©Bruce Domazlicky

An Introduction to Economic Thinking

Chapter Two:  Cases and Examples on the Economic Problem

NOTE: This chapter contains links to other sites over which we have no control.  We cannot be responsible for any material that some people might find offensive.

   

Case 2.1:

Calculating Benefits

and Costs

            The arrival of the new year on January 1 seems to be dominated by college football games.   El Paso, Texas for a long time was the site of the Sun Bowl, usually played on December 31.  Starting in 1990 and for several years, it became the John Hancock Bowl as the financial services company paid $1 million in sponsorship fees to the organizers of the bowl. (Note: The game is now the Wells Fargo Sun Bowl.)  In addition, the company paid out an additional $600,000 for commercial time during the game and for charities and scholarships, giving a total sponsorship cost to John Hancock of $1.6 million.  What did John Hancock receive for these expenditures and were the expenditures justified?  

            John Hancock undertook a very careful estimate of the benefits that they expected to receive from the sponsorship of the bowl game.  Company officials poured through newspapers from throughout the country in search of articles concerning the John Hancock Bowl.  In addition, they looked for instances of TV reports where the Bowl and, of course, the company’s name were mentioned.  They placed a value of $1.1 million on these newspaper and TV reports.  How did John Hancock arrive at that figure?  They estimated the cost to the company of purchasing advertising that would be equivalent to having its name mentioned on national TV or in newspapers.  The network televising the John Hancock Bowl, CBS, ran its own promotions of the game, giving John Hancock additional exposure estimated to be worth $900,000 to the company.  

            In addition to the pregame benefits, the company, of course, received additional exposure during the actual game.  The company noted every time the announcers mentioned John Hancock.  In the end, the company estimated it received exposure worth $3.1 million during the game.  

            The estimated total benefits from sponsoring the bowl game came to an impressive $5.1 million.  Compared to the costs of $1.6 million, the sponsorship would appear to be a very good decision for John Hancock.  This meticulous process which John Hancock used to calculate benefits and costs is typical of companies with sports tie-ins.  As one individual put it, “With companies spending millions of dollars, the days of doing a corporate sponsorship just because the CEO likes it are over.” (Wall Street Journal, April 24, 1991)  That is, corporate sponsorship is efficient only if the benefits exceed the costs.  

QUESTIONS TO CONSIDER  

1. Suppose that John Hancock had decided to use the $1.6 million for training programs for its financial services agents.  These training programs could be expected to increase John Hancock revenues by $7 million.

a) Would such programs be efficient?

b) If John Hancock, has limited funds so that the $1.6 million could be spent on training programs or on a football bowl game sponsorship, which should it do?  Why?  

c. During the game itself, the TV announcers for the football game will mention the name John Hancock many times.  Are the marginal benefits to John Hancock for each time the name is mentioned likely to fall?  (That is, hearing the name John Hancock at the beginning of the game is of more value than the twentieth time the name is repeated during the game.)  If the marginal benefits are likely to fall, is there a danger that John Hancock may overestimate the benefits they expect to receive from sponsoring the football game?

 

Case 2.2  Donny Drake’s Costs  

            Donny Drake (fictitious name) is a Ford dealer somewhere in St. Louis.  He has been at his present location for over forty years.  One day, he ran an ad in the local newspaper that looked like the following:

                                    Other Dealers               Donny Drake  

New Car from Ford:  $12,000                          $12,000

Interest*                            400                                    0

Rent/Mortgage**              350                                    0

------------------------------------------------------------------------

Total Cost                    $12,750                       $12,000  

*Most other dealers borrow money from banks to pay for their cars from the dealer.  The typical car sits on the dealer’s lot for 3-4 months before being sold, therefore, other dealers are paying interest to the bank.  Donny Drake buys most of his cars with his own money and so pays no interest to banks.

**Other dealers either rent their facilities or have a monthly mortgage to pay.  Donny Drake has been in the same location for over forty years and long ago paid for his facilities and so pays no rent or mortgage.

So who’s going to give you the better deal?  

