101-3_07 - Econ 101 Lecture 3 Some Common Pitfalls for...

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Econ 101 Lecture 3 Some Common Pitfalls for Decision Makers Pitfall #1. Measuring Costs and Benefits as proportions rather than as absolute dollar amounts (as in the K-Mart vs. Campus Store examples from lecture 1) Exercise: Your employer has a travel discount voucher that can be redeemed on one of your next two business trips. You could use it to save $100 on a $2000 plane ticket to Tokyo; or you could save $90 on a $200 plane ticket to Chicago? If your goal is to do what would be best for your company, for which trip should you use the coupon? Pitfall #2. Ignoring Opportunity Costs If doing activity x means not being able to do activity y , then the value to you of doing y is an opportunity cost of doing x . Many people make bad decisions because they tend to ignore the value of such foregone opportunities. This insight suggests that it will almost always be instructive to translate questions like "Should I do x ?" into ones like "Should I do x or y ?" In the latter question, y is simply the most highly valued alternative to doing x . Example 3.1. Should I go skiing today? There is a ski area near your campus and you go skiing often. From experience you can confidently say that a day on the slopes is worth $50 to you. The charge for the day is $30 (which includes busfare, lift ticket, and equipment). But this is not the only cost of going skiing. You must also take into account the value of the most attractive alternative you will forego by heading for the slopes. Suppose that if you don't go skiing, you will work at your new job as a research assistant for one of your professors. The job pays $40 dollars per day, and you like it just well enough to have been willing to do it for free. So the question you face is "Should I go skiing or stay and work as a research assistant?" C(x) = cost of skiing plus value of forgone earnings = $30 + $40 = $70 B(x) = $50 < C(x), so don't go skiing. Note in Example 3.1 the role of your feelings about the job. The fact that you liked it just well enough to have been willing to do it for free is another way of saying that there are no psychic costs associated with doing it. This is important because it means that by not doing the job you would not be escaping something unpleasant. Of course, not all jobs fall into this category. Suppose instead that your job had been to scrape plates in the dining hall for the same pay, $40/day, and that the job was so unpleasant that you would be unwilling to do it for less than $25/day. Assuming your manager at the dining hall permits you to take a day off whenever you want, let us now reconsider your decision about whether to go skiing. Example 3.2. Same as Example 3.1, except that the alternative for the day is to scrape plates, not work as a research assistant. There are two equivalent ways to look at this decision:
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101-3_07 - Econ 101 Lecture 3 Some Common Pitfalls for...

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