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(BQ) Part 1 book Microeconomics has contents: First principles; supply and demand, consumer and producer surplus, price controls and quotas - meddling with markets, international trade, decision making by individuals and firms
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Tell us about your experience using LaunchPad Contact us at wortheconomics@macmillan.com MICROECONOMICS Paul Krugman MICROECONOMICS LaunchPad makes preparing for class and studying for exams more effective Everything you need is right here in one convenient location—a complete interactive e-Book, all interactive study tools, and several ways to assess your understanding of concepts Surveys of hundreds of students* taking the principles of economics course and using LaunchPad show that LaunchPad has real benefits: Wells Krugman LaunchPad logo suite When it comes to explaining fundamental economic principles by drawing on current economic issues and events, there is no one more trusted than Nobel laureate and New York Times columnist Paul Krugman and co-author, Robin Wells In this best-selling introductory textbook, Krugman and Wells’ signature storytelling style and uncanny eye for revealing examples help readers understand how economic concepts play out in our world WORTH Robin Wells Find more at http://www.downloadslide.com CHAPTER-OPENING STORIES CHAPTER W RLD VIE O W Applications in Microeconomics GLOBAL COMPARISONS 1: Common Ground, 1: First Principles, 2: Economic Models: Trade-offs 2: From Kitty Hawk to Dreamliner, 25 2: Pajama Republics, 37 3: Supply and Demand, 67 3: NEW: A Natural Gas Boom, 67 3: Pay More, Pump Less, 71 4: Consumer and Producer Surplus, 103 4: Making Gains by the Book, 103 5: Price Controls and Quotas: 5: Big City, Not-So-Bright Ideas, 131 5: Check Out Our Low, Low Wages!, 145 6: Elasticity, 161 6: NEW: Taken for a Ride, 161 6: Food’s Bite in World Budgets, 176 7: Taxes, 187 7: The Founding Taxers, 187 7: You Think You Pay High Taxes?, 209 8: International Trade, 217 8: NEW: The Everywhere Phone, 217 8: Productivity and Wages Around the World, 9: Decision Making by Individuals 9: Going Back to School, 249 9: Portion Sizes, 261 and Trade, 25 Meddling with Markets, 131 and Firms, 249 223 10: The Rational Consumer, 281 10: The Absolute Last Bite, 281 11: B ehind the Supply Curve: Inputs and Costs, 329 11: The Farmer’s Margin, 329 12: Perfect Competition and the 12: NEW: Deck the Halls, 357 13: Monopoly, 385 13: Everybody Must Get Stones, 385 13: The Price We Pay, 391 14: Oligopoly, 419 14: Caught in the Act, 419 14: Contrasting Approaches to Antitrust 15: Monopolistic Competition and Product Differentiation, 445 15: Fast-Food Differentiation, 445 16: Externalities, 465 16: NEW: Trouble Underfoot, 465 16: Economic Growth and Greenhouse Gases 17: Public Goods and Common Resources, 489 17: The Great Stink, 489 17: Voting as a Public Good: The Global 18: The Economics of the Welfare State, 511 18: NEW: The Coming of Obamacare, 511 18: NEW: Redistribution and Inequality in Supply Curve, 357 19: Factor Markets and the Distribution of Income, 543 20: Uncertainty, Risk, and Private Information, 581 19: The Value of a Degree, 543 20: NEW: Extreme Weather, 581 11: Wheat Yields Around the World, 332 Regulation, 434 in Six Countries, 473 Perspective, 496 Rich Countries, 515 19: The Overworked American?, 567 Find more at http://www.downloadslide.com Blue type indicates global example ECONOMICS IN ACTION 1: Boy or Girl? It Depends on the Cost, 10 n Restoring Equilibrium on the Freeways, 17 n Adventures in Babysitting, 20 BUSINESS CASES 1: How Priceline.com Revolutionized the Travel Industry, 21 2: Rich Nation, Poor Nation, 39 n Economists, Beyond the Ivory Tower, 43 2: Efficiency, Opportunity Cost, and the Logic of 3: Beating the Traffic, 78 n Only Creatures Small and Pampered, 85 n The Price of 3: NEW: An Uber Way to Get a Ride, 97 4: When Money Isn’t Enough, 110 n High Times Down on the Farm, 115 n 4: StubHub Shows Up the Boss, 126 5: NEW: Price Controls in Venezuela: “You Buy What They Have,” 140 n NEW: The Rise and 5: Medallion Financial: Cruising Right Along, 154 6: Estimating Elasticities, 165 n Responding to Your Tuition Bill, 173 n Spending It, 6: The Airline Industry: Fly Less, Charge More, Admission, 89 n NEW: The Cotton Panic and Crash of 2001, 95 NEW: Take the Keys, Please, 121 n A Great Leap—Backward, 124 Fall of the Unpaid Intern, 146 n NEW: Crabbing, Quotas, and Saving Lives in Alaska, 152 177 n European Farm Surpluses, 180 7: Who Pays the FICA?, 193 n Taxing the Marlboro Man, 202 n Federal Tax Philosophy, Lean Production at Boeing, 45 182 7: Amazon versus BarnesandNoble.com, 211 205 n The Top Marginal Income Tax Rate, 210 8: NEW: How Hong Kong Lost Its Shirts, 226 n Trade, Wages, and Land Prices in the Nineteenth 8: Li & Fung: From Guangzhou to You, 244 Century, 233 n Trade Protection in the United States, 237 n Beefing Up Exports, 242 9: Farming in the Shadow of Suburbia, 254 n The Cost of a Life, 263 n A Billion Here, a Billion There…, 264 n “The Jingle Mail Blues,” 269 10: Oysters versus Chicken, 284 n The Great Condiment Craze, 289 n Buying Your Way Out of Temptation, 294 n Mortgage Rates and Consumer Demand, 296 11: The Mythical Man-Month, 336 n NEW: Smart Grid Economics, 344 n There’s No Business Like Snow Business, 350 9: NEW: J C Penney’s One-Price Strategy Upsets Its Customers, 271 10: NEW: Having a Happy Meal at McDonald’s, 298 11: Kiva Systems’ Robots versus Humans: The Challenge of Holiday Order Fulfillment, 351 12: NEW: Paid to Delay, 360 n NEW: Farmers Move Up Their Supply Curves, 371 n 12: Shopping Apps, Showrooming, and the 13: Newly Emerging Markets: A Diamond Monopolist’s Best Friend, 392 n Shocked by the 13: NEW: Amazon and Hachette Go to War, 414 14: Is It an Oligopoly, or Not?, 421 n Bitter Chocolate?, 425 n The Rise and Fall and Rise 14: Virgin Atlantic Blows the Whistle…or Blows NEW: From Global Wine Glut to Shortage, 378 High Price of Electricity, 399 n NEW: Why Is Your Broadband So Slow? And Why Does It Cost So Much?, 406 n Sales, Factory Outlets, and Ghost Cities, 412 of OPEC, 431 n The Price Wars of Christmas, 438 15: Any Color, So Long as It’s Black, 449 n The Housing Bust and the Demise of the 6% Commission, 454 n NEW: The Perfume Industry: Leading Customers by the Nose, 459 16: NEW: How Much Does Your Electricity Really Cost?, 471 n Cap and Trade, 477 n The Impeccable Economic Logic of Early-Childhood Intervention Programs, 480 n The Microsoft Case, 483 17: From Mayhem to Renaissance, 492 n Old Man River, 498 n Saving the Oceans with ITQs, 502 n Blacked-Out Games, 504 18: Long-term Trends in Income Inequality in the United States, 519 n NEW: Programs and Poverty in the Great Recession, 524 n What Medicaid Does, 533 n French Family Values, 536 19: The Factor Distribution of Income in the United States, 545 n Help Wanted!, 555 n Marginal Productivity and the “1%”, 562 n The Decline of the Summer Job, 568 20: Warranties, 588 n When Lloyd’s Almost Llost It, 596 n Franchise Owners Try Harder, 600 Challenges Facing Brick-and-Mortar Retailers, 379 It?, 440 15: Gillette versus Schick: A Case of Razor Burn?, 461 16: NEW: Are We Still Friends? A Tale of Facebook, MySpace, and Friendster, 485 17: Mauricedale Game Ranch and Hunting Endangered Animals to Save Them, 506 18: Welfare State Entrepreneurs, 538 19: NEW: Wages and Workers at Costco and Walmart, 569 20: The Agony of AIG, 602 Find more at http://www.downloadslide.com this page left intentionally blank Find more at http://www.downloadslide.com MICROECONOMICS FOURTH EDITION Paul Krugman Princeton University Robin Wells Find more at http://www.downloadslide.com Vice President, Editorial: Charles Linsmeier Cover Photos Credits Marketing Manager: Tom Digiano Central Photo: Lobby in the rush hour is made in the manner of blur and a blue tonality: blurAZ/Shutterstock First Row (left to right): Female Korean factory worker: Image Source/Getty Images; Market food: Izzy Schwartz/Getty Images; High gas prices in Fremont, California: Mpiotti/Getty Images Second Row: Red sports car: Shutterstock; View