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chapter2
Course: ECON 1002, Winter 2011School: HKU
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ScarcityandCompetition ECON1001E,F Introduction PartII 1 Introduction OpportunityCost CostandBenefitAnalysis SomeCommonPitfallsforDecisionMakers PositiveVs.NormativeEconomics WhatisEconomics? Studiesallocationofscarceresourcesamong competingends formostgoods,wants(desires)exceedwhatisavailable (limitedresources). Thus,havingmoreofonethingusuallymeanshavingless ofanother.Peoplehavetomakechoices....
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ScarcityandCompetition
ECON1001E,F
Introduction
PartII
1
Introduction
OpportunityCost
CostandBenefitAnalysis
SomeCommonPitfallsforDecisionMakers
PositiveVs.NormativeEconomics
WhatisEconomics?
Studiesallocationofscarceresourcesamong
competingends
formostgoods,wants(desires)exceedwhatisavailable
(limitedresources).
Thus,havingmoreofonethingusuallymeanshavingless
ofanother.Peoplehavetomakechoices.
Studieshowagentsrespondtoincentive
Iswhateconomistsstudy
Economics:studyingchoiceinaworldof
scarcity
TheScarcityPrinciple,a.k.a.,theNofreelunch
Principle:
Althoughwehaveboundlessneedsandwants,the
resourcesavailabletousarelimited.Sohaving
moreofonegoodthingusuallymeanshavinglessof
another.
TheCostBenefitPrinciple:Anindividual(orafirmora
society)shouldtakeanactionif,andonlyif,theextra
benefitsfromtakingtheactionareatleastasgreatas
theextracosts
OpportunityCosts
Foreconomists,costsmeanopportunitycosts
oralternativecosts.
OpportunityCostsarethebestforegone
opportunities(orbestalternativeyouotherwise
wouldhavechosen)
Costisimportantfordecisionmakingin
economics
Costsandchoicesaretwin(Youcanthaveone
withouttheother)
Example1:OpportunityCosts
Ifyouaregivenachoiceofthefollowingthree
candiesfreeofcharge:
I)M&M($0.5)
II)Snicker($0.7)
III)NestleCrunch($1.0)
Whatisyouropportunitycostifyouchoose
M&M(withnoresaleoption)?(a)$0.7,(b)$1,
(c)Snicker,(d)NestleCrunch,or(e)not
enoughinformation.
Example2:OpportunityCosts
Youhavethreejoboffers,theyareindifferenttoyou
exceptfortheirpay.Herearetheoffers:
GoldmanSachs$100,000
MerrillLynch$90,000
MorganStanley$80,000
Whatisyouropportunitycostifyoutakethejobat
MerrillLynch?(a)$10,000,(b)$100,000(c)$80,000,or
(d)Notenoughinformation.
Example3:OpportunityCosts
YouwonafreetickettoseeanEasonChanconcert(whichhasno
resalevalue).
AndyLauisperformingonthesamenightandisyournextbest
alternativeactivity.TicketstoseeAndycost$40/ticket.
Onanygivenday,youwouldbewillingtopayupto$50tosee
Andy.
Assumetherearenoothercostsofseeingeitherperformer.Based
onthisinformation,whatistheopportunitycostofseeingthe
EasonChanconcert?(a)$0,(b)$10,(c)$40,or(d)$50.
(Source:
http://www.marginalrevolution.com/marginalrevolution/2005/09/opp
ortunity_cos.html)
Example4OpportunityCosts
Paulisahousepainterwhoseroofneedsreplacing.
Ronisarooferwhosehouseneedspainting.
AlthoughPaulisapainter,healsoknowshowtoinstall
roofing.Ron,forhispart,knowshowtopainthouses.
ShouldPaulroofhisownhouse?ShouldRonpainthis
ownhouse?
Paul
Ron
Example4OpportunityCosts
Timerequiredbyeachtocompleteeachtypeofjob:
Painting
Roofing
Paul
300hrs
400hrs
Ron
200hrs
100hrs
Example4.OpportunityCosts
Painting
Roofing
Paul
300hrs
400hrs
Ron
200hrs
100hrs
Opp.Costfor1
Opp.Costfor1
Paul
Painting
0.75Roofing
Roofing
1.25Painting
Ron
2Roofing
0.5Painting
ForPaul,theo.c.ofpaintingonehouse=thenumberofroofingjobs
hecoulddoduringthesametime.
SoPaulso.c.ofpaintingahouseis.75roofingjobs(=300hrsper
painting/400hrsperroofing).
11
CostandBenefitofNewDrugApproval
FoodandDrugAdministration(FDA)decideswhether
newmedicinesshouldbeallowedtogoonsaleinthe
U.S.
