Unit 2 Technology and incentives

2.2 Economic decisions: Opportunity costs, economic rents, and incentives

What happens in the economy is the result of decisions by individuals, firms (or their owners and managers), and governments. To understand the economy, we need to understand how people make decisions, and the factors they take into account when they choose what action to take.

Imagine, for example, that you are deciding whether to go to a concert. You weigh up the costs and benefits. A ticket costs $25. Is the concert worth that much to you? And if it is, do you prefer attending the concert to other ways of spending the evening—allowing for how much you enjoy the different activities, and the costs involved in each one?

Suppose you value the enjoyment that you expect to obtain from the concert at $55. This may seem a strange way to think about it (how do you measure enjoyment?) but you could interpret it as meaning that $55 is the most you would ever be willing to pay for this concert; if a ticket cost more than $55, you would not buy one, irrespective of other activities available.

Then we can work out the net benefit (often called the ‘pay-off’) to you of attending (that is, benefit minus cost):

\[\begin{align*} \text{net benefit of concert} &= \text{enjoyment from attending} - \text{cost of ticket} \\ &= \$55 - \$25 \\ &= \$30 \end{align*}\]

You could perform a similar calculation for other ways of spending the evening, weighing up the costs and benefits in each case. Suppose that your neighbours offer you $40 to babysit, but you know that it is difficult to persuade their child to go to sleep. Your evaluation might be:

\[\begin{align*} \text{net benefit of babysitting} &= \text{payment received} - \text{cost of effort involved} \\ &= \$40 - \$18 \\ &= \$22 \end{align*}\]

Notice that in this case, the benefit is a monetary one, while the cost is something you personally have to assess. You could think of the cost of the effort as the minimum payment you would need to be willing to undertake such a job.

By this calculation, you prefer the concert to babysitting. Suppose that, having evaluated all the alternatives available, you find that the concert gives you the highest pay-off and babysitting is second best. Then, according to this economic analysis, your decision will be to attend the concert.

This example seems artificial. You almost certainly wouldn’t make such a decision by attaching numbers to the enjoyment of the concert or the effort of babysitting. But you probably would take into account how you felt about them, as well as the direct monetary costs and benefits (the ticket and the pay). Effectively, we have developed an economic model of your behaviour, that:

• identifies the main factors you should take into account
• specifies a decision rule for you: ‘take the option that gives the highest net benefit (or pay-off)’
• predicts the outcome, given the monetary costs and benefits and your individual preferences.

It also illustrates three important economic concepts: opportunity cost, economic cost, and economic rent.

Opportunity cost and the next best alternative

opportunity cost

What you lose when you choose one action rather than the next best alternative. Example: ‘I decided to go on vacation rather than take a summer job. The job was boring and badly paid, so the opportunity cost of going on vacation was low.’

reservation option

When someone makes a choice amongst the available options in a particular transaction, the reservation option is their next best alternative option. Also known as: fallback option. See also: reservation price.

economic cost

The direct costs of an action (including monetary costs and costs of effort, for example), plus the opportunity cost.

Economic decisions often involve choosing between alternative and mutually exclusive courses of action. By taking an action (such as going to the concert) you lose the opportunity of taking the next best action (babysitting). We can think of the lost opportunity to babysit as a ‘cost’ of going to the concert. So we say that the value of this lost opportunity (also referred to as the opportunity cost of going to the concert) is $22, because $22 is the pay-off from the next best alternative. The next best alternative is sometimes called the reservation option. The option to babysit is ‘in reserve’ in case your best option is not available—for example, if the concert is sold out.

In general, when we consider the cost of taking action A, we allow for the fact that if we do A, we cannot do B. So ‘not doing B’ becomes part of the cost of doing A. This is called an opportunity cost because doing A means forgoing the opportunity to do B.

Economic cost

Thinking about decisions in this way, we could say that actions have both direct costs and opportunity costs. The economic cost is defined as the sum of the two:

\[\begin{align*} \text{economic cost of an action} &= \text{direct costs incurred by taking the action} \\ &+ \text{opportunity cost} \end{align*}\]

This gives us an alternative way of expressing the decision rule for whether to take an action: ‘take the action if the benefit is greater than the economic cost’. In the case of the concert:

\[\begin{align*} \text{benefit} &= \text{enjoyment of concert} \\ &= \$55 \\ \\ \text{economic cost} &= \text{cost of ticket + opportunity cost} \\ &= \$25 + \$22 \\ &= \$47 \end{align*}\]

Economists think about costs differently from accountants. An accountant would say that the cost of the concert was the direct ‘out-of-pocket’ cost of $25. Economists study how people make choices, so the economic cost includes the opportunity cost as well.