of smoking coal power plant: iStockphoto/Thinkstock; Lab technician using microscope: Jim Arbogast/Getty Images Third Row: Lightbulbs in box: © fStop/Alamy; Market food: Izzy Schwartz/Getty Images Fourth Row: Set of coloured flags of many nations of the world: © FC_Italy/ Alamy; Stack of cargo containers at sunrise in an intermodal yard: Shutterstock; Depression era photo of man holding sign: The Image Works Fifth Row: Stock market quotes from a computer screen: Stephen VanHorn/ Shutterstock; Portrait of a college student on campus: pkchai/Shutterstock; Peaches: Stockbyte/Photodisc Sixth Row: Rear view of people window shopping: Thinkstock; Power plant pipes: Corbis; Power lines: Brand X Pictures; Three students taking a test: © Royalty-Free/ Corbis; Paper money: Shutterstock Seventh Row: Woman from the Sacred Valley of the Incas: hadynyah/Getty Images; Paint buckets with various colored paint: Shutterstock; Close up of hands woman using her cell phone: Shutterstock; Paper money: Shutterstock Eight Row: Cows: Stockbyte/Photodisc; Wind turbine farm over sunset: Ted Nad/ Shutterstock; Wall Street sign: thinkstock; Busy shopping street Center Gai Shibuya, Tokyo: Tom Bonaventure/Photographer’s Choice RF/Getty Images; Paper money: Shutterstock Ninth/Tenth Rows: Waiter in Panjim: Steven Miric/Getty Images; Group of friends carrying shopping bags on city street: Monkey Business Images/Shutterstock; Set of coloured flags of many nations of the world: © FC_Italy/Alamy; Soybean Field: Fotokostic/Shutterstock; Drilling rig workers: Istockphoto; Tropical fish and hard corals in the Red Sea, Egypt: Vlad61/Shutterstock; Modern train on platform: Shutterstock Eleventh/Twelfth Rows: Paper money: Shutterstock; View of smoking coal power plant: iStockphoto/Thinkstock; Welder: Tristan Savatier/Getty Images; container ship: EvrenKalinbacak/Shutterstock; Market food: Izzy Schwartz/Getty Images; Modern train on platform: Shutterstock Thirteenth Row: Printing U.S dollar banknotes: Thinkstock; Stock market quotes from a computer screen: Stephen VanHorn/Shutterstock Marketing Assistant: Alex Kaufman Executive Development Editor: Sharon Balbos Consultant: Ryan Herzog Executive Media Editor: Rachel Comerford Media Editor: Lukia Kliossis Editorial Assistant: Carlos Marin Director of Editing, Design, and Media Production: Tracey Kuehn Managing Editor: Lisa Kinne Project Editor: Jeanine Furino Senior Design Manager: Vicki Tomaselli Cover Design: Brian Sheridan, Hothouse Designs, Inc Illustrations: TSI evolve, Network Graphics Illustration Coordinator: Janice Donnola Photo Editor: Cecilia Varas Photo Researcher: Elyse Rieder Production Manager: Barbara Anne Seixas Supplements Production Manager: Stacey Alexander Supplements Project Editor: Edgar Bonilla Composition: TSI evolve Printing and Binding: RR Donnelley ISBN-13: 978-1-4641-4387-8 ISBN-10: 1-4641-4387-0 Library of Congress Control Number: 2014950828 © 2015, 2013, 2009, 2006 by Worth Publishers All rights reserved Printed in the United States of America First printing Worth Publishers 41 Madison Avenue New York, NY 10010 www.worthpublishers.com Find more at http://www.downloadslide.com To beginning students everywhere, which we all were at one time Find more at http://www.downloadslide.com this page left intentionally blank Find more at http://www.downloadslide.com Author Krugman/Wells _ Title _Economics 4e Perm Fig.# P001_ New Fig.# _ PUN01 Old Fig.# L/LC/TS/CP/B&W/CAR N/PU/PUAC ABOUT THE AUTHORS Paul Krugman, recipient of the 2008 Nobel Memorial Prize in Economic Sciences, taught at Princeton University for 14 years and, as of June 2015, he will have joined the faculty of the Graduate Center of the City University of New York In his new position, he is associated with the Luxembourg Income Study, which tracks and analyzes income inequality around the world He received his BA from Yale and his PhD from MIT Before Princeton, he taught at Yale, Stanford, and MIT He also spent a year on the staff of the Council of Economic Advisers in 1982–1983 His research has included pathbreaking work on international trade, economic geography, and currency crises In 1991, [No caption] Ligaya Franklin Krugman received the American Economic Association’s John Bates Clark medal In addition to his teaching and academic research, Krugman writes extensively for nontechnical audiences He is a regular op-ed columnist for the New York Times His best-selling trade books include End This Depression Now!, The Return of Depression Economics and the Crisis of 2008, a history of recent economic troubles and their implications for economic policy, and The Conscience of a Liberal, a study of the political economy of economic inequality and its relationship with political polarization from the Gilded Age to the present His earlier books, Peddling Prosperity and The Age of Diminished Expectations, have become modern classics Robin Wells was a Lecturer and Researcher in Economics at Princeton University She received her BA from the University of Chicago and her PhD from the University of California at Berkeley; she then did postdoctoral work at MIT She has taught at the University of Michigan, the University of Southampton (United Kingdom), Stanford, and MIT vii Find more at http://www.downloadslide.com BRIEF CONTENTS Preface xvii PART What Is Economics? Introduction The Ordinary Business of Life Chapter First Principles Chapter 2 Economic Models: Trade-offs and Trade 25 Appendix Graphs in Economics 51 PART Chapter Supply and Demand Supply and Demand 67 Chapter Consumer and Producer Surplus 103 Chapter 5 Price Controls and Quotas: Meddling with Markets 131 Elasticity 161 Chapter PART Individuals and Markets Chapter PART Chapter Taxes 187 International Trade 217 4 Economics and Decision Making Chapter 9 Decision Making by Individuals and Firms 249 Appendix How to Make Decisions Involving Time: Understanding Present Value 277 PART The Production Decision Chapter 11 Behind the Supply Curve: Inputs Chapter PART and Costs 329 12 Perfect Competition and the Supply Curve 357 7 Market Structure: Beyond Perfect Competition Chapter 13 Monopoly 385 Chapter 14 Oligopoly 419 Chapter 15 Monopolistic Competition and Product Differentiation 445 PART Chapter Chapter Chapter PART Chapter 8 Microeconomics and Public Policy 16 Externalities 465 17 Public Goods and Common 18 Resources 489 The Economics of the Welfare State 511 Factor Markets and Risk 19 Factor Markets and the Distribution of Income 543 Curve Analysis of Labor Supply 575 Chapter 20 Uncertainty, Risk, and Appendix Indifference Private Information 581 The Consumer Chapter 10 The Rational Consumer 281 Appendix Consumer Preferences and Consumer Choice 303 viii PART Solutions to “Check Your Understanding” Questions S-1 Glossary G-1 Index I-1 Find more at http://www.downloadslide.com 266 PA R T ECONOMICS AND DECISION MAKING A decision maker operating with bounded rationality makes a choice that is close to but not exactly the one that leads to the best possible economic outcome something other than the size of the economic payoff There are three principal reasons why people might prefer a worse economic payoff: concerns about fairness, bounded rationality, and risk aversion Risk aversion is the willingness to sacrifice some economic payoff in order to avoid a potential loss ness as well as about the economic payoff to themselves For example, no law requires you to tip a waiter or waitress But concern for fairness leads most people to leave a tip (unless they’ve had outrageously bad service) because a tip is seen as fair compensation for good service according to society’s norms Tippers are reducing their own economic payoff in order to be fair to waiters and waitresses A related behavior is gift-giving: if you care about another person’s welfare, it’s rational for you to lower your own economic payoff in order to give that person a gift An irrational decision maker chooses an option that leaves him or her worse off than choosing another available option Concerns About Fairness In social situations, people often care about fair- Bounded Rationality Being an economic computing