Cost and Benefit Analysis and
… Some Big Ideas
Ka-fu Wong
University of Hong Kong
Important
More important
KEY POINT
1
Big Ideas
Microeconomics
1.
2.
3.
4.
5.
6.
7.
8.
Incentives Matter
Good Institutions Align Self-interest with the Social Interest
Trade-offs Are Everywhere
Thinking on the Margin
The Power of Trade
The importance of Wealth and Economic Growth
Institutions Matter
Economic Booms and Busts Cannot be Avoided but Can be
Moderated
9. Prices Rise when the Government Prints Too much Money
10. Central Banking is a Hard Job
11. Economics is Fun
2
Will you pick up the check?
o There is an opportunity for you to pick up a check of
$1000 at the city hall. The ticket to enter the city hall
costs $800.
o Yes?
o No?
3
Will you pick up the check?
o There is an opportunity for you to pick up a check of
$1000 at the city hall. The ticket to enter the city hall
costs $1200.
o Yes?
o No?
4
Important Idea: The Cost-Benefit Principle
o A rational individual (or a firm or a society) should take
an action if, and only if, the extra benefits from taking
the action are at least as great as the extra costs
Should I do activity x?
C(x) = the costs of doing x
B(x) = the benefits of doing x
If B(x) ≥ C(x), do x; otherwise don't.
5
Rationality assumption
o People have goals and try to fulfill them as best as they
can.
o Firms maximize profit
o Consumers maximize utility (satisfactions) from
consumption.
o Governments maximize …
o Politicians maximize …
6
Inference, Prediction and, hence, Policy
o For rational individuals, actions are chosen to maximize some goals,
subject to their respective constraints.
o Prediction:
o Knowing a decision-maker’s goal and constraint, we can predict.
o Decision-makers: firms, consumers, …
o Inference:
o By observing their choice of actions, we can guess the goals and
constraints facing them.
o Policy:
o If we can change their goals (preference), and/or constraints,
we can cause them to choose a different action.
7
Policy
o If people are not doing the things we expect them to do, it must be
that they have a slightly different goals and slightly different
constraints from what we assume.
o We would then need to change their goals (preference),
and/or constraints so that they will choose the action we expect
them to do.
o Teachers: What can we do to motivate students to learn hard?
o Students: What can we do to motivate teachers to teach hard?
8
Modelling the complex world
o We need a model to understand, predict, infer and make
policies.
o If we try to include all the details of the complex world, it will
take forever to build the model, and the resulted model will
be too complicated to be usable.
o The key is abstraction.
o Identify the most important elements in the complex world
and incorporate them (as assumptions) in the model.
Confront the model with data (things happened in the
past).
o Continue to modify the model to improve the fit.
9
What is a good model?
o The assumptions made in the abstract model (e.g., some
kind of rationality assumptions) may not include some of
the elements some of us consider important.
o The ultimate test of the model is how well it can fit the
data, how well it can use to predict, not how realistic the
assumptions are.
Friedman, M. “The Methodology of Positive Economics,” Essays In Positive Economics, Univ.
of Chicago Press, Chicago, 1953.
10
Will you go to the drama?
o Based on your experience, you are willing to pay $400 to
see 《Principle》, a drama of Hong Kong Repertory
Theatre (in Cantonese). The price of the ticket is $250.
Will you go to see the drama?
o Yes?
o No?
11
Will you go to the drama?
o Based on your experience, you are willing to pay $200 to
see 《Principle》, a drama of Hong Kong Repertory
Theatre (in Cantonese). The price of the ticket is $250.
Will you go to see the drama?
o Yes?
o No?
12
Inference
o Observed action:
o John pays a price of $250 to see the drama.
o Conclusion:
o It must be the case that John is willing to pay more
than $250 to see the drama.
o Or, the drama is worth more than $250 to John.
13
Policy
o If we want more people to see the drama,
o we can advertise to change people’s preference
o so that they are willing to pay more to see the
drama.
o reduce the price of the tickets.
o Give people cash so that they have a bigger budget to
spend (?)
