KU Summer Academy
Principles of Economics
Murat Usman
Lecture 2
July 9
Corolla v Golf
You have just purchased a new Corolla for 55.000 but the most
you would get for it if sold it privately is 50.000 lira. Now you
learn that VW is offering the new Golf, which normally sells for
60.000, at a special sale price of 55.000 lira.
If you had known before buying the Corolla that you could get
the Golf at the same price, you would have chosen the Golf.
So,
As a rational person what will you do: Keep your Corolla,
or sell it and buy the Golf?
Suggested solution
ANSWER: If you are rational you will keep the car.
Why?
1. Golf is worth to you more than Corolla, but you didn’t pay
the extra 5,000 for the Golf.
2. This means that the difference between B of Golf and B of
Corolla is less than 5,000.
3. Now the situation requires that you pay 5,000 more to switch
to Golf.
4. By point (2) above, you keep your Corolla.
The scarcity principle
The opportunity cost, (fırsat maliyeti)
There is no such thing as a free lunch!
Herşeyin bir bedeli var!
There is no such thing as a free lunch!
“Although we have boundless needs and wants the resources
available to us are limited. As a consequence, having more of
one good necessarily means having less of another.”
Consider the following statement:
“The citizens of Sweden are lucky because they have free health
care while the citizens of the US have to pay for it.”
A simple economic model
The production possibilities frontier
(PPF)
Üretim İmkanları Eğrisi
The Production Possibility Frontier is...
a graph that shows the combinations of goods (and services)
that the economy can produce given the available resources and
technology.
Imagine a country that produces only cars and computers.
Quantity of
computers
produced
3,000
PPY shows the combinations of goods the
country can produce given the available
resources and technology

D
C
2,200
2,000
A
Production
Possibilities
Frontier
B
1,000
0
300
600 700

1,000
Quantity of cars
produced
Quantity of
Computers
Produced
3,000
1. Producing at a point like B means that the
economy is not producing efficiently.
2. Points outside the PPF (like D) are not attainable
with available resources and technology.

D
C
2,200
2,000
A
Production
Possibilities
Frontier
B
1,000
0
300
600 700

Quantity of
1,000
Cars Produced
Quantity of
Computers
Produced
3,000
1. Suppose the country is producing at point C. If they
want to have 100 more cars, how many computers
do they have to give up?
2. What is the opportunity cost of one car at point C?

D
C
2,200
2,000
A
Production
Possibilities
Frontier
B
1,000
0
300
600 700

Quantity of
1,000
Cars Produced
Quantity of
Computers
Produced
3,000
1. Suppose the country is producing at point B. If they
want to have 100 more cars, how many computers
do they have to give up?
2. What is the opportunity cost of one car at point B?

