Economic Applications - Costs and Benefits

Scarcity
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Terms in this set (26)
Scarcity
This occurs because there are finite resources and unlimited demand for those resources. This means we cant get everything we want and have to make choices. Even those who appear to have unlimited resources still dont, they're restricted by time.
What are non-monetary costs?
These are costs that didn't have an exchange of money, they still have a cost value to them, e.g the cost of time or effort.
What is the cost-benefit approach?
This is evaluating the costs and benefits of an activity. Think of it as an equation, B(x) is the benefits of doing the activity x and C(x) is the costs of doing the activity x. If B(x)>C(x) then you should do the activity, and if it doesn't then don't do activity x. The costs and benefits should include non monetary costs/benefits. When theres multiple activities pick the one which give the largest gap between B(x)-C(x).
Opportunity cost
Opportunity cost is the costs of the next best alternative sacrificed or forgone as a result of a choice. Its what you give up when making a choice.
Reservation price
This can be seen two ways:
1. The lowest price which you would have to be paid to do a certain activity.
OR
2. The highest price you would pay someone else to do that certain activity.
Implicit cost
These are non monetary opportunity costs
Direct cost
Theses are costs that are obvious when making a decision e.g University means student loans.
Indirect cost
These are the less obvious costs associated with a decision, like an implicit cost.
Sunk cost
These are costs that once a decision has been made and the cost has been paid, there is no way to get that money back, e.g costs on advertising.
What are the common pitfalls in decision making?
1. Ignoring implicit costs.
2. Including sunk costs.
3. Making valuations in relative terms not absolute terms
4.Failing to understand the marginal-average distinction i.e When thinking about the decision rule you should only continue the activity if your marginal benefit is positive and is bigger than your marginal costs. When making decisions people often think of average costs not marginal.
Example of the cost benefit approachIn Germany child benefits were to increase from the 1st of January in 2007. This lead to mothers due late December wanting to delay the pregnancy to January in order to get that benefit. Benefits: The extra benefits gained Costs: The costs of the pills that delay pregnancy and (non monetary) the health effects it could have on the baby or mother Most women took the pill as it didn't seem to have much effect on the pregnancy - you can see a dip in the number of births in December 2006.Example of ignoring implicit costs in a decisionE.g When you go to university you have the obvious costs of student loan and rent etc but you miss the implicit cost which is if you hadn't gone to university you may have gone straight to work and earned a salary for 3 years. This is the implicit cost.Example of including sunk costs in a decisionE.g If you have two options of what to do in the evening, stay in and read a book or go to the theatre. You decide staying in is a marginally better option so you would rationally pick this option. However you had bought the ticket to the theatre 3 months ago and it's too late to get a refund or resale (this means it's a sunk cost) so you go to the theatre instead, this means you've taken sunk costs into consideration and haven't acted rationally.Example of making valuations in relative terms not absolute termsE.g there's two examples, you go to buy a toothbrush and its £20 in Newcastle city centre and £10 in Gateshead, people see this has a big save (50%) and go to Gateshead to get the offer. Then a few months later you want to get a new laptop and its £1010 in Newcastle city centre and £1000 in Gateshead, people look at this as a small save (1%) and dont do the journey to Gateshead to get the cheaper laptop. However in both cases the saving is £10 and the costs and benefits are the same of going to Gateshead. This is the customer not acting rationally and making valuations on relative terms not absolute.Example of failing to understand the average-marginal distinctionE.g If you offer a minibus service with 10 seats and a trip costs £1000, this means you charge a ticket at £100. Say you only fill 9 seats at full price and then a last minute customer wants a ticket but will only offer £60. If you were thinking about average costs you may not want to let them on but: marginal benefits/costs says you should. The extra cost of adding the customer is minimal i.e extra weight on bus and the benefits are larger i.e the money pays for the extra weight that effects fuel and some left over. Therefore you should let the customer on. (you wouldn't if the money didn't cover the costs).RationaliltyThis is when people make decisions based on the cost-benefit approach. This means they know three things. Firstly this means the person knows the objective, secondly the person knows all feasible alternatives to the objective. Lastly the person can investigate/find out about all the feasible alternatives.Self-interest of rationalityThis is where the assumption is the person only evaluates the costs and benefits that directly effect them. They dont include trying to make other people happy or doing the right thing.Present-aim standard of rationalityThis is where the assumption is that the person acts efficiently in the moment to accomplish their aims. This can cause problems as it can excuse any type of behaviour such as someone drinking petrol because they wanted to do that moment. They then die very painfully but you could argue it was a rational choice.Why do we have the concept of rationality?Economists dont expect everyone to act rationally but having rationality creates a base level and gives a defined meaning which can make it easier to compare to.Decision rule for criminalsThe basic idea is that criminals weigh the costs and benefits of criminal activity and legal work, the equation is: *Utility gained from legal work [U(WL)] = Probability of not getting caught [1-p] x Utility of committing a successful crime [U(WC)] - Probability of getting caught [p] x Disutility of getting caught [U(s)]*. The decision works best for property crime where the gains are big but it can be applied to violent crime.Crime should decrease according to the decision rule if:The opportunity for legal work increases [U(Wl)] increases The probability of getting caught increases e.g policing increases [p] increases The disutility from getting caught increases e.g punishments and prison sentences increase [U(s)] increase.A natural experiment that effects the decision rule (policing):One thing that decreases crime according to the decision rule is more policing (increases p) however this is hard to test and see because an increase in crime also increases the policing, its a two way causality. This is why we need a natural experiment to test whether an increase in policing does effect crime. In 2005 there were terror attack in London, after this policing went up by 30%. Then crime unrelated to the terror attacks decreased. Evidence found that with a 10% increase in policing causes a 3.8% decrease in crime.a natural experiment that effects the decision rule (punishment):According to the decision rule an increase in punishment will lower crime rates. Increasing prison sentences does two things: 1. Increases incapacitation of criminals, keeping them out of society for longer 2. Deterrence, longer prison sentences might put off future criminals from committing the crime in the first place. In 2006 in Italy there was something called a Clemency law introduced because of over crowding in prisons. This law took off 3 years fo 40% of criminals. However if that criminal reoffended within the next 5 years they would have to complete their sentence and the additional 3 years that was taken off their last one (or up to 3 years that was taken off). The effect was that for every month added to future prison sentencing there was a 0.16% decreases in the likelihood of reoffending in the next 7 months.How does crime effect economic conditions?Crime: Increases with unemployment Decreases when certain groups income increases (mainly young men with low qualifications) Increases with the overall richness of the region Increases with areas of economic inequalityHow does an economic hardship (recession) effect crime?A recession causes a loss of jobs and opportunities for work, i.e higher unemployment, this leads to more crime. It also creates less to steal as more people have less money, this decreases the utility gained from committing a crime.How does crime effect migration of cities?Crime effects businesses and families, especially highly qualified people. If there is high crime rates businesses may migrate to other cities. People with higher qualifications and families will not want to settle somewhere with high crime rates. This can lead to a vicious cycle. There is high crime rates so businesses and higher qualified people move out so there are less work opportunities, this increases crime etc.