Thinking Like an Economist

Cost-Benefit Approach
 The Object
• Floods, droughts, fires, tornadoes…
• To me, saga of GHGs most persuasive →
working hypothesis
• Still, main feature: uncertainty
• Policy? For humanity? For Canada?
• Unorthodox
• Based on economics
 Scarcity and Choice
• Economics: study of choices, of making
decisions and of their consequences
• Every choice involves scarcity – by def
• Not just about physical goods
• Not just about money
• Any decision weighs costs and benefits
 Tenets I
(Mankiw)

• Scarcity is pervasive; decisions required

• Trade-offs among good things
• People have reasonably simple objectives
Objectives known to them, fairly stable
• Behaviour is not random
Can be analyzed
 Stability
• Preferences: assumed known, stable
Can you state your preferences over all
possible choices?
We need experience
Preferences can change
But if unknown and unstable, what can
we say about them?
 Tenets II
• Choices exist; decisions are made
• To pursue one objective (a benefit),
another must be curtailed (a cost)
People have a criterion to weigh
benefits and costs
Often, the weights are implicit
 “Science of Common Sense?”
• Suppose we accept the tenets
• Seemingly counter-intuitive conclusions in
economic thinking are plentiful
• , discipline required
• Goal: “to think like an economist”
 “People Respond to Incentives”
• (tautology?) Powerful

• Charles Dickens’s novels are quite thick

• He was paid by the word: Price affected
his behaviour & his literary values
• Price affects everyone’s behaviour
• E.g., plastic grocery bags & thickness,
• “The rich” are & stay rich by responding to
incentives
 The Best Decision
• Criterion: difference between benefits and
costs
• Implies a unit of account, “numeraire”
• Money is the easiest. Why?
• Ecological footprint: land of a given quality
• Proportional?
 Calculation or Custom?
• How does a custom get to be a custom?
• If it is not good, does it change?
• Culture does change.
• Why does it change slowly?
• Does it change slowly?
• How does one choose a marriage partner?
 Opportunity Cost
• Not monetary, still part of choice
• If eat a chocolate now, not available later
• If extract a unit of oil now…
• If plant trees, cannot use land for soccer
• All choices → decisions: economics
• Opportunity cost: net benefit of next-best
choice the person had available
 Decision
• How do we make the decision?
• For the chocolate, weigh the benefits from
eating now and from eating later
• Choose “now” → choice of eating later
foreclosed.
 Net Benefits: One or Another
• Benefit that would have been had by
eating later is a cost of eating now
• If the benefit of “now” is higher than “later”,
better choice is “now”: B – C > 0
• If the benefit of “later” is higher, better
choice is “later”: B – C < 0
 Marginal Net Benefit:
&
• If the addition to as is increased is
greater than the addition to , it is
worthwhile to increase
• If the addition is smaller, it is worthwhile
to reduce
• The additions are equal at an optimum
• If pleasure and tiredness both increase
with distance on a bike ride, stop where
the increases are equalized
 Marginal and Average
• Equating changes of benefits and costs is
a marginal analysis
• Marginal benefit is the change of benefits;
marginal cost is the change of cost
• Different from average, just as average
speed is different from current speed
• If average benefit equals average cost,
net benefits are zero
 “Economic” Accounting
• Like profit: revenue minus cost
• Not commercial accounting
• Involves opportunity cost: values not
normally given monetary value “count”
• Applicable to any decision
• Concept itself is almost trivial, yet
• Counter-intuitive decisions are common
 Interest
• Interest is the opportunity cost of money:
• Earn interest “in the bank” or on bonds…
• Interest is forgone if money is spent today
rather than saved
• Interest rate written
• A penny saved today is “worth”
pennies in a year: A penny saved is
pennies earned next year.
 A Stylized Oil Well
• Stylized oil well is like a box of chocolates
• Many units, many time periods
• Does this make a difference?
• Let us focus on a particular barrel of oil
and the choice of extracting now or a
year from now
 Oil Today and Tomorrow
• If we extract now, we can sell the barrel for
its price, .
• If we extract next year, we can sell it for its
price then, .
• Do we compare and directly?
• No! They are prices at different times and
are not directly comparable.
• Difference: opportunity cost, “the use of”
money
 Money Tomorrow
• Money is the unit of account, not oil.
• We can sell for p, take the money and put
it into the bank to earn interest at rate
. In one year, we have .
• If we are interested in spending tomorrow,
the benefit of owning the oil is the
greater of and .
• We extract now if
 Money Today
• If we want to use our money in the present,
we can choose to wait for a year to
extract and borrow against its value.
• We plan to sell at in a year’s time.
Against we can borrow , since .
• The benefit of owning the oil is the greater
of or .
• Again, we extract now if
 The Optimal Choice
• In tomorrow’s money, we extract now if .
• In today’s money, we extract the oil now if

• Same condition for extracting now.