Pregnantmothersthattookasleepingpillcalled
thalidomidecausedthebirthof12,000deformed
infants.
1962KefauverHarrisAmendmentpassed
Radicallyincreasedthedrugapprovalprocess
Averagetimebetweenfilingandapprovalofanew
drug:7monthsbefore1962and810yearsin
1970s.
CostandBenefitofNewDrugApproval
Benefit:Increasenewdrugsafety
Cost:delayofnewdrugapprovalkilledpatientsthat
couldhavebenefitedfromthesuccessfulnewdrugs.
Example1:ThefiveyearlaginintroducingSeptra(an
antibacterialagent)totheUSkilled,100,000,maybe
amillionpeople.
Example2:Delaytheintroductionofaclassofdrugs
calledbetablockersforadecade(usedtotreatheart
attack,highbloodpressure)killedatleast250,000
Americans
SomeCommonPitfallsforDecisionMakers
Pitfall1:Measuringcostandbenefitsasproportions
ratherthanabsolutedollaramounts
14
Example:Proportionvs.absolute
Youremployerhasatraveldiscountvoucherthatcan
beredeemedononeofyournexttwobusinesstrips.
Youcoulduseittosave$100ona$2,000planeticket
toTokyo;oryoucouldsave$90ona$200planeticket
toChicago?
Ifyourgoalistodowhatwouldbebestforyourcompany,
forwhichtripshouldyouusethecoupon?
(a)$90[asavingsof45%($90/$200)]
(b)$100[asavingsof5%($100/$2,000)]
15
SomeCommonPitfallsforDecisionMakers
Pitfall2:IgnoringOpportunityCosts
Ifdoingactivityxmeansnotbeingabletodoactivityy,
thenthevaluetoyouofdoingyisanopportunitycost
ofdoingx.
Manypeoplemakebaddecisionsbecausetheytendto
ignorethevalueofsuchforegoneopportunities.
16
Example:Opportunitycostwhenlendinga
friendsomemoney?
Supposeafriendlendsyou$10,000freeofchargefora
year.
Shecouldhaveputthatmoneyinthebank,whereit
wouldhaveearnedamarketinterestrateof5percent,
or$500eachyear.
Thus,theopportunitycostofloaningyouthemoneyis
$500interest,theinterestthatcouldhavebeenearned
elsewhere.
Ifshedidn'tchargeyouanyinterest,itwouldbethe
sameasgivingyouagiftof$500/yr.
17
Sunkcost
Sunkcostsarecoststhathavealreadybeenincurred
andwhichcannotberecoveredtoanysignificant
degree.
18
SomeCommonPitfallsforDecisionMakers
Pitfall3:FailureToIgnoreSunkCosts
Anopportunitycostwilloftennotseemlikearelevant
costwheninrealityitis.
Anotherpitfallindecisionmakingisthatsometimesan
expenditurewillseemlikearelevantcostwheninreality
itisnot.
Theonlycoststhatshouldinfluenceadecisionabout
whethertotakeanactionarethosecoststhatwecan
avoidbynottakingtheaction.
Alocalpizzaparloroffersanallyoucaneatlunchfor
$80.
Sunkcostisacostthatisbeyondrecoveryatthe
momentadecisionmustbemade,thereforeitdoesnot
affectdecisionmaking
19
Example:ThePizzaExperiment
Howmuchshouldyoueatatanallyoucaneat
restaurant?
Youpayatthedoor,andthenthewaiterbringsyouas
manyslicesofpizzaasyoulike.
The"waiter"selectshalfofthetablesatrandomand
gaveeveryoneatthosetablesa$80refundbefore
takingorders.
Ifalldinersarerational,willtherebeanydifferencein
theaveragequantityoffoodconsumedbythesetwo
groups?
20
Example:ThePizzaExperiment
The$80admissionfeeisasunkcost,andshouldhave
noinfluenceontheamountofpizzaoneeats.
Sothetwogroupsshouldeatthesameamountof
pizza,ontheaverage.
Infact,however,thegroupthatdidnotgetthe
refundconsumedsubstantiallymorepizza.
Isitapitfallforignoringsunkcost?
21
SomeCommonPitfallsforDecisionMakers
Pitfall4:FailureToUnderstandtheAverageMarginal
Distinction
MarginalBenefit:Theincreaseintotalbenefitthat
resultsfromcarryingoutoneadditionalunitofan
activity.
AverageBenefit:Thetotalbenefitofundertakingn
unitsofanactivitydividedbyn.
MarginalCost:Theincreaseintotalcostthatresults
fromcarryingoutoneadditionalunitofanactivity.
