OPPORTUNITY COST &
INCENTIVES
Economics for Leaders: Lesson 2
Review

Economic Reasoning Principle #1: People choose,
and individual choices are the source of social
outcomes.
 Scarcity
necessitates choices: not all of our desires can
be satisfied.
 People make these choices based on their perceptions
of the expected costs and benefits of the alternatives.
Venezuela

President Hugo Chavez has nationalized
(unilaterally stripped away) the Venezuelan oil
holdings of Exxon Mobile Corporation and Conoco
Phillips.
Result?
The poverty of some nations and the wealth of others is
not an accident; it is the result of choices.
Venezuela

Economic Freedom





Since 1998, President Chavez has pursued a military buildup, hobbled
political opponents through electoral manipulation, imposed foreign
exchange controls, undermined speech and property rights, and
politicized the state oil company that dominates the economy.
Last year, Chavez confiscated control from private sector oil companies
and nationalized the largest electricity superior and the biggest
telephone company…..


Rank: 148 in the world
Regional Rank: 28 of 29
Poverty: Increasing
These policies hurt the lower- income groups.
Venezuela has one of the world’s highest inflation rates. Prices controls
on food, medicines, and basic services discourage private production
and result in shortages.
Economic Reasoning Principle #5:


Understanding based on knowledge
and evidence imparts value to opinions.
Opinions matter and are of equal value at the
ballot box. But on matters of rational deliberation
the value of an opinion is determined by the
knowledge and evidence on which it is based.
Statements of opinion should initiate the quest for
economic understanding, not end it.
Review:
Economic Reasoning Principle # 3:
People respond to incentives in predictable
ways.
 Choices are influenced by incentives, the
rewards that encourage and the punishments
that discourage actions. When incentives
change, behavior changes in predictable ways.
New:
Economic Reasoning Principle # 2:
Choices impose costs; people receive
benefits and incur costs when they
make decisions.
 The cost of a choice is the value of the nextbest alternative foregone, measurable in time
or money or some alternative activity given up.


How Do You Know When Something Is Scarce?
Scarcity Forces You to CHOOSE

SCARCITY

CHOICE
Opportunity Cost:
The foregone Alternative
Think: “next- best”
Scarcity Is: Even in the face of
abundance…..

What’s scarce when you’re
 In
the Mall of America?
 At the all-you-can-eat buffet?
Opportunity Cost= the Next Best
Alternative

Identifying Opportunity Cost:
 What
are the considered alternatives?
 Prioritize the alternatives- what is the best and what is
the “next- best”?
 What
would you do- not what could you do?
 What does the decision- maker perceive to be the benefits
of each alternative?
People’s Choices are always Rational


Rational choice= choosing the alternative that has
the greatest excess of benefits over costs.
If all choices are rational, then the challenge is to
understand the decision- maker’s perception of costs
and benefits.
Opportunity Cost Analysis
st
1
What was the
decision
you made this morning?

Opportunity Cost Analysis
Decision Maker: YOU
Alternatives:
Perceived Benefits
Choice
Opp. Cost
Benefits Refused
Get Up Now
Don’t Get Up Now
Opportunity Cost Analysis

Decision Maker: YOU
Alternatives:
Get Up Now
Don’t Get Up Now
Perceived Benefits
Shower, breakfast, don’t
rush, on time, coffee
More Sleep!
Choice
Opp. Cost
Benefits Refused
Opportunity Cost Analysis

Decision Maker: YOU
Alternatives:
Get Up Now
Don’t Get Up Now
Perceived Benefits
Shower, breakfast, don’t
rush, on time, coffee
More Sleep!
Choice
X
Opp. Cost
Benefits Refused
X
Opportunity Cost Analysis

Decision Maker: YOU
Alternatives:
Get Up Now
Don’t Get Up Now
Perceived Benefits
Shower, breakfast, don’t
rush, on time, coffee
More Sleep!
Choice
X
Opp. Cost
Benefits Refused
X
More Sleep
Use the concept of opportunity cost to
discuss the following questions:



Who might choose to get bumped from a flight?
Should Tiger Woods mow his own lawn?
What is the cost of attending college?
 For
LeBron James?
 For You?
Characteristics of Cost

Costs are the result of ACTIONS
Remember
that people choose, and
choices impose costs.
Characteristics of Cost
Costs are the results of ACTIONS
 Costs are TO people; things have no cost

 “governments,”
”societies,” countries, nations
don’t choose; people do.
 Don’t confuse cost and price.
Characteristics of Cost



Costs are the results of ACTIONS
Costs are TO people; things have no cost
All costs lie in the FUTURE
 The
future is uncertain. When we choose, we anticipate
costs, but we don’t know for sure until the act of
deciding is complete.
Costs
Consequences
Characteristics of Cost




Costs are the results of ACTIONS
Costs are TO people; things have no cost
All costs lie in the FUTURE
Costs are frequently not monetary (although we
may value them in dollars terms).
 Past
costs (also known as “sunk” costs) are not important
to decisions
 Example: Do you consider the cost of a movie ticket in
whether you sit though to the end of a really bad
movie?
Opportunity Cost of Gov’t Policies


Other government programs that you could have
done.
What the resources used by government could have
produced in the private sector.
Back to Scarcity: What the Question?
(And what does opportunity cost have
to do with it?)

Should we ration?
Given that we MUST ration, what is the best
mechanism?
Methods of Rationing Scarce Goods
and Services






prices
command (someone
decides)
majority rule
contests
by force
voting





first-come-first-served
sharing equally
lottery
personal
characteristics
need or merit
Why is price rationing the most
common method of allocating scarce
goods, services, and resources in our
economy?





The outcome in clear
Individuals can affect the outcome based on their
desire for the product.
It directs resources to their most highly valued uses
Individuals’ power and freedom is enhanced
It provides incentives for both consumers and
producers to reduce scarcity.
Prices: POWERFUL Incentives



When prices change, opportunity costs change- and
that is an incentive!
People react to changes in incentives in predictable
ways.
Both consumers and producers react to prices in
ways that help us to deal with scarcity.
Incentives



the rewards or penalties that shape people’s
behavior
Incentives may be negative or positive.
Incentives may be monetary or non-monetary
Choices are made at the Margin

Steps in our economic way of thinking:
 Scarcity
IS
 Because of scarcity; people must choose
 All choices bear COSTS- the value of the next- best
alternative.
 Very few choices are “all or nothing”: choices are made
at the margin.
Marginal Analysis:

Do you want another one?
Choices are made on the Margin

Margin
 The
next one
 A little more or a little less
 An
Area man forces self to
drink another Free Refill!
Making the Choice

People will choose to do an activity so long as the
Marginal Benefit is equal to or greater than the
Marginal Cost: The
Rule
 If MB > MC then DO IT;
 If MB < MC the DO LESS
Economic Reasoning Principle # 4:
Institutions are the “rules of the game” that
influence choices.
 Laws, customs, moral principles, superstitions,
and cultural values influence people’s choices.
These basic institutions controlling behavior set
out and establish the incentive structure and the
basic design of the economic system.

The “Big Ideas” from Lesson 2:




Scarcity forces us to choose and every choice has
an opportunity cost.
When opportunity cost change, incentives change,
and choices change.
Because costs lie in the future, the important costs
and benefits occur at the margin.
Money price rations goods in markets.