• A dollar today grows to next year.
• Dollar next year discounted: today.
 Definitions
• Interest or discount rate:
• Discount factor:
 Hotelling’s Rule
• Oil is extracted today and is going to be
extracted tomorrow.
• If the only consideration is when to extract,
then :
No one can gain by changing the dates
of extraction. Fully arbitraged.
Benefit equals opportunity cost:
.
 Economic Models
• This has been a simple model.
• It illustrates principles such as the time
value of money and the fact that a unit of
oil tomorrow is not the same thing as a
unit of oil today
• Poor predictor of world (or any) oil market:
neglects geology, technology and costs
sunk in drilling, etc.
 The Real Choice
• How?
• The technology of extraction, including
sunk costs, may make choice assumed in
the model unavailable.
e.g., technology may force us to
spread production over many years.
• The fundamental choices are the timing
and level of investment in an oil well
• (Stranded assets)
 Too Easy?
• Going simply, deliberately
• Climate Change is complex, many facets
• Simulated; cf Pindyck
• Aim: “best policy”
• Most important datum: interest rate
 Empirics
• Several points are subtle
• Econometrics: 1. contemplate, math →
clearer, more precise, better questions;
2. more complicated than thought ()
• Econ unlike math, physics, engineering:
easy points → analytic labyrinth
• Pick up pace later; formal CBA, dynamics
 Irreversible, Irrecoverable Cost
• Clarify a major point in intro econ:
• Drilling for oil, cutting old-growth forest
• Ignore such a cost?
• Not before it is incurred. Affects future
think hard about sinking a cost
• We can learn from good & bad decisions
(any decision is sunk)
 “Sunk” Cost
• Once it is cut, the loss of old growth
should not affect the use of the lumber
• Decisions can be improved by ignoring
costs once they are sunk
• But the irreversibility means that one
thinks hard before deciding
• Sometimes people do not ignore sunk
cost after they are sunk; a mistake
Example: Drive or take the bus?
• A large part of the cost of using a car is the
sunk cost of owning it
• What is sunk? An expense that does not
depend on how much the car is used
• One reason it is hard to get commuters to
use public transit
 Costs and Benefits
• Be careful here
• We use a common numeraire (money)
• We are interested in deciding on the
choice that has the highest level of
benefits minus cost
• Net benefit is total benefit minus total cost
• No proportions (a 5% gain in benefit
compared to a 7% increase in cost)
 Total, Average, Marginal
• Riding a bicycle; drawing bath water
• There is a total distance or total volume
• There is an average of each over time
• Marginal: speed of bicycle; flow of water
• A change in a variable
 Maximizing
• Idea is to make the best choice
• “To maximize”
• Often, benefits and costs are functions of
some common variable, say, quantity
• Choice of the best value of
 Top of the Hill
• Suppose both increase when increases
• may increase at first, then fall
• Especially if benefits rise less and less,
costs more and more quickly
• In this case there is a maximum
• Nearer the maximum the net benefit of a
change in , , is lower:
• Approximations may be all right
 On Economic Policy
• Scarcity exists
• Therefore, decisions must be made
• “Trade-offs” among good things consistent
with the values of the decision maker
• Observed trade-offs reveal relative values
in the mind of the decision maker
 Role of Incentives

• Recognize that each individual is different

(has different “tastes”)
• Recognize that people respond to
incentives consistently with tastes
• Should aim to devise policies that use
rather than seek to thwart incentives
 Basic Ideas: Recap

• People respond to incentives

• Many decisions should be made at the
margin
• All costs and benefits must be evaluated
• Sunk costs must be studied carefully: they
influence the future
• Once sunk, sunk costs are neglected
 Rationality
• In microeconomics we begin with
preferences of an individual
• The preferences, such as the perceived
benefit of charity and voting, are given
• De gustibus non est disputandum
• “Maximized” or “optimized” or get close
• Bounded rationality: use of subjective
statistics, cost of gaining information
 Benefits of Education
• If don’t know what is to your own benefit,
can inform you: incandescent light bulbs
• Can make people more receptive to policy
and more willing to implement it…if others
do and there are penalties for not doing so
• (Also makes selfish people more capable)
• Culture is the technology for running a
society
 Unbridled Self Interest?
• Individuals do “cheat”
• , resources are devoted to minimizing
anti-social behaviour
• Fewer votes are cast when weather is bad
• “What do economists economize?”
• Lionel Robbins: Love!
• “Whatever that means.”
 Love, Unselfishness
• We can use altruism to make our society
better.
• Philosophers laud the unselfish
• But think of incentives
• Much to be said for using not just the
incentive of money but also internal
incentives altruism provides.
 Reliance on Unselfishness?
• Assurance that enough is provided?
• Which volunteer work is better – hospital
or school, etc.?
• Pay directs to the appropriate work
• “Unfair”? Good people sacrifice; others do
not, e.g., obeying covid restrictions
 Regrettable Incentives
• Incentives in bureaucracies: pay according
to the budget overseen → incentive
to maximize cost
• Paying previously unpaid volunteers may
reduce the number of volunteers if
people do not have a warm glow when
paid
 Planning?
• Avoid comparing what is with what is ideal.
Planning has been tried:
Even more subject to poor incentives
• In Soviet Russia, production quotas of
machines were set by tonnage, since
machines are differentiated goods. As a
result, the bases of machines were made
very heavy.
 Corporate Bureaucracies?
• Oliver Williamson, Nobel 2009:

• For some activities, markets are better

• For others, hierarchies are better
• Which? Williamson has a theory.
• Boils down to ease of contracting and
enforcement
• Unforeseeable contingencies →
hierarchies work better
 Sustainable Forestry
• “There is now a more widespread
understanding that forests are
ecosystems…”
• So what?
• There is scarcity
• Sustaining is a decision; part of economics
• thinking about benefits, costs
• And about what sustaining means
 Unsustainable Fishery
• Fish and fishing grounds are scarce
• Unsustainable fishing on the Grand Banks
was a decision
• , part of economics
• Moratorium on cod fishing also a decision
• Think of benefits, costs, externalities,…
 Climate Change
• Some emphasize ethics, education
• Can we rely on these?
• If Canada ceased to exist, the effect on
climate change would be negligible
• Benefits of individual action: “feel-good”
effect; who and how much?
• We need policy that takes into account
how people behave
• “People respond to incentives.” Use them?