Revision Note for Econ1210

Chapter 1
- Cost & Benefit Analysis

Covering:
1. Cost & Benefit Analysis

2. Rationality Assumption

3. What is Modelling?

4. Additional Benefit Vs Additional Cost

5. Incentives Matter - The Importance of Motivation

6. Opportunity Cost

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1. Cost & Benefit Analysis

Easiest to say, a rational person, when he makes a decision

or behaviour, he has to consider the cost and benefit of the
problem.

A rational person will only continue to do that thing if the

additional benefits are greater than the additional cost. The
important point is to know the concept of "additional", from
now on our mindset should be placed on this concept of
"additional". There will be more examples to explain later.

This assumption is the most mainstream traditional

economics, advocating irrational behavior is impossible to
exist. What is being irrational? It means that you do
something without weighing any pros and cons, you are
completely selfless in your dedication, and contributing
unconditionally.

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2. Rationality Assumption

A rational person/organization will do

everything to

1. Fulfill the goals as best as they can

2. Maximize profit

3. Maximize all the benefits/satisfaction that

can be obtained from consumption.

4. Everything should work in the best

direction anyway. Maximize everything!

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What does it mean to be rational?

Rational decision making in practice must have the following

basic conditions:

1. All valid information must be available in the decision making

process.

2. The identification of all decision options is relevant to the

achievement of the goal.

3. The ability to accurately predict the outcome of each option

under different objective conditions.

4. The ability to select the most optimal solution

Essentially, economics is a way of thinking. From now on, our

thinking is, why am I doing this? If it can bring me additional
benefit, and the additional benefit is greater than the additional
cost, I should do this thing. This is one of the most fundamental
assumptions in traditional economics - rationality.

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3. WHAT IS MODELLING? (OPTIONAL)

"Abstraction" is a thought process of abstracting concepts

from their original objects.

For example, the ball with the portrait of a person above.

After the abstraction process, no matter how beautiful it is, it
is just a ball, and we only keep the general information about
the properties and behaviours of the ball, everything else will
be eliminated.
The main purpose of abstraction is to reduce the complexity
in order to get a simpler and easier model.

In this way, we can use the simplest way to examine the

different attributes of events in the complex economic world.
(Identify most important elements and incorporate them in a
model.)

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 What makes a good model?

What makes a good model is how well it accommodates the
data we have and predicts future trends. (Fit in the data
and predict the future)

Prediction, inference, policy

In the end, you have to estimate how people's attitude
towards a change will be, and then figure out the reason
why they have such an attitude, and finally come up with
some ways to make them accept the thing.
For example, as a pork seller, after you have raised the
price, you have fewer customers than before. You have to
reason out, is your pork too expensive, or is people's
buying power reduced? Finally, take an action to solve it,
such as giving a discount.

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4. Additional Benefit Vs Additional Cost

It means doing everything with the idea that it might bring

"extra" benefits or costs. Think at the margin!

What does that mean?

For example, if you don't consider the "extra" benefits or costs, it means
that every bite of ice cream you eat will be equally pleasurable and costly.

But in fact, this is not the case. First of all, you will be full, and with each
bite, you will be more and more full, and your extra cost will be higher
and higher. Secondly, you will also gradually be more unhappy and more
unsatisfied, because you are more and more bored by it, and your extra
benefit will be smaller and smaller.

When you eat more and become more unhappy, more full, after a certain
amount of bites, you will stop.

That's how you instinctively think about the additional benefit and
additional cost in an economic mindset.

So, from an economic point of view, as long as MB(Q) > MC(Q), you
should continue to do it; if MB(Q) = MC(Q), you can consider whether to
do it or not, if MB(Q) < MC(Q), then you should not do it.

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5. Incentives Matter

There is no behavior that does not require incentive to be

completed. Motivations can be positive or negative.
Motivation can be:

Spiritual (I will feel happy after I do this).

Monetary (I will have money after I do this)
Motivation of punishment (I will be punished if I don't
do this)

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5. Incentives Matter

There is no behavior that does not require incentive to be

completed. Motivations can be positive or negative.
Motivation can be:

Spiritual (I will feel happy after I do this).

Monetary (I will have money after I do this)
Motivation of punishment (I will be punished if I don't
do this)

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 Practice questions (Allocation of labor):

CREDIT SOURCE: 2019 MIDTERM HKU ECON1210

The marginal benefits of allocating an additional officer to

Causeway Bay and Mongkok aresummarised in the table below:

Choosing the top 4 allocation methods that will yield the highest
marginal benefits, we will allocate 1 officer to Causeway Bay and 3
to Mongkok.