Since the benefit is greater than the economic cost, you should go to the concert.

Economic rent

A third way to express the decision rule is ‘take the action if the net benefit is greater than the opportunity cost’. For the concert:

\[\begin{align*} \text{net benefit} &= \text{enjoyment of concert} - \text{cost of ticket} \\ &= \$55 - \$25 \\ &= \$30 \\ \\ \text{opportunity cost} &= \text{net benefit from babysitting} \\ &= \$22 \end{align*}\]

Yet again, this rule tells you: go to the concert.

economic rent

Economic rent is the difference between the net benefit (monetary or otherwise) that an individual receives from a chosen action, and the net benefit from the next best alternative (or reservation option). See also: reservation option.

The difference between the net benefit and the opportunity cost gives us a measure of your overall gain when you choose the best option rather than the next best one. This difference is called economic rent. Your economic rent from the concert is $8.

In general, when taking action A results in a greater net benefit to yourself than the next best action, we say that you have received an economic rent.

\[\begin{align*} \text{economic rent} &= \text{net benefit from option taken} - \text{net benefit from next best option} \\ &= \text{net benefit from option taken} - \text{opportunity cost} \end{align*}\]

Finally, we can express the decision rule in terms of economic rent only:

• If action A would give you an economic rent: do it!
• If you are already doing action A, and it earns you an economic rent (that is positive, or at least zero): carry on doing it!

The term ‘rent’ is easily confused with everyday uses of the word, such as the rent for temporary use of a car, apartment, or piece of land. To avoid this confusion, when we mean economic rent, we emphasize the word ‘economic’. Remember, an economic rent is something you would like to get, not something you have to pay.

Innovation rents

Imagine that you have figured out a new way of reproducing sound in high quality. Your invention is much cheaper to use than anyone else’s method. Your competitors cannot copy you, either because they cannot figure out how to do it or because you have a patent on the process (making it illegal for them to copy you). So they continue offering their services at a price that is much higher than yours.

If you match their price, or undercut them by just a bit, you will be able to sell as much as you can produce, so you can charge the same price but make profits that greatly exceed those of your competitors.

The extra profits that you make from exploiting your invention are a form of economic rent, called innovation rent. A more precise definition is:

innovation rent

Profits in excess of the opportunity cost of capital that an innovator gets by introducing a new technology, organizational form, or marketing strategy.

\[\begin{align*} \text{innovation rent } = &\text{ profits from using the new technology} \\ &- \text{profits if you continued with the same technology} \\ &\text{ as your competitors} \end{align*}\]

Incentives and relative prices

incentive

An economic reward or punishment, which influences the benefits and costs of alternative courses of action.

Economic rents occur throughout the economy. They provide incentives for people to take action. For example, potential innovation rents may motivate the owners of a firm to switch from one technology to another. In Section 2.6, we use this idea to explain some of the factors that contributed to the Industrial Revolution.

Economics focuses attention on alternatives and choices. Our analysis of the Industrial Revolution is based on the idea that people are free to select different courses of action, and that economic incentives—potential rewards (or penalties, sometimes called disincentives)—affect the choices they make. They consider the costs and benefits, and attempt to do as well as they can, according to some standard. Typically, we assume that the owners and managers of a firm will choose the option that delivers the highest profits.

People are motivated not only by the desire for material gain but also by love, hate, a sense of duty, ethical considerations, and a desire for approval. Sometimes, economic analysis allows for other such motivations.

relative price

The price of one good or service compared to another (usually expressed as a ratio of the two prices).

Relative prices are an important factor in determining economic incentives. When managers of firms decide how many workers to hire, or shoppers decide what and how much to buy, prices affect their decisions. And what matters is the price of one option relative to another. If prices are a lot lower in the supermarket than in the corner shop, and it is not too far away, then this will be a good argument for shopping in the supermarket rather than the corner shop. If all of the prices were to rise by 5%, the decision probably wouldn’t change.

Relative prices are simply the price of one option relative to another, often expressed as the ratio of the two. In our explanation of the Industrial Revolution, the ratio of energy prices (the price of the coal needed to power a steam engine) to the wage rate (the price of an hour of a worker’s time) plays an important part in the story.