Chapter 1 Thinking as an economist

Answers to review questions

1

They probably mean that, given the competing demands on their limited resources,
there are other things (a holiday, private school fees, a new computer) that they choose
to spend their income on rather than a plasma screen television.

Your friend probably means that your tennis game will improve faster if you take
individual lessons instead of group lessons. However, individual lessons are also more
costly than group lessons, so those people who are less concerned about how rapidly
they improve may do better to take group lessons and spend what they save on other
things that they value more.

The more valuable opportunity is the one that yields the greatest absolute gain. Even
though saving $100 on a $2000 plane ticket represents only a 5 percent saving, which is
less than the 45 percent saving you would make on the Brisbane ticket, the $100 save is
more valuable to you than the $90 saving.

Because the price of a movie ticket is a cost the patron must pay explicitly, it tends to
be more noticeable than the money that she would fail to earn by seeing the movie. As
Sherlock Holmes recognised, its easier to notice that a dog has barked than that it has
failed to bark.

You are wrong to suggest that the album cost you nothing. The astute economic thinker
would know to ask the question What would I otherwise have done with the gift
voucher? If the answer to this question was to let it expire unused, then you would be
correct in treating the Black Eyed Peas album as free. It is, however, more likely that
you would have used the voucher to buy some other album. If so, the opportunity cost
of the Black Eyed Peas album is your reservation price for the album that you would
have otherwise purchased.

If your tuition payment is non-refundable, it is a sunk cost. If the payment is refundable

until a certain date, it is not a sunk cost before that date but becomes one after it.

It is impossible to determine whether you should increase the number of times you visit
the gym each week based on the information provided. While we know the marginal
cost of an additional visit to the gym each week ($15), we know only the average
benefit of gym visits at the current number of visits ($30 per week). Sound economic
thinking requires that we compare marginal benefits and marginal costs when deciding
whether to increase the number of gym visits.

The farmer may fail to recognise the costs that may arise in terms of erosion, declining
water quality and loss of habitat when trees are removed from the banks of a stream
(Pitfall 1). Harvesting the trees may be more attractive to the farmer who places greater
weight on costs and benefits that occur now than on costs and benefits that occur in
future periods, which is what Pitfall 6 requires us to do.

Answers to problems
1

The economic surplus from washing your dirty car is the benefit you receive from
doing so ($6.00) minus your cost of doing the job ($3.50); that is, $2.50.

The benefit of adding an extra bag of compost is the extra revenue you will get from the
extra tomatoes that result. The cost of adding a bag of compost is $5. Adding the fourth
bag of compost will result in two extra kilos of tomatoes, or $6 in extra revenue, which
more than covers the $5 cost of the extra bag of compost. However, adding the fifth bag
of compost gives only one extra kilo of tomatoes, so the corresponding revenue
increase ($3) is less than the cost of the compost. The cost-benefit principle suggests
that you should add four bags of compost and no more.

A 2 per cent saving on a $100 000 bill is $2000. A 15 per cent saving on a $10 000 bill
is $1500. For the same investment the cafes owner should prefer the 2 per cent saving
on $100 000 rather than the 15 per cent saving on $10 000. The rules of sound
economic thinking suggest that it is the absolute change in the value of costs and
benefits that matter, not the proportional change.

Lucys statement reflects one of the pitfalls of economic thinking: namely, failing to
account for all opportunity costs. Lucy must ask herself, What would I otherwise be
doing if I didnt work in my own business? The value of the opportunity that she is
foregoing is an implicit cost of doing business and should be included when assessing the
profitability of Lucys business.

When the newly elected government decides whether to allocate extra funds to complete
a particular infrastructure project, the costs that have already been incurred become sunk
costs. The decision should be based on a comparison of the extra benefits and extra costs
that will result from completing the project, evaluated at that point in time. Insisting that
all projects be completed could result in throwing good money after bad and in
investments being made by the government for which costs exceed benefits.

In the first case, the cost is $6 per week no matter how many bins are put out, so the cost
of disposing of an extra bin of rubbish is $0. Under the tag system, the cost of putting out
an extra bin is $2, regardless of the number of the bins. Since the relevant costs are higher
under the tag system, we would expect this system to reduce the number of bins put out
for collection.

At Smiths house, each child knows that the cost of not drinking a can of cola is that it
is likely to be drunk by his sibling. Each child thus has an incentive to consume rapidly
in order to prevent the other from encroaching on his share. Jones, by contrast, has
eliminated that incentive by making sure that neither child can drink more than half the
cans. This step permits his children to consume at a slower, more enjoyable pace.

If Tom kept the $2000 and invested it in his business, at the end of a year his
investment would have resulted in earnings of $200. Dick must therefore give Tom
$200 in interest in order for Tom not to lose money on the loan.

According to the cost-benefit criterion, the two women should make the same decision.
After all, the benefit of seeing the play is the same in both cases, and the cost of seeing
the playat the moment each must decideis exactly $10. Many people seem to feel
that in the case of the lost ticket, the cost of seeing the play is not $10 but $20, the price
of two tickets. In terms of the financial consequences, however, the loss of a ticket is
clearly no different from the loss of a $10 bill. In each case, the question is whether

seeing the play is worth spending $10. If it is, you should see it; otherwise not.
Whichever the answer, it must be the same in both cases.
10

Since you have already bought your ticket, the $30 you spent on it is a sunk cost. It is
money you cannot recover, whether or not you go to the game. In deciding whether to
see the game, then, you should compare the benefit of seeing the game (as measured by
the largest dollar amount you would be willing to pay to see it) only to those additional
costs you must incur to see the game (the opportunity cost of your time and whatever
cost you assign to driving through the hailstorm). However, you should not include the
cost of your ticket; that is $30 you will never see again, whether you go to the game or
not.
Joe, too, must weigh the opportunity cost of his time and the hassle of the drive in
deciding whether to attend the game. But he must also weigh the $25 he will have to
spend for his ticket. At the moment of deciding, therefore, the remaining costs Joe must
incur to see the game are $25 higher than the remaining costs for you. And since you
both have identical tastesthat is, since your respective benefits from attending the
game are exactly the sameJoe should be less likely to make the trip. You might think
the cost of seeing the game is higher for you, since your ticket cost $30, whereas Joes
will cost only $25. But at the moment of deciding whether to make the drive the $25 is
a relevant cost for Joe, whereas your $30 is a sunk costand hence an irrelevant one
for you.

11

The two phone systems charge exactly the same amount (70 cents) for a seven-minute
call. However, the marginal cost under the new plan is only 2 cents per minute,
compared to 10 cents per minute under the current plan. Since the benefit of talking for
additional minutes is the same under both plans, Tom will make longer calls under the
new plan.

12

In College A, everybody will keep eating until the benefit from eating an extra
kilogram of food is equal to $0, since that is the extra cost to them for each extra
kilogram of food they eat. In College B, the cost of eating an extra kilogram of food is
$2, so people will stop eating when the benefit of eating an extra kilogram falls to $2.
Food consumption will thus be higher at College A.

13

The differences in the choices that people make reflect differences in the costs and
benefits that they face. In this case, the benefit of testing the alarm more regularly is the
reduction in the value of the expected loss from fire. Assessment of the size of this
benefit will differ across individuals. The cost associated with more regular alarm
testing may also differ depending on factors such as age. It may also be the case that
some people are more skilled economic thinkers than others and are better at applying
the cost-benefit principle and avoiding its pitfalls.