©Bruce
Domazlicky
An Introduction to Economic Thinking
Chapter
Two
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| Case 2.1:
Calculating Benefits and Costs |
The arrival of the new year on January 1 seems to be dominated by
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
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?
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?
4.
Would higher taxes on cigarettes be an effective method for helping cigarette
users to quit their habit?
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.
| 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
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.
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.