machine—choosing the option that gives you the best economic payoff—can require a fair amount of work: sizing up the options, computing the opportunity costs, calculating the marginal amounts, and so on The mental effort required has its own opportunity cost This realization led economists to the concept of bounded rationality— making a choice that is close to but not exactly the one that leads to the highest possible profit because the effort of finding the best payoff is too costly In other words, bounded rationality is the “good enough” method of decision making Retailers are particularly good at exploiting their customers’ tendency to engage in bounded rationality For example, pricing items in units ending in 99¢ takes advantage of shoppers’ tendency to interpret an item that costs, say, $2.99 as significantly cheaper than one that costs $3.00 Bounded rationality leads them to give more weight to the $2 part of the price (the first number they see) than the 99¢ part And retailers also make use of shoppers’ tendency to engage in what social scientists call anchoring, making decisions according to some perceived benchmark or reference point For example, retailers attempt to influence shoppers’ belief about whether they are getting a good deal by showing both the full price (the anchor) and the discounted price Risk Aversion Because life is uncertain and the future unknown, sometimes a choice comes with significant risk Although you may receive a high payoff if things turn out well, the possibility also exists that things may turn out badly and leave you worse off So even if you think a choice will give you the best payoff of all your available options, you may forgo it because you find the possibility that things could turn out badly too, well, risky This is called risk aversion—the willingness to sacrifice some potential economic payoff in order to avoid a potential loss (We’ll discuss risk in detail in Chapter 20.) Because risk makes most people uncomfortable, it’s rational for them to give up some potential economic gain in order to avoid it In fact, if it weren’t for risk aversion, there would be no such thing as insurance Irrationality: An Economist’s View Sometimes, though, instead of being rational, people are irrational—they make choices that leave them worse off in terms of economic payoff and other considerations like fairness than if they had chosen another available option Is there anything systematic that economists and psychologists can say about economically irrational behavior? Yes, because most people are irrational in predictable ways People’s irrational behavior typically stems from six mistakes they make when thinking about economic decisions The mistakes are listed in Table 9-8, and we will discuss each in turn Misperceptions of Opportunity Costs As we discussed at the beginning of this chapter, people tend to ignore nonmonetary opportunity costs—opportunity Find more at http://www.downloadslide.com CHAPTER 9 DECISION MAKING BY INDIVIDUALS AND FIRMS costs that don’t involve an outlay of cash Likewise, a misperception of what exactly constitutes an opportunity cost (and what does not) is at the root of the tendency to count sunk costs in one’s decision making In this case, someone takes an opportunity cost into account when none actually exists Overconfidence It’s a function of ego: we tend to think we 267 The Six Common Mistakes in Economic Decision Making TABLE 9-8 Misperceiving opportunity costs Being overconfident Having unrealistic expectations about future behavior Counting dollars unequally know more than we actually And even if alerted to how Being loss-averse widespread overconfidence is, people tend to think that it’s Having a bias toward the status quo someone else’s problem, not theirs (Certainly not yours or mine!) For example, a 1994 study asked students to estimate how long it would take them to complete their thesis “if everything went as well as it possibly could” and “if everything went as poorly as it possibly could.” The results: the typical student thought it would take him or her 33.9 days to finish, with an average estimate of 27.4 days if everything went well and 48.6 days if everything went poorly In fact, the average time it took to complete a thesis was much longer, 55.5 days Students were, on average, from 14% to 102% more confident than they should have been about the time it would take to complete their thesis As you can see in the following For Inquiring Minds, overconfidence can cause problems with meeting deadlines But it can cause far more trouble by having a strong adverse effect on people’s financial health Overconfidence often persuades people that they are in better financial shape than they actually are It can also lead to bad investment and spending decisions For example, nonprofessional investors who engage in a lot of speculative investing—such as quickly buying and selling stocks—on average have significantly worse results than professional brokers because of their misguided faith in their ability to spot a winner Similarly, overconfidence can lead people to make a large spending decision, such FOR INQUIRING MINDS Dan Ariely, a professor of psychology and behavioral economics, likes to experiments with his students that help him explore the nature of irrationality In his book Predictably Irrational, Ariely describes an experiment that gets to the heart of procrastination and ways to address it At the time, Ariely was teaching the same subject matter to three different classes, but he gave each class different assignment schedules The grade in all three classes was based on three equally weighted papers Students in the first class were required to choose their own personal deadlines for submitting each paper Once set, the deadlines could not be changed Late papers would be penalized at the rate of 1% of the grade for each day late Papers could be turned in early without penalty but also without any advantage, since Ariely would not grade papers until the end of the semester Students in the second class could turn in the three papers whenever they In Praise of Hard Deadlines wanted, with no preset deadlines, as long as it was before the end of the term Again, there would be no benefit for early submission Students in the third class faced what Ariely called the “dictatorial treatment.” He established three hard deadlines at the fourth, eighth, and twelfth weeks So which classes you think achieved the best and the worst grades? As it turned out, the class with the least flexible deadlines—the one that received the dictatorial treatment—got the best grades The class with complete flexibility got the worst grades And the class that got to choose its deadlines performed in the middle Ariely learned two simple things about overconfidence from these results First—no surprise—students tend to procrastinate Second, hard, equally spaced deadlines are the best cure for procrastination But the biggest revelation came from the class that set its own deadlines The majority of those students spaced their deadlines far apart and got grades as good as those of the students under the dictatorial treatment Some, however, did not space their deadlines far enough apart, and a few did not space them out at all These last two groups did less well, putting the average of the entire class below the average of the class with the least flexibility As Ariely notes, without well-spaced deadlines, students procrastinate and the quality of their work suffers This experiment provides two important insights: People who acknowledge their tendency to procrastinate are more likely to use tools for committing to a path of action Providing those tools allows peo- ple to make themselves better off If you have a problem with procrastination, hard deadlines, as irksome as they may be, are truly for your own good • Find more at http://www.downloadslide.com 268 PA R T ECONOMICS AND DECISION MAKING Mental accounting is the habit of mentally assigning dollars to different accounts so that some dollars are worth more than others as buying a car, without doing research on the pros and cons, relying instead