AverageCost:Thetotalcostofundertakingnunitsof
anactivitydividedbyn.
22
Example:ShouldNASAexpandthespace
shuttleprogram?
NASAcurrentlymakesfourlaunchesperyear.
ShouldNASAexpandthespaceshuttleprogramfrom
fourlaunchesperyeartofive?
Benefits
Totalof$24billion
Averageof$6billion/launch
Costs
Totalof$20billion
Averageof$5billion/launch
23
Example:ShouldNASAexpandthespace
shuttleprogram?
# of Launches
Total Cost
Average Cost
Marginal Cost
($ billion)
($ billion/launch)
($ billion/launch)
0
0
0
1
3
3
3
4
5
2
3
4
7
12
3.5
4
8
12
What is the optimal number of launches?
20
5
Assume: Average Benefit = Marginal
Benefit = $6 billion
5
32
6.4
24
Rulesforallocatingresources
Thegeneralruleforallocatingaresourceefficiently
acrossdifferentproductionactivitiesis:
Allocateeachunitoftheresourcetotheproduction
activitywhereitsmarginalbenefitishighest.
Foraresourcethatisperfectlydivisible,andfor
activitiesforwhichthemarginalproductoftheresource
isnotalwayshigherinonethanintheothers,therule
is:
Allocatetheresourcesothatitsmarginalbenefitis
thesameineveryactivity.
25
ExampleFishingboatallocation
Supposeyouownafishingfleetconsistingofagiven
numberofboats,andcansendyourboatsinwhatever
numbersyouwishtoeitheroftwoendsofan
extremelywidelake,eastorwest.
Whereshouldyousendyourboats?
Example1.16.Fishingboatallocation
Underyourcurrentallocationofboats,theonesfishing
attheeastendreturndailywith100poundsoffish
each,whilethoseinthewestreturndailywith120
poundseach.
Thefishpopulationsateachendofthelakeare
completelyindependent,andyourcurrentyieldscanbe
sustainedindefinitely.
AverageCatch:
WestEnd:120lbs/boat
EastEnd:100lbs/boat
TrueorFalse:Ifyoushiftsomeofyourboatsfromthe
eastendtothewestend,youwillcatchmorefish.
Example1.17.Shouldyoumoveoneofyour
boatsfromtheeastendtothewestend?
Currentlytwoboatsaresenttotheeastendandtwoto
thewestend.
Averageoutputperboat
Numberofboats
Eastend
Westend
1
100lbs/boat
130lbs/boat
2
100lbs/boat
120lbs/boat
3
100lbs/boat
110lbs/boat
4
100lbs/boat
100lbs/boat
Example1.17.Shouldyoumoveoneofyour
boatsfromtheeastendtothewestend?
Averageoutputperboat
Numberofboats
Eastend
Westend
1
100lbs/boat
130lbs/boat
2
100lbs/boat
120lbs/boat
3
100lbs/boat
110lbs/boat
4
100lbs/boat
100lbs/boat
Numberofboats
Eastend
Westend
Totaloutput
2
2
440lbs
3
1
430lbs
1
3
430lbs
4
0
400lbs
0
4
400lbs
Example1.17.Shouldyoumoveoneofyour
boatsfromtheeastendtothewestend?
Averageoutputperboat
Numberofboats
Eastend
Westend
1
100lbs/boat
130lbs/boat
2
100lbs/boat
120lbs/boat
3
100lbs/boat
110lbs/boat
4
100lbs/boat
100lbs/boat
Marginaloutputperboat
Thenthboat
Eastend
Westend
1
100lbs
130lbs
2
100lbs
110lbs(=240130)
3
100lbs
90lbs(=330240)
4
100lbs
70lbs(400330)
Rulesforallocatingresources
Thegeneralruleforallocatingaresourceefficiently
acrossdifferentproductionactivitiesis:
Allocateeachunitoftheresourcetotheproduction
activitywhereitsmarginalbenefitishighest.
Foraresourcethatisperfectlydivisible,andfor
activitiesforwhichthemarginalproductoftheresource
isnotalwayshigherinonethanintheothers,therule
is:
Allocatetheresourcesothatitsmarginalbenefitis
thesameineveryactivity.
PositiveEconomics
Positivestatementsarestatementsthatcanbe
classifiedaseithertrueorfalse
OfferTESTABLEimplications(orrefutable
hypotheses):IfA,thenB
IfAandnotB,thenrejectthenullhypothesis
PositiveEconomicsaddressesquestionlikesIfthis,
thenthatformofanalysis
Increasetheminimumwageraisesunemployment
rateamongyoungandunskilledworkers
Threestrikesandyouareoutreducescrime
PositiveEconomics
ItinvolvesNOvaluejudgments.
