orange, you are giving up the chance to have two bad oranges.

Then Rizzo asked us the question: Which of those states, on average, do you expect to eat better oranges? Rizzo says the answer is NY.

The reason behind this is that in NY, there is less of an opportunity cost. The relative price is cheaper for good oranges as opposed to bad oranges in NY. So someone in NY is more likely to eat a good orange. This is all talking about what is known as substitution effects.

Important to note: Expensive goods get cheaper when you add a fixed cost to it (the 50 cent transaction cost, in this example).

Because of this, in NY, the more expensive orange is actually cheaper!

Then, we learned about most examples like the above, such as:

Should I bungee jump?

It is worth $60 of fun vs. cost of going = $40

But comparing these two monetary figures is not the entire decision. There are opportunity costs that need to be considered.

Let's say if I don't go jumping, I can do research in Rizzos office. This is worth $45 to me. So the correct way to figure out this is to add up all the benefits and costs.

Benefits of bungee= $60

Costs: Direct cost= $40

           Indirect cost= $45 (research)

Thus if you add up these two costs = $85. I am actually losing money by going bungee jumping 60-85= -25. If the number turned out positive, then it'd be the rational decision to go bungee jumping.

Prof. Rizzo then concluded class with a very interesting example about the Indianapolis Colts and who they should start at QB next year. Below is the email Prof. Rizzo sent out to the class about this very topic:

The NFL team the Indianapolis Colts has a decision to make - continue to keep their Hall of Fame quarterback (who also is facing career threatening injuries) and pay him gobs of money, or to play a great new rookie quarterback next year. 

The problem? The Colts paid Peyton a $26 million salary last year. Another problem, if they keep him and play him next year, it will cost them $28 million (I may have the numbers backward). If they draft a new quarterback (almost surely they will) they will only have to pay him $10 million.

So, the Colts and their fans have made comments to the effect of "well, we paid Peyton $26 million already, so we HAVE to play him next year if he can walk!" Well, that is some poor economic thinking. No matter what happens the Colts cannot recover the $26 million they already paid him. When they decide how to proceed, they must ONLY consider the value of Peyton (i.e. the benefit) playing QB next year versus the $28 million cost to play him. And they must compare that net value with the net value of their next best option - which is to draft, pay and play Stanford QB Andrew Luck (for those football fans out there, I'd prefer to see them draft RGIII). In any case Luck will cost something like $10 million.

So, how much better than Peyton must Andrew Luck be in order for the Colts to drop Peyton? Let's write down their benefit-cost problem.

ANDREW LUCK: B(lLuck) - C(Luck) = B(Luck) - $10 million

PEYTON: B(Peyton) - C(Peyton) = B(Peyton) - $28 million.

So, the Colts would be indifferent between playing Luck and Peyton if these values were equal:

B(Luck) - $10 million = B(Peyton) - $28 million

Or if B(Peyton) - B(Luck) = $18 million

In other words, they should pay Peyton only if he is at least $18 million better than Luck, and no less.

What is the common economic error? 

It is treating the sunk cost of Peyton's former salary as a recoverable benefit. Some Colts fans and management who say, "we have to play him because we already paid him" are treating the $26 million as a benefit of playing Peyton, and so for them, they are treating the decision rule as if:

ANDREW LUCK: B(lLuck) - C(Luck) = B(Luck) - $10 million

PEYTON: B(Peyton) +$26 million - C(Peyton) = B(Peyton) - $2 million.

So, the Colts would be indifferent between playing Luck and Peyton if these values were equal:

B(Luck) - $10 million = B(Peyton) - $2 million

Or if B(Peyton) - B(Luck) = MINUS $8 million

In other words, if the Colts treat his old salary as a benefit, then they will be willing to play Peyton even if he is a much worse quartback than Andrew Luck! That idea doesn't pass our gut instinct, and happily this time the rational choice approach confirms it.