on anecdotal evidence Even worse, people tend to remain overconfident because they remember their successes, and explain away or forget their failures Loss aversion is an oversensitivity to loss, leading to unwillingness to recognize a loss and move on Unrealistic Expectations About Future Behavior Another form of The status quo bias is the tendency to avoid making a decision and sticking with the status quo overconfidence is being overly optimistic about your future behavior: tomorrow you’ll study, tomorrow you’ll give up ice cream, tomorrow you’ll spend less and save more, and so on Of course, as we all know, when tomorrow arrives, it’s still just as hard to study or give up something that you like as it is right now Strategies that keep a person on the straight-and-narrow over time are often, at their root, ways to deal with the problem of unrealistic expectations about one’s future behavior Examples are automatic payroll deduction savings plans, diet plans with prepackaged foods, and mandatory attendance at study groups By providing a way for someone to commit today to an action tomorrow, such plans counteract the habit of pushing difficult actions off into the future Dmitriy Shironosov/Alamy Counting Dollars Unequally If you tend to spend more when you pay A dollar is a dollar, whether it’s in your wallet or on your credit card with a credit card than when you pay with cash, particularly if you tend to splurge, then you are very likely engaging in mental accounting This is the habit of mentally assigning dollars to different accounts, making some dollars worth more than others By spending more with a credit card, you are in effect treating dollars in your wallet as more valuable than dollars on your credit card balance, although in reality they count equally in your budget Credit card overuse is the most recognizable form of mental accounting However, there are other forms as well, such as splurging after receiving a windfall, like an unexpected inheritance, or overspending at sales, buying something that seemed like a great bargain that you later regretted It’s the failure to understand that, regardless of the form it comes in, a dollar is a dollar Loss Aversion Loss aversion is an oversensitivity to loss, leading to an unwillingness to recognize a loss and move on In fact, in the lingo of the financial markets, “selling discipline”—being able and willing to quickly acknowledge when a stock you’ve bought is a loser and sell it—is a highly desirable trait to have Many investors, though, are reluctant to acknowledge that they’ve lost money on a stock and won’t make it back Although it’s rational to sell the stock at that point and redeploy the remaining funds, most people find it so painful to admit a loss that they avoid selling for much longer than they should According to Daniel Kahneman and Amos Tversky, most people feel the misery of losing $100 about twice as keenly as they feel the pleasure of gaining $100 Loss aversion can help explain why sunk costs are so hard to ignore: ignoring a sunk cost means recognizing that the money you spent is unrecoverable and therefore lost Status Quo Bias Another irrational behavior is status quo bias, the tendency to avoid making a decision altogether A well-known example is the way that employees make decisions about investing in their employer-directed retirement accounts, known as 401(k)s With a 401(k), employees can, through payroll deductions, set aside part of their salary tax-free, a practice that saves a significant amount of money every year in taxes Some companies operate on an opt-in basis: employees have to actively choose to participate in a 401(k) Other companies operate on an opt-out basis: employees are automatically enrolled in a 401(k) unless they choose to opt out Find more at http://www.downloadslide.com CHAPTER 9 DECISION MAKING BY INDIVIDUALS AND FIRMS If everyone behaved rationally, then the proportion of employees enrolled in 401(k) accounts at opt-in companies would be roughly equal to the proportion enrolled at opt-out companies In other words, your decision about whether to participate in a 401(k) should be independent of the default choice at your company But, in reality, when companies switch to automatic enrollment and an opt-out system, employee enrollment rises dramatically Clearly, people tend to just go with the status quo Why people exhibit status quo bias? Some claim it’s a form of “decision paralysis”: when given many options, people find it harder to make a decision Others claim it’s due to loss aversion and the fear of regret, to thinking that “if I nothing, then I won’t have to regret my choice.” Irrational, yes But not altogether surprising However, rational people know that, in the end, the act of not making a choice is still a choice Rational Models for Irrational People? So why economists still use models based on rational behavior when people are at times manifestly irrational? For one thing, models based on rational behavior still provide robust predictions about how people behave in most markets For example, the great majority of farmers will use less fertilizer when it becomes more expensive—a result consistent with rational behavior Another explanation is that sometimes market forces can compel people to behave more rationally over time For example, if you are a small-business owner who persistently exaggerates your abilities or refuses to acknowledge that your favorite line of items is a loser, then sooner or later you will be out of business unless you learn to correct your mistakes As a result, it is reasonable to assume that when people are disciplined for their mistakes, as happens in most markets, rationality will win out over time Finally, economists depend on the assumption of rationality for the simple but fundamental reason that it makes modeling so much simpler Remember that models are built on generalizations, and it’s much harder to extrapolate from messy, irrational behavior Even behavioral economists, in their research, search for predictably irrational behavior in an attempt to build better models of how people behave Clearly, there is an ongoing dialogue between behavioral economists and the rest of the economics profession, and economics itself has been irrevocably changed by it s ECONOMICS in Action “The Jingle Mail Blues” I t’s called jingle mail—when a homeowner seals the keys to his or her house in an envelope and leaves them with the bank that holds the mortgage on the house (A mortgage is a loan taken out to buy a house.) By leaving the keys with the bank, the homeowner is walking away not only from the house but also from the obligation to continue paying the mortgage And to their great consternation, banks have been flooded with jingle mail To default on a mortgage—that is, to walk away from one’s obligation to repay the loan and lose the house to the bank in the process—used to be a fairly rare phenomenon For decades, continually rising home values made homeownership a good investment for the typical household In recent years, though, an entirely different phenomenon—called “strategic default”—has appeared In a strategic default, a homeowner who is financially capable of paying the mortgage instead chooses not to, voluntarily walking away Strategic defaults account for a significant proportion of jingle mail; in September 2010, they accounted for 36% of all 269 Find more at http://www.downloadslide.com 270 PA R T ECONOMICS AND DECISION MAKING © Tom Cheney/The New Yorker Collection/www.cartoonbank.com foreclosures, up from 26 percent in 2009 And there is little indication that number will change dramatically: through 2013, 20% of all mortgages remained underwater with another 20% of homeowners barely above water What happened? After decades of huge increases, house prices began a precipitous fall in 2008, known as the Great American Housing Bust Prices dropped so much that a significant proportion of homeowners found their homes “underwater”—they owed more on their homes than the homes were worth And with house prices projected to stay depressed for several years, possibly a decade, there