QUESTIONS  

1.  Is it correct for Donny Drake to place a zero next to his interest costs?  What cost is he ignoring if he assumes his interest cost is zero?  Would the same apply to rent/mortgage cost?  

2.  The Federal Trade Commission is responsible for monitoring advertising.  If the advertising is false and misleading, it will tell the company to change its advertising.  Do you think this qualifies as ‘false and misleading’ advertising?   

3.  Do you think most people would recognize that Donny Drake is taking some liberties with the ‘facts’ of this case?  

Case 2.3 Dining Room Service at a University  

            At the university that I attended in the 1960s, the dining room service was operated very simply.  By paying a fixed fee for the semester, a student was allowed to eat all the food that s/he wanted.  There were three meals per day, seven days a week and no restrictions were placed on how much was eaten.   

            At a university where I used to teach, the dining room service is operated much differently.  Students do pay a fee for the semester for their meals.  However, the service is not an all-you-can eat system.  A portion of the meal charge is deducted from each student’s semester fee to pay for the fixed costs of running the dining service: water, electricity, some labor, etc.  For the remainder of the fee, the student receives a credit towards the purchase of food at the dining hall.  All of the food items at the dining hall have (relatively) low prices.  Students can take all the food they want, but the cost of the food is deducted from their semester payment.  If the student runs out of meal money before the semester ends, then s/he must purchase additional food credits.  If the student does not eat up his or her food allotment (literally!), then s/he receives a refund or a credit towards next semester’s food purchases.  

QUESTIONS  

1.  Which pricing plan, the one I experienced in the 1960s or the second one described, would lead to greater efficiency?  Explain your answer.  

2.  In addition to efficiency, economists are also concerned about equity or fairness.  Equity considers not only the benefits and costs of a particular choice, but also who receives the benefits and who pays the costs.  Which of the two pricing plans do you think is fairest?  Why?  (Hint: under the pricing plan that I experienced in the 1960s, what sort of student tends to benefit?  tends to lose?)   

3.  Under the pricing plan of the 1960s, the dining service will tend to set its fee to cover the costs of feeding the average student.  So if the average student will eat $1000 of food during the semester, then that will be the semester fee for all students.  In this situation it is likely that some students wind up subsidizing other students.  Explain why.   

4.  If you were the president of a university and could choose either meal service plan, which would you choose?  Why?  

 

Case 2.4  The Decision to Attend College  

            Since you are reading this text, you have decided to attend college.  If your decision was an efficient one, you expect the benefits you receive from attending college to exceed the costs.  To get more specific, write down all of the expected benefits and expected costs to you from attending college.

                        Benefits                                    Costs

                        _____________                      _______________

                        _____________                      _______________

                        _____________                      _______________

                        _____________                      _______________

 

One of the very first benefits you probably wrote down related in some way to increased income.   By obtaining a college degree, you expect to be worth more to future employers and, therefore, receive more money.  This is indeed the case since college graduates earn on the average, about $12,000 more per year than do high school graduates.  In fact, economists refer to additional schooling as investment in human capital.  Human capital refers to the individual’s knowledge, education, skills, etc. that are valuable to employers.  By increasing your human capital, you should increase your income.  

            Some of the other benefits that you listed may be nonmonetary in nature: social interaction, independence, joy of learning, etc. It may difficult to place a dollar value on these benefits, but that does not mean they are not important.  Without the prospect of an improved income, you may not choose to attend college.  But if you do attend, you will receive nonmonetary benefits, which must not be neglected.  

            On the cost side, items such as tuition and books should be included.  What about payments for room and board?  Are these part of the cost of attending college?  Since you will need a place to stay and food to eat even if you are not in college, room and board probably do not belong in your column of costs.  Only to the extent that room and board are more expensive in college as compared to other situations should you include any of the money you spend for them.  On the cost side, did you include the opportunity cost of attending college?  That would be your foregone income since you are unable to work full time while attending college.  In fact, for many students this opportunity cost is the biggest cost of attending college even though you never have to write a check to ‘pay’ for it.   