Itdoesnotcommentontheresultoftheanalysis.
Whethertheresultisgoodorbadtothesocietyis
noneofthebusinessofpositiveeconomicsanalysis.
Donotletyourownvaluesdirectyouranalysisin
positiveeconomics.
NormativeEconomics
Normativeeconomicsaddressquestionslikeswhat
shouldbedoneorwhatoughttobedone
Containsbasisfordecidingwhatisgoodorbad(value
judgment).
Examples
Thedistributionofincomeshouldbemoreequal
Antitrustlawsshouldbeusedvigorouslyto
reducemonopoly.
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INTRODUCTIONTOCORPORATEFINANCESECONDEDITIONLawrenceBooth&W.SeanClearyChapter6BondValuation&InterestRatesPreparedbyKenHartviksen&JaredLaneusEditedbyDr.WilliamF.Rentz,Ph.D.,LIFAChapter 6 Learning6.1 Describe the Objectives variousbasic structure
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2011 Dr. William F.Rentz & AssociatesChapter 7 Equity ValuationNon-Normal Growth: 3 Steps to Finding P01.Find the PV of the dividends during thenon-normal growth period or periods.2a.Find the value of the C/S at thebeginning of the normal growth
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INTRODUCTIONTOCORPORATEFINANCESECONDEDITIONLawrenceBooth&W.SeanClearyChapter7EquityValuationPreparedbyKenHartviksen&JaredLaneusEditedbyDr.WilliamF.Rentz,Ph.D.,LIFAChapter 7 LearningObjectives7.1 Identify the basic characteristics of equity secu
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INTRODUCTIONTOCORPORATEFINANCESECONDEDITIONLawrenceBooth&W.SeanClearyChapter8Risk,Return,&PortfolioTheoryPreparedbyKenHartviksen&JaredLaneusChapter 8 LearningO ex post and ex8.1 Distinguish betweenbjectives ante returns andexplain how they are
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INTRODUCTIONTOCORPORATEFINANCESECONDEDITIONLawrenceBooth&W.SeanClearyChapter9TheCapitalAssetPricingModel(CAPM)Chapter 9 LearningObjectives affected once the9.1 Describe how the efficient frontier ispossibility of risk-free borrowing and invest
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INTRODUCTIONTOCORPORATEFINANCESECONDEDITIONLawrenceBooth&W.SeanClearyChapter10MarketEfficiencyPreparedbyKenHartviksen&JaredLaneusEditedbyDr.WilliamF.Rentz,Ph.D.,LIFALearning Objectives10.1 Explain the importance of the concept of marketefficien
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Financial ManagementChapter 13Non-Normal Projects and IRRADM 2350Prepared byDr. William F. Rentz, Ph.D., LIFA 2011 Dr. William F. Rentz & Associates, All Rights Reserved1IRR Difficulties: Chapter 13 The traditional IRR rule is incorrectwhen cash
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Capital Budgeting: Problem 39Capital structure: 60% debt & 40% equityBefore-tax cost of debt = 12%Common equity beta = 1.20Risk-free rate = 5%Market risk premium = 8%Tax rate = 40% CF0 = $120,000, CF1 = =CF5 = $37,500 2011 Dr. William F. Rentz & A
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Financial ManagementChapter 13Projects with Unequal LivesADM 2350Prepared byDr. William F. Rentz, Ph.D., LIFA 2011 Dr. William F. Rentz & Associates, All Rights Reserved1Introduction This demonstration looks at the capitalbudgeting decision when
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INTRODUCTIONTOCORPORATEFINANCESECONDEDITIONLawrenceBooth&W.SeanClearyChapter13CapitalBudgeting,RiskConsiderations,&Chapter 13: LearningObjectives13.1 Describe the capital budgeting process and explain itsimportance to corporate strategy.13.2
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INTRODUCTIONTOCORPORATEFINANCESECONDEDITIONLawrenceBooth&W.SeanClearyChapter14CashFlowEstimationandCapitalBudgetingDecisionsPreparedbyKenHartviksen&JaredLaneusEditedbyDr.WilliamF.Rentz,Ph.D.,LIFALearning Objectives14.1 Outline the basic framew
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Divisional Costs of Capital Some divisions of a company have higheror lower systematic risk The discount rates for these divisionsshould be higher or lower than thediscount rate for the firm as a whole 2010 Dr. William F. Rentz & Associates, All Rig
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MCC Schedule Step 1: Calculate the cost of capital foreach component 2010 Dr. William F. Rentz & Associates, All Rights Reserved1MCC Schedule Step 2: Compute the MCC for eachincrement of capital raised Equal to the equilibrium rate of returndeman