appeared to be little chance that an underwater house would recover its value enough in the foreseeable future to move “abovewater.” Many homeowners suffered a major loss They “Officer, that couple is walking away from their mortgage!” lost their down payment, money spent on repairs and renovation, moving expenses, and so on And because they were paying a mortgage that was greater than the house was now worth, they found they could rent a comparable dwelling for less than their monthly mortgage payments In the words of a Florida resident, who paid $215,000 for an apartment in Miami where similar units were now selling for $90,000, “There is no financial sense in staying.” Realizing their losses were sunk costs, underwater homeowners walked away Perhaps they hadn’t made the best economic decision when purchasing their houses, but in leaving them showed impeccable economic logic Quick Review • Behavioral economics combines economic modeling with insights from human psychology • Rational behavior leads to the outcome a person most prefers Bounded rationality, risk aversion, and concerns about fairness are reasons why people might prefer outcomes with worse economic payoffs • Irrational behavior occurs because of misperceptions of opportunity costs, overconfidence, mental accounting, and unrealistic expectations about the future Loss aversion and status quo bias can also lead to choices that leave people worse off than they would be if they chose another available option Check Your Understanding 9-4 Which of the types of irrational behavior are suggested by the following events? a A lthough the housing market has fallen and Jenny wants to move, she refuses to sell her house for any amount less than what she paid for it b Dan worked more overtime hours last week than he had expected Although he is strapped for cash, he spends his unexpected overtime earnings on a weekend getaway rather than trying to pay down his student loan c Carol has just started her first job and deliberately decided to opt out of the company’s savings plan Her reasoning is that she is very young and there is plenty of time in the future to start saving Why not enjoy life now? d Jeremy’s company requires employees to download and fill out a form if they want to participate in the company-sponsored savings plan One year after starting the job, Jeremy had still not submitted the form needed to participate in the plan How would you determine whether a decision you made was rational or irrational? Solutions appear at back of book Find more at http://www.downloadslide.com J C Penney’s One-Price Strategy Upsets Its Customers I n early 2013, the department store chain J C Penney unceremoniously dumped its recently hired chief executive, Ron Johnson The action followed a disastrous 2012 for the company, in which sales dropped 25% to $13 billion And it was a humbling defeat for Mr Johnson’s strategy of “everyday” low prices, implemented in early 2012 A year before the one-price strategy was put into effect, the company held numerous sales, 590 of them in fact, and almost three-quarters of its goods were marked down 50% or more Yet customers weren’t actually paying less The chain would just raise the prices of merchandise on the racks and then discount prices during the promotions But why play an expensive game that is costly for the company and an illusion for customers? So the new strategy seemed like a no-brainer for J C Penney Rather than continue to promote sales and offer coupons, customers were now assured a low price at all times, regardless of the season and without clipping coupons The company reaped benefits from the strategy in the form of cost-savings from more accurate inventory and profit projections, from more consistent revenues, and by eliminating the need for manual labor to continually change prices As John T Gourville, a marketing professor at Harvard Business School, noted, a one-price pricing strategy “makes the operations side of things much easier You don’t have the whiplash effects of selling, say, a ton of Diet Coke one week and virtually none the next week.” But, there were problems with this pricing strategy as well Just how low the prices were wasn’t clear “Trust us,” was the message J C Penney communicated to its shoppers, “We will give you a fair deal.” In addition, unlike Walmart, Penney did not offer to match competitors’ prices, and it could not depend on making up for tiny per-item profits with a high volume of regular customers Unlike Costco, it would not make money from annual membership fees And a one-price strategy doesn’t draw customers in during seasonal high-intensity shopping times, like Black Friday, when the holiday shopping season officially starts Mr Johnson’s strategy clearly alienated Tracie Fobes, who runs Penny Pinchin’ Mom, a blog about couponing strategies, who said, “ seeing that something is marked down 20% off, then being able to hand over the coupon to save, it just entices me.” So with Johnson’s departure, J C Penney backtracked and began offering coupons and weekly sales again And the store assistants went back to work, marking items up in order to then immediately mark them down Jeff Greenberg/Alamy CASE The Photo Works BUSINESS QUESTIONS FOR THOUGHT 1. Give an example of a type of rational decision making illustrated by this case and explain your choice 2. Give an example of a type of irrational decision making illustrated by this case and explain your choice 3. What purpose does Walmart’s price-match guarantee serve? What you predict would happen if it dropped this policy? Would you predict its competitors— say, the local supermarket or K-Mart—would adopt the same policy? 271 Find more at http://www.downloadslide.com 272 PA R T ECONOMICS AND DECISION MAKING SUMMARY All economic decisions involve the allocation of scarce resources Some decisions are “either–or” decisions, in which the question is whether or not to something Other decisions are “how much” decisions, in which the question is how much of a resource to put into a given activity The cost of using a resource for a particular activity is the opportunity cost of that resource Some opportunity costs are explicit costs; they involve a direct outlay of money Other opportunity costs, however, are implicit costs; they involve no outlay of money but are measured by the dollar value of the benefits that are forgone Both explicit and implicit costs should be taken into account in making decisions Many decisions involve the use of capital and time, for both individuals and firms So they should base decisions on economic profit, which takes into account implicit costs such as the opportunity cost of time and the implicit cost of capital Making decisions based on accounting profit can be misleading It is often considerably larger than the economic profit because it includes only explicit costs and not implicit costs According to the principle of “either–or” deci- sion making, when faced with an “either–or” choice between two activities, one should choose the activity with the positive economic profit A “how much” decision is made using marginal analy- sis, which involves comparing the benefit to the cost of doing an additional unit of an activity The marginal cost of producing a good or service is the additional cost incurred by producing one more unit of that good or service The marginal benefit of producing a good or service is the additional benefit earned by producing one more unit The marginal cost curve is the graphical illustration of marginal cost, and the marginal benefit curve is the graphical illustration of marginal benefit In the case of constant marginal cost, each addi- tional unit costs the same amount to produce as the previous unit However, marginal cost and marginal benefit typically depend on how much of the activity has already been done With increasing marginal cost, each unit costs more to produce than the previous unit and is represented by an upward-sloping marginal cost curve With decreasing marginal cost, each unit costs less to produce than the previous unit, leading to a downward-sloping marginal cost curve In the case of