QUESTIONS  

1. Chapter 1 presented an example of a production possibilities curve where capital goods and consumer goods were the two axes.  How is your decision to attend college similar to the decision that countries A and B have to make with respect to where on the production possibilities curve they choose to produce?  

2. Estimate the dollar amount of the total costs that you will incur by attending college for four years.  Do you think your benefits from attending college will outweigh your estimate of costs?  Explain.  

3.  The benefits and costs of attending college are not the same for everyone.  How will they tend to differ between individuals?   Specifically, which benefits and costs are likely to be different for different individuals?   

4. Looking at the benefits and costs of attending college, why is a forty-five year old person with just a high school diploma less likely to attend college than an eighteen year-old person who just graduated from high school?  (Hint: Assume they are both single so that family concerns need not be considered.)  

Case 2.5: Benefits, Costs, Dieting, Financial Planning and Addiction 

            It is easy to observe daily seemingly self-destructive behavior on the part of human beings.  People smoke, yet smoking is known to be hazardous to one's health.  People overeat, yet obesity is a major cause of a variety of health problems: heart problems, diabetes, to name a couple.  People often also neglect to provide adequately for their future well-being, particularly for their retirement years.  Is this observed behavior on the part of so many of the planet's population evidence that people are not rational beings? 

            This might appear to be the case.  Yet, if we use the ideas of benefits and costs, perhaps such behavior will not appear to be so irrational after all.  Consider the lack of adequate financial planning.  We all know we are going to grow old (unless something unfortunate occurs), and we all would like to have at least a few years of comfortable retirement before our days are done.  We also know that the sooner one starts to plan and save for the future, the more one will have at retirement (since an individual can take advantage of compound interest for a longer period of time).  But there is a cost to sitting down and making the required calculations and estimates to determine how much to save, etc. And there is a further cost to doing the actual saving (reduced consumption of goods and services today).  But notice that delaying the decision until tomorrow means one less day of retirement saving, which, if you are 25 years old or so, will make no real difference in the final amount you will ultimately have in your retirement account.  So the benefit of starting today versus, say, starting tomorrow is virtually zero.  But the cost of starting today is rather high (the time and effort needed, the reduction in spending).  But notice this will be true tomorrow as well.  So it will be very easy for the individual to decide to wait until tomorrow to do the math.  And, of course, it is always easier to wait and do the math tomorrow. 

            Notice how these ideas relate in the same way to an addiction such as smoking.  The long-term costs of smoking are quite severe, as we all (should) know.  But the cost of deciding to quit right now and not have that next cigarette can be quite high to someone who is addicted to nicotine.  The benefit from NOT smoking that next cigarette is not real high.  (I can always quit tomorrow, one more day or one more cigarette will not matter to my long term health.)  Therefore, the benefits of quitting smoking today are relatively low, but the immediate cost is quite high.  Therefore, the individual decides to smoke today.   

            We can define addiction as a state where the benefits of quitting an activity are less than the costs from quitting the activity.  Hence, we find smokers who never quit, who quit for a short time, or even for a long time, before resuming their habit.  The only factor that might cause them to quit is a serious brush with a life-threatening illness (heart attack, lung cancer, etc.).  The same could be true, of course, for people addicted to the use of illegal drugs.  Such a framework as we developed may explain why drug users tend to be arrested over and over again. 

QUESTIONS 

1. Apply the analysis of this reading to someone who is seriously overweight and wants to go on a diet to lose 20 pounds.  Why might they never go on or, if they do, not stay on their diet very long? 

2.  In terms of public policy, can we view mandatory participation in Social Security as a method to force retirement saving by individuals?  Given the framework developed in this case, does this mean that Social Security is a good idea? 

3. Would increasing punishments for illegal drug use be an effective method for getting drug addicts to stop their illegal drug use?  Explain.

