Lesson 2: Opportunity Cost and Incentives

Introduction

This lesson uses examples, videos and three mini-activities to teach about opportunity cost and incentives.  Download lesson guide above for activity instructions.

Economic Concepts 

Opportunity Cost	Marginal Benefit & Cost	Supply
Incentives	Rationing	Sunk cost
Money Price	Demand

Key Ideas

1. Review:

• Scarcity forces us to make choices.
• People (not governments, nations, or societies) choose.

2. Every choice has an opportunity cost. The opportunity cost of choosing an alternative is the value of the “next-best” foregone alternative.

• Relate opportunity cost to the choices students made in the “The Magic of Markets” trading game.

3. Because people make choices, all opportunity costs have the following characteristics:

• All costs are costs to someone. Only people bear costs.
• Costs are subjective. Individuals may value costs differently.
• Opportunity costs result from actions. “Things” have no costs in and of themselves.
• All costs relevant to decision making lie in the future. People can anticipate costs, but they occur only after a choice has been made.

4. Incentives are the rewards or punishments that shape people’s choices.

• Incentives can be either monetary or non-monetary.
• When opportunity costs change, incentives change, and people’s choices and behavior change.
• Changes in incentives cause people to change their behavior in predictable ways.

5. Price acts as an incentive to consumers and producers.

• Higher (lower) prices require consumers to give up more (fewer) resources to obtain goods.
• Consumers react to changing price incentives by altering their consumption choices or the quantity demanded of goods.
• The Law of Demand predicts an inverse or negative relationship between quantity demanded and the price of a good.
• Prices affect producers of goods by offering them greater benefits from production when prices increase or lower benefits when prices decrease.
• The Law of Supply predicts a positive relationship between quantity supplied and the price of a good.

6. All costs or benefits that affect decisions are marginal costs or marginal benefits.

• As long as the marginal benefit of an activity exceeds the marginal cost, people are better off doing more of it. When the marginal cost exceeds the marginal benefit, they are better off doing less of it.
• Past costs are called “sunk” costs. The sunk cost fallacy occurs when people fail to recognize that the relevant costs and benefits occur at the margin, which necessarily involves future costs and benefits.
• Marginal analysis helps people to make more informed decisions.
  • Those who do not use marginal analysis are likely to reduce the total benefits available from the choices made.
• In the whole economy, a lack of marginal decision making reduces income and growth.

7. Because of scarcity, all goods and services must be rationed. The question is: How are they rationed?

• Economies must use rationing mechanisms to determine what is produced, how it’s produced, and who gets what is produced.
• People’s choices are influenced by the incentives incorporated in rationing mechanisms.
• The rationing mechanism may encourage or discourage economic growth. Rationing by money price has proven effective in addressing the allocation problem presented by scarcity, and in providing information that encourages economic growth.
• Changes in price create incentives for predictable changes in people’s behavior that reduce the impact of scarcity.
  • A higher money price encourages more production (or a greater quantity supplied), while at the same time requiring buyers to give up more resources.
  • When buyers face higher opportunity costs to acquire a particular good or service, they react by seeking less costly substitutes; thereby reducing quantity demanded.
  • As production increases and quantity demanded decreases, quantities that people are willing to exchange come into balance. Thus, a changing money price causes the marketplace to reach equilibrium between quantity supplied and quantity demanded.
• While we employ a variety of rationing mechanisms in the American economy, the advantages of money-price rationing mean that most goods and services are rationed in this way.

Ideas To Take Away From This Lesson

• Scarcity forces us to choose and every choice has an opportunity cost.
• Changing opportunity costs affect incentives and choices.
• Because costs lie in the future, the relevant costs and benefits occur at the margin.
• Money price acts effectively to balance quantity supplied with quantity demanded, and to ration goods in markets.
• Decisions about quantity supplied and quantity demanded are affected by opportunity costs.
• Price is a powerful incentive. The law of supply and the law of demand describe producers’ and consumers’ predictable reactions to changes in price.