14
Advertise to change people’s preference
Willing to pay
15
Reduce the price of the tickets
Willing to pay
16
Will you pick up the one-dollar coin?
o On your way to school, you see a one-dollar coin on the
road. Will you pick up the coin?
o Yes
o No
17
Will you pick up the two-dollar coin?
o On your way to school, you see a two-dollar coin on the
road. Will you pick up the coin?
o Yes
o No
18
Inference
o Observation:
o Yesterday, on her way to school, Mary spotted a onedollar coin but ignored it.
o Today, on her way to school, Mary spotted a twodollar coin and picked it up.
o Conclusion:
o Mary’s cost of picking up a coin is between 1 to 2
dollars.
19
Policy
o If we want more people to pick up something, increase
the benefit of that something.
o Some people may pick up $1 coins.
o More people will pick up $2 coins.
o Even more people will pick up $10 coins.
20
How many bowls of “leung cha” (herbal tea)
should I have?
https://multimedia.scmp.com/news/hong-kong/article/2162156/herbal-tea/index.html
21
How many bowls of “leung cha” (herbal tea)
should I have?
o The key is to convert the original decision to a sequence
of “Yes-No” decisions!
o
o
o
o
Start from zero bowl. Should I have the first bowl?
Start from one bowl. Should I have the second bowl?
…
Start from (n-1)-th bowl. Should I have the n-th
bowl?
o I would have the n-th bowl if the marginal benefit of the
n-th bowl is larger than marginal cost of the n-th bowl.
22
Important Idea: Thinking at the margin
o Actual trade-offs are usually at the margin.
Margin means additional
o MB(n-th unit): the additional benefit due to the n-th unit.
o TB(n units) – TB(n-1 units)
o MC(n-th unit): the additional cost due to the n-th unit.
o TC(n units) – TC(n-1 units)
o Should I do the n-th unit of activity X?
o Yes, if MB(n-th unit) ≥ MC(n-th unit)
23
Important Idea: Thinking at the margin
o Should I do the n-th unit of activity X?
o Yes, if MB(n-th unit) ≥ MC(n-th unit)
o Assumptions:
o MB is non-increasing in additional units
o MB(5-th unit) ≥ MB(6-th unit)
o MC is non-decreasing in additional units
o MC(10-th unit) ≥ MC(9-th unit)
Fine Print as in your
bank statement.
24
Important Idea: Thinking at the margin
o Should I do the n-th unit of activity X?
o Yes, if MB(n-th unit) ≥ MC(n-th unit)
o When goods or activities are perfectly divisible, the rule is
o do the additional ∆ unit of activity X if an only if
MB(additional ∆ unit | Q units) ≥
MC(additional ∆ unit | Q units)
o Let ∆ approach zero, the rule becomes
MB(additional ∆ unit | Q units) =
MC(additional ∆ unit| Q units)
MB(additional ∆ unit | Q units): benefit from an additional ∆ unit given that we have Q units
25
Allocation of caterpillar fungus
gatherers
Ophiocordyceps
sinensis is a
fungus that
parasitizes larvae
of ghost moths
and produces a
fruiting body
valued as an
herbal remedy.
http://en.wikipedia.org/wiki/Ophiocordyceps_sinensis
(Chinese: 冬虫夏草;
literally "winter
worm, summer
grass").
26
Allocation of caterpillar fungus
gatherers
o We have four gatherers. How many gatherers should we
send to the east or west side of the hill given the
average output as shown below?
Average output per gatherer (kgs)
Number of gatherers
East side
West side
1
10
13
2
10
12
3
10
11
4
10
10
27
Allocation of caterpillar fungus
gatherers
Average output per gatherer (kgs)
Number of gatherers
East side
West side
1
10
13
2
10
12
3
10
11
4
10
10
Marginal output per gatherer (kgs)
Number of gatherers
East side
West side
1
10
13
2
10
11 (=24-13)
3
10
9 (=33-24)
4
10
7 (=40-33)
28
Allocation of caterpillar fungus
gatherers
Marginal output per gatherer (kgs)
Number of gatherers
East side
West side
1
10
13
2
10
11 (=24-13)
3
10
9 (=33-24)
4
10
7 (=40-33)
Should I send the first gatherer to the east (or the west)?
No. B(East 1) = 10 < C(East 1) = B(West 1) = 13
Should I send the second gatherer to the east (or the west)?