4. Would higher taxes on cigarettes be an effective method for helping cigarette users to quit their habit?  Explain.

 

Example 2.6   The Marginal Approach to Benefits and Costs   

            In the previous chapter we considered the decision involving how many hours of economics to study per week.  The marginal benefit of studying economics one more hour per week is the increase in your grade from studying that additional hour.  The marginal cost of using that hour to study economics is the reduction in your math grade from not using that hour to study math.  

            Assume that you have only twelve hours per week available for studying math and economics.  First consider the relationship between hours spent studying economics and your grade in economics.  Most likely, your grade in economics will increase as you devote more hours per week to that subject.  But as mentioned in the previous chapter, the relationship is not likely to be proportional.  That is, your grade in economics will increase at a decreasing rate as you allot more hours to studying economics.  This relationship might look something like that found in Table 2.1.

 

Table 2.1

            Hours Studied/Week                Grade   (%)      Marginal Benefit

                                     0                                     0                         

                                     1                                   14                              14  

                                      2                                   27                              13

                                     3                                   39                              12

                                     4                                   50                              11

                                     5                                   60                              10

                                     6                                   69                                9

                                     7                                   77                                8

                                     8                                   84                                7

                                     9                                   90                                6       

                                    10                                  95                                5

                                    11                                  99                                4

                                    12                                100                                1

 

The ‘Marginal Benefit’ column is the additional increase in your economics grade from studying one more hour of economics per week.  This is found as the change in your grade when the hours of study is increased by one per week.  Draw two separate graphs for Table 2.1.  Both graphs will measure hours studied per week along the horizontal axis.  The first graph will show the total grade in economics from studying so many hours per week (2 hours, 3 hours, etc.).  The second graph will show the marginal change in your economics grade from studying one additional hour per week.   

            As we noted, in addition to studying economics, you could also spend time on math.  Table 2.2 gives your math grade from studying so many hours of that subject per week.  The marginal benefit column is interpreted the same as before.  

                                                            Table 2.2

                        Hours Studied/Wk                    Grade(%)                     Marg. Ben.

                                       0                                    0                                 ---

                                       1                                  15                                 15

                                       2                                  29                                 14

                                       3                                  42                                 13

                                       4                                  54                                 12

                                       5                                  65                                 11

                                       6                                  75                                 10

                                       7                                  84                                   9

                                       8                                  91                                   7

                                       9                                  96                                   5

                                     10                                  99                                   3

                                     11                               100                                   1

                                     12                               100                                   0

 

Similar to the economics table, your math grade increases as you study more math per week, but it increases at a decreasing rate.  This can be seen by looking at the marginal benefit column.  Once again, you should graph both columns in Table 2.2, this time with hours studied per week in math along the horizontal axis.  The shapes of both curves should be quite similar to the graphs you drew for Table 2.1.  

            Given the information in Tables 2.1 and 2.2, how many hours per week should you study economics?  To have a place to start, assume that you are currently spending all 12 available hours on mathematics.  Then note that the marginal benefit you receive from the first hour spent on economics each week is 14; that is, your grade in economics increases by 14 percentage points.  To determine if you should spend the first hour on economics, consider the marginal cost of that decision. If you study the first hour of economics, it means that you cannot study the 12th hour of mathematics. That is, the opportunity cost of studying the first hour of economics is the reduction in your grade from studying math for one less hour.  What is the reduction in your math grade if you spend the 12th hour per week studying math?  It is zero.  Therefore, the marginal cost of the first hour spent on economics is zero.  Is it efficient for you to study the first hour of economics?  Clearly, it is.  The marginal benefit is a 14-percentage point increase in your economics grade with no reduction in your math grade.  

            What about spending a second hour per week studying economics?  What is the marginal benefit?  It is equal to a 13-percentage point increase in your economics grade?  What is the marginal cost?  You will be unable to spend the 11th hour studying math.  Since the marginal benefit of the 11th hour you spend on math each week is 1, that is the marginal cost to you of spending a second hour studying economics each week  

            By now, you should be able to see that the marginal cost of studying economics one more hour each week is just the reverse of the marginal benefit column for math.  In fact, we can add the marginal cost column to Table 2.1 (and omit the total grade for simplicity) to get Table 2.3.  Note that for all of the additional hours spent studying economics up to the sixth one per week, the marginal benefit (increase in your economics grade) exceeds the marginal cost (reduction in your math grade).  For the sixth hour spent on economics, the marginal benefit just equals the marginal cost.  It is efficient for you to spend those first six hours on economics.  It is not efficient for you to spend a seventh hour studying economics.  Why not?  

