Lecture 3: Practice

Making economic decisions: opportunity cost, rents, and incentives

Work through each problem on paper before you open its Solution.

1. Adopting a new technology

Lena runs a small print shop. Her old press does the job, but it takes three operators. A supplier offers to lease her a digital press that needs one. Either way the shop sells the same work: $150,000 a year.

Keep the old press. Wages, ink, and maintenance come to $120,000 a year.
Lease the new press. The lease is $25,000 a year, and wages, ink, and maintenance fall to $80,000. Total: $105,000 a year.

(a) Make a table with a column for each option, and work out three rows: benefit, direct cost, and net benefit.

Solution

	Old press	New press
Benefit	$150,000	$150,000
Direct cost	$120,000	$105,000
Net benefit	$30,000	$45,000

Net benefit is benefit minus direct cost.

Old press: $150,000 − $120,000 = $30,000
New press: $150,000 − $105,000 = $45,000

(b) What is the opportunity cost of each option?

Solution

The opportunity cost of an option is what Lena gives up by choosing it, which is the net benefit of the next best alternative. She can run only one press, so each option’s opportunity cost is the other’s net benefit.

Keeping the old press means giving up the new press, so it costs $45,000.
Leasing the new press means giving up the old one, so it costs $30,000.

(c) What is the economic cost of each option?

Solution

Economic cost is direct cost plus opportunity cost.

Old press: $120,000 of direct cost plus $45,000 of opportunity cost, so $165,000.
New press: $105,000 of direct cost plus $30,000 of opportunity cost, so $135,000.

(d) Which option should Lena choose? What is her economic rent from that option?

Solution

Compare the net benefits of the two options and take the higher: $45,000 with the new press against $30,000 with the old one. She leases the new press.

Economic rent is the net benefit of the option chosen minus its opportunity cost.

New press: $45,000 − $30,000 = $15,000 a year

That is her innovation rent, earned by adopting before her rivals.

(e) Two years later every print shop in town has the new press, and competition has pushed prices down: the same work now brings in $120,000 a year with either press. Work out the net benefit of each option again. Is leasing still the right choice? What has happened to the extra profit Lena earned by moving first?

Solution

Redo the net benefits with revenue at $120,000.

Old press: $120,000 − $120,000 = $0
New press: $120,000 − $105,000 = $15,000

Leasing is still the right choice, and the rent is still $15,000 ($15,000 − $0). What has fallen is the level of profit: she netted $45,000 a year while she was the only shop with the new press, and $15,000 once everyone has it, because competition passed the cost saving on to customers. The reward for moving first was temporary, so firms keep looking for the next technology.

2. Is the shop really profitable?

Lena’s cousin looks at her books from problem 1 and says she cannot lose: either press turns a profit. But suppose Lena could close the shop and earn $40,000 a year managing another print shop.

(a) With the old press, the shop nets $30,000 a year. Was running it really profitable?

Solution

The job is the outside option for Lena’s own time, so it is the opportunity cost of running the shop, and the shop’s net benefit has to beat it.

Shop with the old press: $30,000 − $40,000 = −$10,000 a year

No. The books showed a profit, but in economic terms the shop was losing $10,000 a year.

(b) With the new press it nets $45,000 a year. Is it profitable now, and by how much?

Solution

Same comparison, with the new press.

Shop with the new press: $45,000 − $40,000 = +$5,000 a year

Yes, and that $5,000 is her economic rent from running the shop rather than taking the job.

(c) In one or two sentences: why do the books and the economist disagree about the same shop?

Solution

The books count the presses’ costs and not Lena’s time. Economics counts both: her time has an opportunity cost, the $40,000 job.

(d) With the old press, the numbers say the job wins. Is there any justification for Lena keeping the shop anyway?

Solution

Yes, if being her own boss is worth more than $10,000 a year to her. The comparison so far counts only money, and running your own shop can be worth something in itself: independence, pride, doing work you chose. The lecture’s first move applies here too: put a number on it, the most Lena would pay to be her own boss rather than an employee. If that number is more than the $10,000 gap, keeping the shop passes the decision rule after all.

3. Multiple choice

1. An airline sells a last-minute seat on an otherwise empty plane for $25. The opportunity cost to the airline of filling that seat is:

The average cost per seat for the flight.
The full-fare ticket price.
Close to zero, since the plane flies either way and the seat would otherwise be empty.
Negative, since the passenger may buy a drink on board.

Solution

The plane, crew, and fuel are paid for whether or not the seat is filled, so almost nothing is given up by letting one more passenger on.

2. You win a free ticket to see Band A tonight, and it cannot be resold. Band B plays at the same time; a Band B ticket costs $40, and an evening with Band B is worth $50 to you. Apart from the tickets, neither concert has any other cost. What is the opportunity cost of using your free ticket to see Band A?

Solution

Going to Band A means giving up the evening with Band B, and the net benefit of that alternative is $50 − $40 = $10.