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6. Opportunity Cost

Trade-offs are everywhere.

What does it mean?
It means that you can't have both the fish and the bear's
paw. Every decision you make means you are sacrificing
something. And the thing that will be sacrificed is your
opportunity cost. Literally, if you decide to do A, you will
lose the opportunity to do B, and the opportunity to profit
from B. And we usually quantify this opportunity, giving it
a value, so that we can judge whether we should do A or B.

When calculating the opportunity cost, it is not necessary

to consider the benefits and costs that are not related to the
decision. For example, if you are now deciding to either go
to college, or to work, then you need to consider whether
the sacrificed things are related to this decision such as
education, future career, and so on,. You do not need to
take the cost of eating dinner into account.

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Also do not need to calculate Sunk Cost, the cost that have
become the past and will not affect our current decision
making. For example, you are now waiting for a cab. You
have already waited for a long time and still couldn't catch
one. Then you will start to think, should I keep waiting, or
leave? From an economic point of view, you need to put
aside your own personal feelings and know that the time
spent waiting for a taxi is already a sunk cost. So when
considering whether you should continue to wait, you
should not calculate the sunk cost, but rather consider the
factor of the late arrival of the taxi, how long it is expected
to take for the taxi to arrive, and what is the additional
return for me if I wait any longer. Simply put, Sunk Cost
means that even if I stop doing a certain thing now, I won't
be able to get back the sunk cost. For example, for non-
refundable movie tickets, I can't get back the cost of the
movie tickets if I don't go to watch the movie, so it should
not affect my decision of whether to go watch the movie or
not after buying the ticket.

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PRACTICE QUESTIONS (OPPORTUNITY COST PROBLEM)

CREDIT SOURCE: 2019 MIDTERM HKU ECON1210

First of all, the tuition and meal costs are the same for both schools, so it is the same wherever we go, there
is no additional benefit or cost to consider.

Then we have to look at what kind of opportunity we were losing by choosing OKU and how much extra
benefit that opportunity would bring us. We found that if we go to OKU, we have to pay $700 for textbooks,
$1500 for transportation, and $1000 for parking, for a total cost of $3200. If we go to MKU, the cost is $800
+ $3000, for a total of $3800.

Opportunity cost = additional cost of current option + benefits lost for not choosing the
next best alternative
The opportunity cost of attending OKU =
$700 textbook + $1,500 transportation cost + $1,000 parking fee
- $800 on other activities - $3,000 lodging fee

So the answer is None of the above.

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PRACTICE QUESTIONS (OPPORTUNITY COST PROBLEM)

CREDIT SOURCE: 2019 MIDTERM HKU ECON1210

Since the consideration of opportunity cost will only be the next best alternatives, plus the
question says that no matter how ， Hermione's ranking is unchanged, so we can directly
ignore the third choice.
I. There will be no increase in opportunity cost because if I have more money for my first
choice, I will not regret giving up other options.
II. Even if I can have a monthly income of 30 million tutoring people, it does not matter to me,
because it is not my next best choice.
III. Same logic as above, it will always be my third choice.
IV. The right answer. Because then I might feel that it's also pretty good to be a housewife, so
the opportunity cost for me to give it up would be higher.

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PRACTICE QUESTIONS (OPPORTUNITY COST PROBLEM)

CREDIT SOURCE: 2019 MIDTERM HKU ECON1210

Lucy bought a soccer ticket at a cost of $550.

Jack bought a concert ticket, costing $650.

Lucy believes soccer ticket worths $600; concert ticket worths $800.

Since tickets are non-refundable, they are sunk cost. The opportunity cost
should be calculated without considering the ticket cost.

So if Lucy insists on going to the soccer game, she will lose the opportunity to
see the concert, which is worth $800.

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 PRACTICE QUESTIONS (OPPORTUNITY COST PROBLEM)

CREDIT SOURCE: 2019 MIDTERM HKU ECON1210

Opportunity cost = additional cost of current option + benefits lost for not choosing the
next best alternative

First of all, you will have to pay rent whether you go to Thailand or not, thus rent will be
a sunk cost and should not be a factor in the decision.

Secondly, by going to Thailand, you will lose the opportunity to work and earn money,
which worth $20*10 = $200.
The cost of going to Thailand = Flight ticket ($600) + More expensive meal ($300-75)

So the answer = $600+$200+$225

= $1025.

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 The End of Chapter 1

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