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.