D
C
2,200
2,000
A
Production
Possibilities
Frontier
B
1,000
0
300
600 700

Quantity of
1,000
Cars Produced
Back to Sweden vs. the US healthcare question:
“Citizens of Sweden are lucky because they have free health care
while the citizens of the US have to pay for it.”
Cars
US
A
B
Sweden
Healthcare
Measuring the costs and benefits of an action is not
always very easy!
People sometimes count costs that
should be ignored.
Sunk costs
Example:
A group has arranged a bus trip to Niagara Falls. The driver’s fee
is $100, the bus rental is $500 and the fuel costs $75.
The driver’s fee is not refundable.
The bus rental may be canceled a week in advance but there is a
cancellation fee of $100.
At $25 a ticket, how many people
must buy tickets a week before so
that canceling the trip is definitely a
bad idea?
Suppose that 20 people bought tickets. Should we cancel the trip
or not?
We have to make a decision because this is the last day for
cancelling without paying the full amount of the bus rental.
Should we go or cancel? Compare costs and benefits!
Benefit = number of tickets soldx$25
What is the cost of this trip?
Driver’s fee $100 + the bus rental $500 + fuel costs $75 = $675
If we have sold $675/$25 = 27 tickets, benefits > costs
 go.
Sunk cost : driver’s fee + cancellation fee = $200
Ignore $200
Relevant costs are $475
If we have sold $475/$25 = 19 tickets, benefits > costs  go.
Failure to Ignore Sunk Costs
Sunk costs are
costs that are beyond recovery at the moment a decision is
made.
They are borne whether or not the action is taken.
Therefore, they are irrelevant to a decision on whether to take
the action.
Sometimes people are influenced by sunk costs when they
“should be” ignored.
Idea #1
People respond to incentives!
Implication of Rationality
People compare costs and benefits when they decide what to
do.
Do activity x if B(x) ≥ C(x)
So, if the costs or the benefits change, rational people will
change their behavior.
Economists say that “people respond to incentives”.
Incentive: dictionary definition
An incentive is something
– that induces a person to act.
– such as the fear of punishment or the expectation of
reward, that induces action or motivates effort.
Simple story
The price of an apple rises…
People decide to eat fewer apples (and possibly more pears),
because the cost of buying and eating apples is higher.
Apple orchards decide to hire more workers and harvest more
apples, because the benefit of selling apples is higher.
George Monbiot’s long article in The
Guardian
Drowning in money: the untold story of the crazy public
spending that makes flooding inevitable
George Monbiot, The Guardian, Monday 13 January 2014
Water sinks into the soil under trees at 67 times the rate at
which it sinks into the soil under grass.
You are a farmer in an EU country.
The “single farm payment” is the biggest part of farm subsidies
and is a big part of your income.
So, what is this SFP?
The "Single Farm Payment" gives subsidies (money) to farmers
based on the size (area) of the land they have ready for
agriculture.
The subsidy doesn’t depend on what type of product the farmer
grows on the land and how much output she produces.
But…
To receive that money you must clear your land from "unwanted
vegetation".
Land covered by trees is not eligible.
What do farmers do?
Even in places where farming makes no sense because the land
is so poor, farmers remove the trees so that they can receive this
money from the government.
These subsidy rules have caused the mass clearance of
vegetation from the hills.
and the result is…
Water sinks into the soil under trees at 67
times the rate at which it sinks into the soil
under grass.
Now something completely different:
Traffic safety
How does a mandatory seat belt law affect auto safety?
The direct effect is obvious.
With seat belts in all cars the chances of surviving a major auto
accident is higher.
In this sense, seat belts save lives.
But that's not the end of the story.
To fully understand the effects of this law, we must recognize
that people change their behavior in response to the incentives
they face.
The relevant behavior here is the speed and care with which
drivers operate their cars.
Driving slowly and carefully is costly because it uses the driver's
time and energy.
Benefits are: lower probability of having an accident.
When deciding how safely to drive, rational people compare the
benefit from safer driving to the cost.
How does the seat belt law changes the cost-benefit calculation
of the rational driver?
Seat belts make accidents less costly for the driver because they
reduce the probability of injury or death!
Thus, the seat belt law reduces the benefits to slow and careful
driving.
When the benefit of an activity is lower, rational people do less
of that activity.
Seatbelts, or safety features such as airbags, make rational
drivers drive less carefully.
The law of unintended consequences
or
Bad things happen to good people
Seat belts reduce the number of driver deaths by making it
easier to survive an accident.
But, they may increase the number of driver deaths by
encouraging reckless (less careful) driving behavior.
Which effect is the greater? Will the number of driver deaths
decrease or increase?
In 1975 Sam Peltzman (University of Chicago) investigated this
issue. He found that
The two effects cancel each other out. There are more
accidents and fewer driver deaths per accident, but the total
number of driver deaths is unchanged.
The number of pedestrian deaths also increase because
pedestrians do not benefit from safer cars.
The Effects of Automobile Safety Regulation by Sam Peltzman
published in 1975 in the Journal of Political Economy
Abstract:
Technological studies imply that annual highway deaths would
be 20 percent greater without legally mandated installation of
various safety devices on automobiles.
However, this literature ignores offsetting effects of nonregulatory demand for safety and driver response to the devices.
This article indicates that these offsets are virtually complete, so
that regulation has not decreased highway deaths.
Time-series (but not cross-section) data imply some saving of
auto occupants' lives at the expense of more pedestrian deaths
and more nonfatal accidents, a pattern consistent with optimal
driver response to regulation.
Almost 30 years later, Peltzman’s results were
overturned
The Effects of Mandatory Seat Belt Laws on Driving Behavior and
Traffic Fatalities by Alma Cohen & Liran Einav. published in 2003 in the
Review of Economics and Statistics
Abstract:
This paper investigates the effects of mandatory seat belt laws on driver
behavior and traffic fatalities.
Using a unique panel data set on seat belt usage rates in all U.S. jurisdictions,
we analyze how such laws, by influencing seat belt use, affect traffic fatalities.
Controlling for the endogeneity of seat belt usage, we find that it decreases
overall traffic fatalities.
The magnitude of this effect, however, is significantly smaller than the
estimate used by the National Highway Traffic Safety Administration.
Testing the compensating behavior theory, which suggests that seat belt use
also has an adverse effect on fatalities by encouraging careless driving, we
find that this theory is not supported by the data.
Finally, we identify factors, especially the type of enforcement used, that
make seat belt laws more effective in increasing seat belt usage.