"Pitfalls" of economic thinking: some examples.

1. Ignoring opportunity costs:

You lend a friend $500; he agrees to pay you back in 2 years.
What's the opportunity cost?

Depends on what else you would have done with the money. Perhaps you would have put it in the bank.

If the interest rate is a simple interest rate of 5%, how much money would you have at the end of the year if you put it in the bank?

r =.05

(1 + .05 ) 500

or (1 + r) 500

at the end of one year.

At the end of two years,

(1 + .05 ) (1 + .05 ) 500

or (1 +r) (1+r) 500

or (1+r)² 500.

Let t represent time in number of years;

(1 +r)^t times the "principal" is what you would have at the end of the period

Your reservation price for a vacation at Fort Lauderdale is $1,350. Round trip airfare is $500 but you have a frequent flyer coupon you could use. Other costs would equal $1000. If you didn't use the frequent flyer coupon to go to Fort Lauderdale, you could use it to fly to Boston for your brother's wedding, saving you $400.

Should you go to Fort Lauderdale?

If the frequent flyer coupon were really "free", yes. But the opportunity cost of using it to go to Fort Lauderdale is $400. So the total cost of that trip is greater than your reservation price.

2. Failure to ignore sunk costs:

Sunk cost is a cost that is beyond recovery at the moment the decision is made. Because sunk costs must be borne whether or not an action is taken, they should be irrelevant to the decision of whether to take the action.

A) You and Joe have identical tastes. You bought a ticket to a basketball game in Boston through Ticketmaster for $30. Joe is planning to buy a ticket at the game, which will cost him $25 (no Ticketmaster surcharge). An unexpected snowstorm begins...what a drag. It will make the drive a big hassle.

Which of you is more likely to attend the game?

Joe should be less likely to attend the game--because he will incur driving/hassle costs plus ticket, whereas you will incur only driving/hassle costs

B) Jennifer has purchased a $50 theater ticket. Her reservation price for the theater performance was $80.

R^T=80

On the day before the performance, George, the guy in her economics class asks her to dinner the next day. If she had known he was going to ask her she wouldn't have bought the ticket.

So we know that her reservation price for the dinner with George was greater than her reservation price for the theatre, less the ticket price:

R^D > R^T-50

In fact, she estimates her reservation price for going out with George at $70. In other words:

 R^D=70

But under the current circumstances, with a theatre ticket in hand, should she go to dinner with George?

Um, no (if she is a Rational Economic Woman). She compares the total benefit she places on the theatre ticket ($80) with the total benefit she places on the dinner with George ($70). She doesn't take the cost of the ticket into account because it's a sunk cost. Sorry, George.

3. Failure to consider marginal costs and benefits:

Consider the following table regarding the relationship between number of widgets produced at total costs:

Assume we produce 5 widgets.

What's the average cost of producing a widget?

Suppose we can sell widgets for $8 a piece.

Should we produce another widget?

Um, be careful. Even though the average cost of a widget is only $6, the numbers show that the marginal cost of producing a widget is going up. For instance, the 5^th widget cost $10 extra dollars to produce, even though the 2^nd widget only cost $2. So before you decide to produce another (6^th) widget, ask what the MARGINAL cost would be.

HERE ARE A COUPLE OF PITFALLS THAT ARE NOT DESCRIBED IN THE TEXT:

4. Lack of emotional self-awareness or emotional intelligence:

Do you really know what you want, or are you just guessing based on what other people want?

are you acting out of habit (or addiction)

e.g. most problem solving is aided by emotional intelligence as much as cognitive intelligence

people who can identify when they need help (and know how to get it) are better problem solvers than those who don't

This applies to studying...people who learn to enjoy studying, or at least how to make it a less alienating or frustrating experience, are the academic success stories NOT the ones who are necessarily smartest.

5. Temptations to opportunistic behavior:

Capitalist competition exhorts everyone to be self-interested. But pursuit of self-interest only has good effects within clear boundaries, or rules of the game.

Think of sports. Competition can bring out the best in athletes. But only if they pour their energy into their own performance. What if they start bribing the umpires? What if they start firing referees that disagree with them? What if they all start taking drugs with long run health risks in order to enhance their present performance?

Insider trading is a good example of opportunistic behavior.

The rules of the game are that if you work for a company and you have "inside information" about what is likely to happen to the company's stock prices, it is illegal for you to knowingly act on this information.

This rule is almost impossible to enforce, unless very dramatic cases are involved, with stock trades that are quite visible.

Take Samuel Waksal, who was head of Imclone. a biotech firm. He and his friends and family members owned large chunks of stock. The future of the company was becoming increasingly dependent on getting approval for a particular drug they developed for fighting cancer.

The drug was not approved by the Federal Drug Administration. Sam got on the phone and called his family members and told them to sell, sell, sell, quick. All the stockbrokers who handled these sales then called many of their clients and told them to sell, sell, sell.

Martha Stewart was one of these. She claimed she was planning to sell the stock anyway.

Was this a big chunk of money for her? No. Did she know that she was getting inside information? Probably (she used to work as a stockbroker, after all).

Headline on CNN today: it seems that her staff also picked up on the tip, and they also started selling their shares in Martha Steward OmniMedia as soon as they sniffed the possibility of scandal (prices of those shares have indeed fallen, and hard).

There is a somewhat sympathetic article about Martha Stewart in the current New Yorker . Has some good jokes: Conan O'Brian quoted Stewart as saying "a subpoena should be served with a nice appetizer." David Letterman monologue about Lizzie Grubman, the publicist who pleaded guilty to running down night-club customers in her car, had been complaining about the food in jail. "Hang on until Martha Stewart gets there."