 

                             Table 2.3

 

Hours Studied              MB                              MC                 

              1                                14                                  0

              2                                13                                  1

              3                                12                                  3

              4                                11                                  5

              5                                10                                  7

              6                                  9                                  9

              7                                  8                                10

              8                                  7                                11

              9                                  6                                12

            10                                  5                                13

            11                                  4                                14

            12                                  1                                15

 

            If you spend six hours each week studying economics and six hours studying math, what would be your combined total grade in the two courses?  Is there any combination of hours between the two subjects that would give a higher total grade?  (Note: There is a combination that would give the same total grade: 7 hours on math and five on economics.)   

            The approach that has  been used is called the marginal approach by economists.  The maximum net benefits (benefits minus costs) from an activity can be attained by increasing the level of any activity up to the point where the marginal benefit just equals the marginal cost.  Therefore, it is efficient to increase the level of some  activity (studying, purchasing some good, etc.)  by one unit  as long as the marginal benefit of that additional unit exceeds the marginal cost associated with that additional unit.  

            Another way to look at this approach is to draw a graph.  Figure 2.1 is a graphical depiction of the economics problem that was just discussed.  The horizontal axis measures the number of hours spent studying economics each week.  The vertical axis is a measure of the marginal benefit and marginal cost of each hour.  Note that the marginal benefit declines as more time is devoted to economics while the marginal cost increases.  Where the two curves intersect (6 hours), the maximum net benefit from studying economics is achieved.  

  Download a PowerPoint Presentation of the Marginal Benefits/Marginal Costs Example

Case 2.7

Recycling in Florida

            Florida has a trash problem.  Its burgeoning population daily increases the amount of trash to be disposed.  Since a high water table precludes the burying of trash in most places, trash disposal is a very real problem.  Florida could soon be known more for its mountains of trash than for being the Sunshine State.  

            To tackle the problem, the state has passed legislation designed to increase the amount of recycling that is occurring.  Pressure is being placed on cities to meet recycling targets for many products made of glass, paper, aluminum and plastic.  If the targets are not met, disposal fees will be increased on items made of these materials.  The fees are meant to encourage the push toward recycling as well to provide the state with the necessary funds for building a state-wide recycling infrastructure.  For example, a ten-cent per ton fee exists on newsprint that will rise to 50 cents per ton if a 50% recycling target is not met.  Eventually, it is anticipated that people will need five garbage cans-one each for plastic, aluminum, paper, glass and one for everything else.

 

QUESTIONS  

1.  What benefits and costs are likely to occur as a result of the legislation passed by the state of Florida?  

2.  Are there any equity effects that are likely to occur as a result of the new legislation?  That is, will some people experience reduced incomes while others may have increased incomes?  

3.  Do you think this new legislation is a good idea?  Explain.  

 

Case 2.8  Corporate Average Fuel Economy Standard: Should Cars Get Better Mileage?

            In the face of rising gasoline prices and shortages of fuel in some areas, Congress in 1975 passed a law that required automobile producers to raise the fuel efficiency of their auto fleets.   Known as CAFE (for Corporate Average Fuel Economy), the law currently requires the autos that a company sells average 27.5 miles per gallon (mpg).  There is also a separate category for light trucks, sport utility vehicles, vans, and minivans, which has a current CAFE standard of 20.6 mpg.   

            To meet their requirements under CAFE, automobile producers have made predictable responses.  The average car has gotten smaller and lighter while some improvements to automobile engines have occurred (primarily the use of fuel-injected engines).  The drive (no pun intended) to improve fuel efficiency has led to the use of lighter metals (such as aluminum) and composites (such as fiberglass), timing belts instead of chains, radial tires, better aerodynamics, and many other adjustments.  Despite the improvements, the manufacture of smaller cars has probably been the primary way in which the standards have been met.  

