Graded Homework 1
This assignment is worth 64 points. It is due in class on the day of Exam 1.
Please adhere to
my guidelines which are posted on WebCT under “Course Content”. Failure to do will result
in a penalty.
Opportunity Cost (2 pts.)
Your friend is preparing for an exam and in the review session makes the following statement: "Instead of
attending microeconomics class for two hours, Kiki could have played tennis or watched a movie.
Therefore, the opportunity cost of attending class is the tennis and the movie she had to give up." Is your
friend's analysis correct or not? Explain your answer.
No, she is incorrect. Opportunity cost is the cost of the highest valued alternative foregone, so the cost of
attending class is not both tennis and the movie she gave up, but rather whichever one had the most value
based on whatever system Kiki decided to use.
2. Incentives (2 pts.)
Consider the following summary of a
The number of people involuntarily bumped off flights bounced up more than 40% to 185,368 in
the second quarter, compared with the same period in 2005, according to government data.
Also, the number of passengers enticed to voluntarily give up seats on overbooked flights
rose more than 10% in the second quarter over last year." The reason for the increase in
overbooked flights: Higher fuel prices. With the increased marginal cost of flying planes,
airlines have cut back on the number of flights, thus jamming more people onto remaining
trips. Furthermore, airlines have the financial incentive to overbook flights. "The DOT requires
that airlines compensate passengers for bumping them off flights, but the maximum amount of
$400 was set in 1978 and hasn't changed. Had the maximum amount been adjusted for inflation,
it would be more than $1,200 today. And some argue that since the last tickets sold are usually
more expensive, airlines have too much incentive to sell $1,000 tickets when no seats are
available if the penalty is only $400 to bump a cheaper-fare passenger.
Source: “More Fliers Forced to Give Up Seats”, by Scott McCartney, Oct 10, 2006, Wall Street Journal, Page
Why does the policy of airlines paying bumped flyers $400 encourage airlines to overbook flights?
(No more than 3 choice sentences, please. Use economic concepts and terms.
Airlines have the positive incentive to bump passengers off flights because their marginal return is greater
than their marginal cost. Here, the cost is $400 for the bumped passenger, but they are able to sell that
passenger’s seat to another person for $1000, giving them a profit of $600. Because prices have not been
adjusted for inflation over the years they are able to accrue a hefty profit while keeping bumped
passengers happy because they are given $400 that they did not have before, and the potential new
passengers happy with seats on the flight.