decreasing marginal benefit, each additional unit produces a smaller benefit than the unit before The optimal quantity is the quantity that generates the highest possible total profit According to the profit-maximizing principle of marginal analysis, the optimal quantity is the quantity at which marginal benefit is greater than or equal to marginal cost It is the quantity at which the marginal cost curve and the marginal benefit curve intersect A cost that has already been incurred and that is nonrecoverable is a sunk cost Sunk costs should be ignored in decisions about future actions because they have no effect on future benefits and costs With rational behavior, individuals will choose the available option that leads to the outcome they most prefer Bounded rationality occurs because the effort needed to find the best economic payoff is costly Risk aversion causes individuals to sacrifice some economic payoff in order to avoid a potential loss People might also prefer outcomes with worse economic payoffs because they are concerned about fairness An irrational choice leaves someone worse off than if they had chosen another available option It takes the form of misperceptions of opportunity cost; overconfidence; unrealistic expectations about future behavior; mental accounting, in which dollars are valued unequally; loss aversion, an oversensitivity to loss; and status quo bias, avoiding a decision by sticking with the status quo KEY TERMS Explicit cost, p 250 Implicit cost, p 250 Accounting profit, p 251 Economic profit, p 252 Capital, p 252 Implicit cost of capital, p 253 Principle of “either–or” decision making, p 253 Marginal cost, p 256 Increasing marginal cost, p 257 Marginal cost curve, p 257 Constant marginal cost, p 257 Decreasing marginal cost, p 257 Marginal benefit, p 258 Decreasing marginal benefit, p 258 Marginal benefit curve, p 258 Optimal quantity, p 260 Profit-maximizing principle of marginal analysis, p 261 Sunk cost, p 264 Rational, p 265 Bounded rationality, p 266 Risk aversion, p 266 Irrational, p 266 Mental accounting, p 268 Loss aversion p 268 Status quo bias, p 268 Find more at http://www.downloadslide.com CHAPTER 9 DECISION MAKING BY INDIVIDUALS AND FIRMS 273 PROBLEMS Jackie owns and operates a website design business To keep up with new technology, she spends $5,000 per year upgrading her computer equipment She runs the business out of a room in her home If she didn’t use the room as her business office, she could rent it out for $2,000 per year Jackie knows that if she didn’t run her own business, she could return to her previous job at a large software company that would pay her a salary of $60,000 per year Jackie has no other expenses a How much total revenue does Jackie need to make in order to break even in the eyes of her accountant? That is, how much total revenue would give Jackie an accounting profit of just zero? b How much total revenue does Jackie need to make in order for her to want to remain self-employed? That is, how much total revenue would give Jackie an economic profit of just zero? You own and operate a bike store Each year, you receive revenue of $200,000 from your bike sales, and it costs you $100,000 to obtain the bikes In addition, you pay $20,000 for electricity, taxes, and other expenses per year Instead of running the bike store, you could become an accountant and receive a yearly salary of $40,000 A large clothing retail chain wants to expand and offers to rent the store from you for $50,000 per year How you explain to your friends that despite making a profit, it is too costly for you to continue running your store? Suppose you have just paid a nonrefundable fee of $1,000 for your meal plan for this academic term This allows you to eat dinner in the cafeteria every evening a You are offered a part-time job in a restaurant where you can eat for free each evening Your parents say that you should eat dinner in the cafeteria anyway, since you have already paid for those meals Are your parents right? Explain why or why not b You are offered a part-time job in a different restaurant where, rather than being able to eat for free, you receive only a large discount on your meals Each meal there will cost you $2; if you eat there each evening this semester, it will add up to $200 Your roommate says that you should eat in the restaurant since it costs less than the $1,000 that you paid for the meal plan Is your roommate right? Explain why or why not You have bought a $10 ticket in advance for the college soccer game, a ticket that cannot be resold You know that going to the soccer game will give you a benefit equal to $20 After you have bought the ticket, you hear that there will be a professional baseball post-season game at the same time Tickets to the baseball game cost $20, and you know that going to the baseball game will give you a benefit equal to $35 You tell your friends the following: “If I had known about the baseball game before buying the ticket to the soccer game, I would have gone to the baseball game instead But now that I already have the ticket to the soccer game, it’s better for me to just go to the soccer game.” Are you making the correct decision? Justify your answer by calculating the benefits and costs of your decision Amy, Bill, and Carla all mow lawns for money Each of them operates a different lawn mower The accompanying table shows the total cost to Amy, Bill, and Carla of mowing lawns Quantity of lawns mowed Amy’s total cost Bill’s total cost Carla’s total cost $0 $0 $0 20 10 2 35 20 7 45 30 17 50 40 32 52 50 52 53 60 82 a Calculate Amy’s, Bill’s, and Carla’s marginal costs, and draw each of their marginal cost curves b Who has increasing marginal cost, who has decreasing marginal cost, and who has constant marginal cost? You are the manager of a gym, and you have to decide how many customers to admit each hour Assume that each customer stays exactly one hour Customers are costly to admit because they inflict wear and tear on the exercise equipment Moreover, each additional customer generates more wear and tear than the customer before As a result, the gym faces increasing marginal cost The accompanying table shows the marginal costs associated with each number of customers per hour Quantity of customers per hour Marginal cost of customer $14.00 14.50 15.00 15.50 16.00 16.50 17.00 a Suppose that each customer pays $15.25 for a one- hour workout Use the profit-maximizing principle of marginal analysis to find the optimal number of customers that you should admit per hour Find more at http://www.downloadslide.com 274 PA R T ECONOMICS AND DECISION MAKING b You increase the price of a one-hour workout to $16.25 What is the optimal number of customers per hour that you should admit now? Georgia and Lauren are economics students who go to a karate class together Both have to choose how many classes to go to per week Each class costs $20 The accompanying table shows Georgia’s and Lauren’s estimates of the marginal benefit that each of them gets from each class per week Quantity of classes Lauren’s marginal benefit of each class Georgia’s marginal benefit of each class Quantity of hours worked Total benefit Total cost $0 $0 30 10 55 21 75 34 90 50 100 70 a Use marginal analysis to determine Patty’s optimal number of hours worked b Calculate the total profit to Patty from working $23 $28 19 22 14 15 hours, hour, hours, and so on Now suppose Patty chooses to work for hour Compare her total profit from working for hour with her total profit from working the optimal number of hours How much would she lose by working for only hour? 10 Assume De Beers is the sole producer of diamonds a Use marginal analysis to find Lauren’s optimal num- ber of karate classes per week Explain your answer b Use marginal analysis to find Georgia’s optimal number of karate classes per week Explain your answer The Centers for Disease Control and Prevention (CDC) recommended against vaccinating the whole population against the smallpox virus because the vaccination has undesirable, and sometimes fatal, side effects Suppose the accompanying table gives the data that are available