No. B(East 1) = 10 < C(East 1) = B(West 2) = 11
Should I send the third gatherer to the east (or the west)?
Yes. B(East 1) = 10 > C(East 1) = B(West 3) = 9
Should I send the fourth gatherer to the east (or the west)?
Yes. B(East 2) = 10 > C(East 2) = B(West 3) = 9
29
Important Idea: Allocation of fixed amount
of resources (still about thinking at margin)
o When allocating a fixed amount of resources among
several activities, allocate the additional unit of resources
to activities with the highest marginal benefits.
o When the resource is perfectly divisible and when the
MB of one activity is not always higher than the others,
allocate the resources such that
MB(∆ unit | A1)=MB(∆ unit | A2)=…=MB(∆ unit | An)
MB(∆ unit | An):
Benefit of doing a additional ∆ unit from the current total An unit.
30
Reducing the death rate of the Prisoner
Transport Business
o In 1787, the British government had hired sea captains
to ship convicted felons to Australia.
o The British public had no love for the convicts. On one
voyage, more than one third of the men died and the
rest arrived beaten, starved, and sick.
o How do we reduce the death rate?
Policy: Pay the ship captains by the number of living
convict on arrival.
31
Reducing the death rate of the Prisoner
Transport Business
o Understand the decision of the captains:
o Should the captain raise the number of surviving
convicts on arrival by 1 person?
o Yes, if the benefit of doing so is higher than the cost
of doing so.
32
Thinking on the margin in the Prisoner
Transport Business
o How many convicts should the captain keep alive?
o Should the captain keep alive the first convict?
o Should the captain keep alive the second convict?
o…
o Should the captain keep alive the n-th convict?
o By paying the ship captains by the number of living
convicts on arrival, the benefit of keeping one additional
convict alive is raised. Thus, the captains will keep more
convicts alive.
33
Reducing the death rate of the Prisoner
Transport Business
o In 1787, the British government had hired sea captains to ship
convicted felons to Australia.
o The British public had no love for the convicts. On one voyage,
more than one third of the men died and the rest arrived beaten,
starved, and sick.
o How do we reduce the death rate?
Policy and its impact:
After the ship captains were paid per living convict on
arrival, the death rate fell from over 33% to less than
1%.
34
Important Idea: Incentives Matter
o Incentives: rewards and penalties that motivate
behavior.
o People respond to incentives in predictable ways.
o Self-interest is an important incentive in economics.
35
Incentives in the garment and
textile industry
o In the 60s to 80s, garment and textile industry in Hong
Kong hired a lot of workers. If you were the boss of a
garment and textile company, how would you pay your
workers?
A) By hours of work
B) By pieces of completed garment items
36
Important Idea: Trade-offs are Everywhere
o For every choice something is gained, something lost.
o The opportunity cost of a choice: the value of the
opportunities lost.
o Includes monetary and nonmonetary costs
o Includes explicit and implicit costs.
o And people respond to changes in opportunity costs.
o Unemployment rates and college enrollment ......
37
Why unemployment rate and college
enrollment related?
38
John has a full-time job as an accountant
last year. What can we conclude?
o If John does not work, he could at least enjoy leisure.
o Should I work as an accountant or enjoy leisure?
o Yes, only if the benefit of taking up the accounting job is
larger than the cost of taking up the accounting job.
o B(accounting job) = salary + ...
o C(accounting job) = B(leisure) + …
o The cost of taking up the account job = the benefit he
gets from leisure.
o Thus, the fact that John had a full time job tells us
o B(accounting job) ≥ B(leisure)
Fine Print: Assume “…” ≈ 0
39
John has a full-time job as an accountant
last year. What can we conclude?
o John did not attend college. If John attends college, he will
have to give up his full-time job.
o Should I attend college or work as an accountant?
o Yes, only if the benefit of attending college is larger than the
cost of attending college.
o B(college) = higher salary in the future + …
o C(college) = B(accounting job) + …
o The cost of attending college = the benefit he gets
from job.
o Thus, the fact that John had a full-time job tells us
o B(college) ≤ B(accounting job)
Fine Print: Assume “…” ≈ 0
40
Will John choose to attend college should he
become unemployed?
o Know, for John,
o B(college) ≤ B(accounting job)
o B(accounting job) ≥ B(leisure),
i.e., B(leisure) ≤ B(accounting job)
o Two possibilities:
o Suppose B(leisure) ≤ B(college) ≤ B(accounting job),
will John attend college should he become
unemployed?
o Suppose B(college) ≤ B(leisure) ≤ B(accounting job),
will John attend college should he become
unemployed?
41
Why unemployment rate and college
enrollment related?
o Suppose, for John,
o B(leisure) ≤ B(college) ≤ B(accounting job)
o When John who are employed,
o attending a full-time college would mean giving up his fulltime job. Thus, the cost of pursuing a full-time college will
include at least the salary he could have earned from his
full-time job.
o B(college) ≤ B(accounting job)
o When John becomes unemployed,
o attending a full-time college would mean giving up his
leisure time only.
o B(leisure) ≤ B(college)
42
Why unemployment rate and college
enrollment related?
o Suppose, for John,
o B(college) ≤ B(leisure) ≤ B(accounting job)
o When John who are employed,
o attending a full-time college would mean giving up his fulltime job. Thus, the cost of pursuing a full-time college will
include at least the salary he could have earned from his
full-time job.
o B(college) ≤ B(accounting job)
o When John becomes unemployed,
o attending a full-time college would mean giving up his
leisure time only.
o B(college) ≤ B(leisure)
43
Important Idea: Good Institutions Align
Self-interest with the Social Interest
o Markets magically align your self-interest with social
interest (usually).
o Because the apple growers wants profit, you get your
apple!
44
Alignment of self-interest with
social interest
o Because Mr. WONG Wai Kay, Ricky of the City Telecom
wanted profit, we had call-back service in Hong Kong
and hence a lower rate of international calls.
o He supplied the call-back service because the benefit of
doing so is larger than its cost!
o Did he do it solely because he wanted to improve our
well-being?
45
“It is not from the
benevolence of the
butcher, the brewer,
or the baker that we
expect our dinner, but
from their regard to
their own interest.”
-Adam Smith,
The Wealth of Nations
Adam Smith saw the invisible hand
46
Moral Sentiments as Commitment Devices
o Note that economists also emphasize moral sentiments.
o There are situations in which pursuit of self interest will yield
inefficient outcome.
o prisoner’s dilemma game yields inefficient outcome
because the lack of commitment
o If commitment problems cannot be solved by altering the
relevant material incentives, it may nonetheless be possible to
solve them by altering people's psychological incentives.
o For example, feelings of guilt when they cause harm to others,
feelings of sympathy for the interests of their trading partners,
feelings of outrage when they are treated unjustly, and so on.
o These feelings may lessen the incentive to behave in
opportunistic and mutually destructive ways.
47
Two Standards of Rationality
1. The Self-interest Standard:
o A person is rational if she is efficient in pursuit of her
own interests.
o The self-interest model appears inadequate in
explaining some real-world phenomena.
Return wallets
Rescues
Bone marrow
donation
Blood donation
48
Two Standards of Rationality
2. The Adaptive Rationality Standard:
o A taste can be added to the self-interest model, but
only if people with such taste will not be penalized in
the long run, and acquiring such taste will not lead
to the extinction.
Return wallets
Rescues
Bone marrow
donation
Blood donation
49
Important Idea: Power of Trade
o What caused the improvement of
life expectancy and income over time?
o Free trade! …. Among many other things, like
technological innovations.
o Example: China
50
Important Idea: Institutions Matter
o Why are some countries rich and others poor?
o Incentives are sometimes lacking.
o Strong institutions that support these incentives foster
economic growth.
51
Can you
tell which
country has
better
institutions?
North and
South
Korea at
night
52
If …
o If we have the right institution that foster the alignment
of self-interest with social interest,
o Government officials can go fishing!
53
Big Ideas
Microeconomics
1.
2.
3.
4.
5.
6.
7.
8.
Incentives Matter
Good Institutions Align Self-interest with the Social Interest
Trade-offs Are Everywhere
Thinking on the Margin
The Power of Trade
The importance of Wealth and Economic Growth
Institutions Matter
Economic Booms and Busts Cannot be Avoided but Can be
Moderated
9. Prices Rise when the Government Prints Too much Money
10. Central Banking is a Hard Job
11. Economics is Fun
54