             There are some people who support a further increase in the CAFE standards to as much as 40 mpg for cars and 26 mpg for the light-truck category.  Manufacturers oppose such a move, claiming that the only way they could meet stricter standards would be to shrink cars and trucks even further, something that the buying public opposes.   For now, at least, it seems unlikely that Congress will mandate further increases in fuel economy for autos and light trucks.  But another round of gasoline price increases such as was experienced in the 1970s could lead Congress to consider higher CAFE standards.  

QUESTIONS  

1.  What benefits are there to society if the CAFE standards are increased?

What are the costs of an increase in the standards?  How difficult or easy would it be to attempt to place dollar values on the benefits and costs that you identified?  Explain.  

2.  If the CAFE standards are increased, this could affect the behavior of individuals in several ways.  For example, how might a significant increase in the standards affect people’s choices between cars and vehicles in the light truck category?  If the standards are raised and automobile manufacturers comply by producing cars that get better mileage, how might the number of miles driven per year be affected?  Why is this an important question?  

3.  There are cars presently available that get 40 mpg or better.  If fuel economy were important to buyers, what should we see happening even without an increase in the CAFE standards?  Do you believe that we need to have CAFE standards?  Explain.

Example 2.9 The Edsel  

            The concept of consumer sovereignty was introduced in the previous chapter.  This refers to the fact that consumers decide what to produce in a market economy.  By casting their dollar votes in a market, they determine whether some of society’s scarce resources will be used, for example, for producing typewriters or for personal computers.    

            It is not always easy to accept the fact of consumer sovereignty.  Large corporations appear to decide what to produce and then to bombard consumers with advertising to ‘convince’ then that these are the goods that they want to purchase.   What choice do consumers have but to purchase the goods that corporations have produced?  

            Actually, they have plenty of choices.  The road to capitalism is littered with products that consumers soundly rejected by withholding their dollar votes.  The Ford Edsel is probably the classic case of what happens when consumers' wants are ignored.  In 1957, Ford Motor Company announced the production of a new luxury automobile called the Edsel.  Observers of the automobile industry in 1957 widely praised Ford for its decision to manufacture the Edsel.  But the luxury auto lasted only three years in production due to dismal sales.  Ford lost millions on the venture because consumers did not like the Edsel and were not ready for another luxury car.   

            Ford decided it was time to pay more attention to what buyers wanted.  Market research indicated that an increasing proportion of the auto buying public consisted of young men and women, who were more interested in small, sporty autos.  In 1964, Ford introduced the Mustang.  The rest is history.  Ford made enormous profits on the Mustang and the model is still in production today.  Because the Mustang is a smaller car, Ford makes less profit per unit than it does on larger, luxury-type autos.  But so many Mustangs have been sold that Ford’s total profit on the auto has been enormous.  Consumer sovereignty works!

-------------------------------------------------------------------------------------------------------

If you really want to have some fun, go to the website below, which is a mock dealer touting the introduction of the 1958 Edsel.   

http://edsel.net  

It may just make you want to buy an Edsel, but, alas, it is not to be. ---------------------------------------------------------------------------------------------------------

QUESTIONS  

1.  Can you think of other products that have not been very successful?  Why do you think those products failed?  

2.  The Edsel was not an auto that many people liked.  Why was the existence of competition an important factor in the failure of the Edsel?  What if Ford had been the only seller of autos in 1957, do you think the Edsel still would have been a big failure?  Explain.  

3.  Designing an auto, setting up a factory for the production run and selling the auto to dealers involves a huge investment on the part of an automobile manufacturer, an investment that might be lost if the auto turns out to be an Edsel.  What steps can an automobile manufacturer take to try to avoid mistakes such as the Edsel?  Are there costs associated with taking the steps you have identified?  Does the existence of these costs at least partially, explain why mistakes such as the Edsel still occur?  Explain.