about the effects of a smallpox vaccination program Percent of population vaccinated Deaths due to smallpox Deaths due to vaccination side effects 0% 200 0 10 180 4 20 160 10 30 140 18 40 120 33 50 100 50 60 80 74 a Calculate the marginal benefit (in terms of lives saved) and the marginal cost (in terms of lives lost) of each 10% increment of smallpox vaccination Calculate the net increase in human lives for each 10% increment in population vaccinated b Using marginal analysis, determine the optimal per- centage of the population that should be vaccinated Patty delivers pizza using her own car, and she is paid according to the number of pizzas she delivers The accompanying table shows Patty’s total benefit and total cost when she works a specific number of hours When it wants to sell more diamonds, it must lower its price in order to induce shoppers to buy more Furthermore, each additional diamond that is produced costs more than the previous one due to the difficulty of mining for diamonds De Beers’s total benefit schedule is given in the accompanying table, along with its total cost schedule Quantity of diamonds Total benefit Total cost $0 $0 1,000 50 1,900 100 2,700 200 3,400 400 4,000 800 4,500 1,500 4,900 2,500 5,200 3,800 a Draw the marginal cost curve and the marginal benefit curve and, from your diagram, graphically derive the optimal quantity of diamonds to produce b Calculate the total profit to De Beers from produc- ing each quantity of diamonds Which quantity gives De Beers the highest total profit? 11 In each of the following examples, explain whether the decision is rational or irrational Describe the type of behavior exhibited a Kookie’s best friend likes to give her gift cards that Kookie can use at her favorite stores Kookie, however, often forgets to use the cards before their expiration date or loses them Kookie, though, is careful with her own cash Find more at http://www.downloadslide.com CHAPTER 9 b In 2010, the Panera Bread company opened a store in Clayton, Missouri, that allowed customers to pay any amount they like for their orders; instead of prices, the store listed suggested donations based on the cost of the goods All profits went to a charitable foundation set up by Panera In 2011, the store was pleased with the success of the program DECISION MAKING BY INDIVIDUALS AND FIRMS 275 12 You have been hired as a consultant by a company to develop the company’s retirement plan, taking into account different types of predictably irrational behavior commonly displayed by employees State at least two types of irrational behavior employees might display with regard to the retirement plan and the steps you would take to forestall such behavior c Rick has just gotten his teaching degree and has two job offers One job, replacing a teacher who has gone on leave, will last only two years It is at a prestigious high school, and he will be paid $35,000 per year He thinks he will probably be able to find another good job in the area after the two years are up but isn’t sure The other job, also at a high school, pays $25,000 per year and is virtually guaranteed for five years; after those five years, he will be evaluated for a permanent teaching position at the school About 75% of the teachers who start at the school are hired for permanent positions Rick takes the five-year position at $25,000 per year d Kimora has planned a trip to Florida during spring break in March She has several school projects due after her return Rather than them in February, she figures she can take her books with her to Florida and complete her projects there e Sahir overpaid when buying a used car that has turned out to be a lemon He could sell it for parts, but instead he lets it sit in his garage and deteriorate f Barry considers himself an excellent investor in stocks He selects new stocks by finding ones with characteristics similar to those of his previous winning stocks He chocks up losing trades to ups and downs in the macroeconomy WORK IT OUT For interactive, step-by-step help in solving the following problem, visit by using the URL on the back cover of this book 13. Hiro owns and operates a small business that provides economic consulting services During the year he spends $57,000 on travel to clients and other expenses In addition, he owns a computer that he uses for business If he didn’t use the computer, he could sell it and earn yearly interest of $100 on the money created through this sale Hiro’s total revenue for the year is $100,000 Instead of working as a consultant for the year, he could teach economics at a small local college and make a salary of $50,000 a. What is Hiro’s accounting profit? b. What is Hiro’s economic profit? c. Should Hiro continue working as a consultant, or should he teach economics instead? Find more at http://www.downloadslide.com Find more at http://www.downloadslide.com CHAPTER How to Make Decisions Involving Time: Understanding Present Value APPENDIX As we learned in Chapter 9, the basic rule to follow when deciding whether or not to undertake a project is to compare the benefits of the project with its costs— explicit as well as implicit—and choose the course of action with the higher economic profit But many economic decisions involve choices in which the benefits and the costs arrive at different times, making comparisons between those choices more difficult Ashley’s decision, whether to go back to school and get an advanced degree or to get a job, is one of those types of comparisons If she chooses to get an advanced degree, the costs—forgone wages, tuition, and books—are incurred immediately, while the benefits—higher earnings—are reaped in the future In other cases, the benefits of a project come earlier than the costs, such as taking out a loan to pay for a vacation that must be repaid in the future So how should we make decisions when time is a factor? The economically correct way is to use a concept called present value Using present value calculations allows you to convert costs and/or benefits that arrive in the future into a value today This way, we can always compare projects that occur over time by comparing their values today You might wonder why you didn’t see present value calculations when we analyzed Ashley’s decision in Chapter The fact is that present value was used, but implicitly For example, statements like “she will receive earnings from her degree valued today at $600,000 over the rest of her lifetime” mean that the future benefits had already been converted into a value today—that value being $600,000 Now let’s see exactly how present value works How to Calculate the Present Value of a One-Year Project Suppose that you will graduate exactly one year from today and you will need $1,000 to rent your first apartment In order to have $1,000 one year from now, how much you need today? It’s not $1,000, and the reason why has to with the interest rate The interest rate, which we will denote by r, is the price charged a borrower for borrowing money expressed as a percentage of the amount borrowed And let’s use X to denote the amount you need today in order to have $1,000 one year from now If you put X in the bank today and earn an interest rate r on it, then after one year the bank will pay you X × ( + r) If the amount paid to you by the bank one year from now is $1,000, then the amount you need to deposit with the bank today is given by the following equation: (9A-1) X × (1 + r) = $1,000 You can apply some basic algebra to find that: (9A-2) X = $1,000/ (1 + r) When someone borrows money for a year, the interest rate is the price, calculated as a percentage of the amount borrowed, charged by the lender 277 Find more at http://www.downloadslide.com 278 PA R T ECONOMICS AND DECISION MAKING The present value of X is the amount of money needed today in order to receive X at a future date given the interest rate So the amount you need today to be assured of having $1,000 one year from now, X, is equal to $1,000 divided by (1 + r) Notice that the value of X depends on the interest rate, r, which is always greater than zero This fact implies that X is always less than $1,000 For example, if r = 5% (that is, r = 0.05), then X = $1,000/1.05 = $952.38 In other words, $952.38 is the value today of receiving $1,000 one year from now given an interest rate of 5% Now we can define the present value of X: it is the amount of money needed today in order to receive X in the future given the interest rate In this example, $952.38 if the present value of $1,000 today given an interest rate of 5% The concept of present value is very useful when making decisions that require paying upfront costs now for benefits that arrive in the future Say you had two options, A and B: the choice of taking a one-year job that pays $10,000 immediately (option A) or taking a one-year course that costs $1,000 now but allows you to earn a one-time payment of $12,000 one year from now (option B) Which one should you take? On the one hand, the present value of option A is simply $10,000 because you receive its payoff immediately On the other hand, the present value of option B, with an interest rate of 5%, is: (9A-3) $12,000/1.05 − $1,000 = $11,429 − $1,000 = $10,429 Since the present value of option B ($10,429) is greater than the present value of option A ($10,000), you should choose option B This example illustrates a general principle: when evaluating choices where the costs and/or benefits arrive over time, make your choice by converting the payoffs into their present values and choose the one with the highest present value Next we will see how to use present value when projects have a time span of more than one year How to Calculate the Present Value of Multiyear Projects Let’s represent the value of $1 to be received two years from now as X2yrs If you lend out X2yrs today for two years, you will receive: (9A-4) X2yrs × (1 + r) at the end of one year which you then reinvest to receive: (9A-5) X2yrs × (1 + r) × (1 + r) = X2yrs × (1 + r)2 at the end of two years From Equation 9A-5 we can calculate how much you would have to lend today in order to receive $1 two years from now: (9A-6) X2yrs (1 + r)2 = $1 To solve for X2yrs, divide both sides of Equation 9A-6 by (1 + r)2 to arrive at: (9A-7) X2yrs = $1/(1 + r)2 For example, if r = 0.10, then X2yrs = $1/(1.10)2 = $1/1.21 = $0.83 Equation 9A-7 points the way toward the general expression for present value, where $1 is paid after N years It is (9A-8) XNyrs = $1/(1 + r) N Find more at http://www.downloadslide.com CHAPTER A P P E N D I X : T O W A R D A F U L L E R U N D E R S TA N D I N G O F P R E S E N T V A L U E 279 In other words, the present value of $1 to be received N years from now is equal to $1/(1 + r) N How to Calculate the Present Value of Projects with Revenues and Costs Now let's suppose you have to choose which one of three projects to undertake Project A gives you an immediate payoff of $100 Project B costs you $10 now and pays $115 a year from now Project C gives you an immediate payoff of $119 but requires you to pay $20 a year from now We will assume that r = 0.10 In order to compare these three projects, you must evaluate costs and revenues that are expended or realized at different times It is here, of course, that the concept of present value is extremely handy: by using present value to convert any dollars realized in the future into today’s value, you can factor out differences in time Once differences in time are factored out, you can compare the three projects by calculating each one’s net present value, the present value of current and future revenues minus the present value of current and future costs The best project to undertake is the one with the highest net present value Table 9A-1 shows how to calculate the net present value of each TABLE 9A-1 The Net Present Value of Three Hypothetical Projects of the three projects The second Dollars realized and third columns show how many Dollars realized one year from Present value Net present value dollars are realized and when they Project today today formula given r = 0.10 are realized; costs are indicated by A $100 — $100 $100.00 a minus sign The fourth column B −$10 $115 −$10 + $115/(1 + r) $94.55 shows the equations used to conC $119 −$20 $119 − $20/(1 + r) $100.82 vert the flows of dollars into their present value, and the fifth column shows the actual amounts of the total net present value for each of the three projects For instance, to calculate the net present value of project B, you need to calculate the present value of $115 received one year from now The present value of $1 received one year from now is $1/(1 + r) So the present value of $115 received one year from now is 115 × $1/(1 + r) = $115/(1 + r) The net present value of project B is the present value of current and future revenues minus the present value of current and future costs: −$10 + $115/(1 + r) From the fifth column, we can immediately see that, at an interest rate of 10%, project C is the best project It has the highest net present value, $100.82, which is higher than the net present value of project A ($100) and much higher than the net present value of project B ($94.55) This example shows how important the concept of present value is If we had failed to use the present value calculations and had instead simply added up the revenues and costs, we would have been misled into believing that project B was the best project and C was the worst one KEY TERMS Interest rate, p 277 Present value, p 278 Find more at http://www.downloadslide.com 280 PA R T ECONOMICS AND DECISION MAKING PROBLEMS Suppose that a major city’s main thoroughfare, which is also an interstate highway, will be completely closed to traffic for two years, from January 2014 to December 2015, for reconstruction at a cost of $535 million If the construction company were to keep the highway open for traffic during construction, the highway reconstruction project would take much longer and be more expensive Suppose that construction would take four years if the highway were kept open, at a total cost of $800 million The state department of transportation had to make its decision in 2013, one year before the start of construction (so that the first payment was one year away) So the department of transportation had the following choices: (i) Close the highway during construction, at an annual cost of $267.5 million per year for two years (ii) Keep the highway open during construction, at an annual cost of $200 million per year for four years a Suppose the interest rate is 10% Calculate the present value of the costs incurred under each plan Which reconstruction plan is less expensive? b Now suppose the interest rate is 80% Calculate the present value of the costs incurred under each plan Which reconstruction plan is now less expensive? You have won the state lottery There are two ways in which you can receive your prize You can either have $1 million in cash now, or you can have $1.2 million that is paid out as follows: $300,000 now, $300,000 in one year’s time, $300,000 in two years’ time, and $300,000 in three years’ time The interest rate is 20% How would you prefer to receive your prize? The drug company Pfizer is considering whether to invest in the development of a new cancer drug Development will require an initial investment of $10 million now; beginning one year from now, the drug will generate annual profits of $4 million for three years a If the interest rate is 12%, should Pfizer invest in the development of the new drug? Why or why not? b If the interest rate is 8%, should Pfizer invest in the development of the new drug? Why or why not? ... Gains from Trade 11 6 The Gains from Trade 11 6 The Efficiency of Markets 11 7 Equity and Efficiency 12 1 ECONOMICS ➤ IN ACTION Take the Keys, Please 12 1 A Market Economy 12 2 Why Markets Typically... 3.75 W PA R T 71 An Increase in Demand 3-2 Price of natural gas (per BTU) 94 S U P P LY A N D D E M A N D in 2002 7 .1 7.5 8 .1 8.9 10 .0 11 .5 14 .2 in 2006 8.5 9.0 9.7 10 .7 12 .0 13 .8 17 .0 For Inquiring... 249 223 10 : The Rational Consumer, 2 81 10: The Absolute Last Bite, 2 81 11: B ehind the Supply Curve: Inputs and Costs, 329 11 : The Farmer’s Margin, 329 12 : Perfect Competition and the 12 : NEW: