Economics in Two Lessons: Chapter 4

by John Quiggin on March 15, 2018

Thanks to everyone who the first three chapters of my book, Economics in Two Lessons. I’ve learned a lot from the comments and made changes in response to some of them. These chapters have been a bit abstract, but now I’m moving on to some applications, which might be more interesting for some readers. Here’s the introduction to Part II

Lesson 1, Part II: Applications

The economic analysis showing how market equilibrium prices reflect the opportunity costs facing producers and consumers is elegant and, for a certain kind of mind, convincing.

For most of us, however, it’s more useful to see how the logic of prices and opportunity costs works in particular cases, sometimes in ways that conflict with strongly held intuitions. This will also give us more insight into the ways in which prices can fail to reflect opportunity costs for society as a whole, some of which we will examine in Lesson 2.
end

Now here’s the draft of Chapter 4:Lesson 1: Applications. Again, I welcome comments, criticism and encouragement.

The book so far is available
Table of Contents
Introduction.
Chapter 1: What is opportunity cost?
Chapter 2: Markets, opportunity cost and equilibrium
Chapter 3:Time, information and uncertainty

Feel free to make further comments on these chapters if you wish.

{ 24 comments }

1

Peter T 03.15.18 at 5:12 am

Some thoughts:

It would be useful to note more strongly in Chapter 3 that estimates of risk and uncertainty are strongly influenced by attitudes, both personal and social – Keynes’ “animal spirits”. These are usually taken to influence appetite for risk but, as we saw with the GFC, they also influence the estimate itself.

Does not the inability of economists to estimate opportunity cost tell us something about the difficulty of applying the concept? Your examples are of binary choices and clear monetary values, but what does the situation look like with – as is usual – neither? Few people are precise on the monetary value of a concert ($50 is ok, $30 is a bargain, $80 is stretching it, $150 is right out is more like it) and, if one feels like a going out, the free concert ‘saves’ $50 which can be put to other uses. So the opportunity cost is a meal to go with the concert, or the kids’ lunches next week, or….So $50, or $10, or somewhere in the vicinity of $20, take your pick.

A second issue that that once a plethora of choices is opened up (often by design) then an avenue opens up for preying on the ill-informed, time-short or otherwise unable to calculate. It is not by accident that there are over 600 mobile phone plan options on the market, or endless private health cover plans.

Also, as your air fare example illustrates, once the pricing is of a bundle (from the seller’s viewpoint), then the buyer is not in the frame as an individual but as a random member of a class. Just who is the counter-party to the exchange here?

2

LFC 03.15.18 at 5:20 am

Haven’t read the previous chaps., so take this fwiw (or not).

The section on airline dereg. (in the U.S.) says “On the whole, air travelers have benefited from deregulation. However, not everyone has” and then proceeds to identify three categories of people who haven’t gained from deregulation: (1) business-class passengers who (often) pay more, (2) people who don’t fly but who pay higher prices for goods and services resulting from the higher cost of business travel, and (3) airline workers.

Istm, as a non-expert on this, there are two other categories of people who haven’t gained: (1) people for whom comfort and ease of travel is/was just as important or more important than price, who could usu. afford to fly when they needed or wanted to in the pre-dereg. era, and for whom paying a lower fare does not make up for the discomfort and inconvenience of feeling often like a sardine packed in a can of sometimes half-stale air; (2) people in small towns and other small places that sometimes or often tended to be served more directly under the old system (or were served by a route, period, and may not be now).

3

nastywoman 03.15.18 at 8:03 am

The funny cartoon in ‘Tricks and Traps’ – which tries to prove that ‘the single who is free and can take off whenever she wants’ and thusly ends up with a 3.500$ fare might be the best example for the challenge ‘economists’ -(and ‘non-economists’) face nowadays?

As I’m not still ‘single’ but ‘free’ – can take off whenever I/we want and so ended up at the 23rd of January with the lowest fares we ever got in the last five years from Europe to Atlanta – from Atlanta to Miami and back (for just 160 Bucks) and then one-way to LA -(for an un-believable 120 bucks) – and after driving cross-country flying back from NYC
to Europe just ten days ago.

Which somehow reminded me on the ‘American Erection’ and the major (economical) trap of these times – (especially) ‘economists’ in these times very seldom seem to think about-
”Tata”!! –
‘Unintended consequences’ –
as we avoided the trap to pay 3.500 bucks for a last minute flight by flying at a time where probably the least amount of people are flying – and IF such type of ‘economics’ are a type of ‘three dimensional chess’ we just added one dimension more to the game the cartoon character overlooked?

Which seems to be some constant problem for ‘economics’ and ‘economists’ in these very confusing times – to forget sometimes even more than one dimension more – or all the unintended consequences – especially using examples from some other – much more simple and straightforward ”good ole times”?

4

nastywoman 03.15.18 at 8:18 am

‘good ole times’ –
which could remind us on these damn (low) interest rates -(or ‘cheap money forever’) – economist probably never thought could change our whole economical system into such a Splendid and Crazy Casino of sure bets – but only for the Rich – forever?

5

nastywoman 03.15.18 at 10:46 am

– But just watching a minute ago -(on you tube – because I couldn’t see it life) – a really great American ‘Economist’ -(and Philosopher) who just yesterday evening gave US all one of the best lessons about (contemporary) economics I have witnessed for quite some time – there is reason for a lot of hope that sooner or later all economists will understand how this ‘thing’ currently works?

Jimmy Kimmel will make sure of it – by filing the complaint.

6

philip 03.15.18 at 12:34 pm

I like the progression from abstract to more complex examples. I was in the camp of not liking the abstract nature of the first few chapters, partly because it was stuff I was already familiar with and partly because it is like trolley problems, okay to highlight a theoretical point but obviously not how the world works.

For the airline ticket section you could make more of the infrastructure issues. People living near spoke airports will not get the same level of benefit as people living near hub airports. They will face higher prices and less choice or the opportunity cost of extra travel to a hub airport. People living near a hub airport will face lower prices and greater choice but also noise and air pollution and the costs and benefits of more visitors. I know this straying more into lesson 2 but you could mention that the issues exist and would be relevant in another chapter. Also you suggest this but could make it explicit, that people may not know what the next best alternative to a flight as due to the search costs they will use a heuristic and know that taking the flight from their local airport will be the most convenient option and so will be willing to pay more and not consider other options, only once the flight is not available will they consider other options and decide the next best one.

The UK still funds the BBC and part funds channel 4 through the TV licence and you can still pay a lower rate for a black and white TV. Iplayer content is available to people with a UK IP address and who tick a box to say they have a TV licence. The tick box came about because people didn’t like the idea of getting the content over the internet and free riding on licence payers, not that it would really stop them. You could also mention people will pay a subscription fee for ad-free content e.g. streaming services, software/apps, etc. There is the rise ad-blocking software and the attempts of websites to prevent it being used. Also how advertising has changed and less of consumption of free-to-air TV and more social media, even if you just say you don’t have space to discuss it properly. The channel 4 online catch up service still puts adverts in the middle of the programme and this always feels old-fashioned to me now.

7

Robert 03.15.18 at 1:27 pm

This is for later chapters, perhaps the one if which you argue that involuntary unemployment puts an economy inside its Production Possibilities Frontier and should lead to drastic changes in how one thinks about opportunity costs.

Under the conditions of the non-substitution theorem (inputs to production consist only of produced circulating capital and labor), long-run equilibrium prices do not vary with the distribution of income and, thus, do not reflect opportunity costs. Under these conditions, opportunity costs can, at most, apply to short-run adjustments.

I think this argument extends beyond the conditions of the non-substitution. Anyways, you can quote from the first couple of pages of the first chapter of Ricardo’s Principles, where he puts aside the consideration of opportunity costs, except for a few commodities (e.g., good wine made out of grapes grown on scarce land of a particular setting).

8

LFC 03.15.18 at 2:02 pm

@6
The channel 4 online catch up service still puts adverts in the middle of the programme and this always feels old-fashioned to me now.

In the U.S., the Public Broadcasting System (PBS) online catch-up service does the same thing. So if you’ve made a sufficient monetary contribution to the local PBS station to be able to access its catch-up service (it calls the service its ‘Passport’ benefit, b/c ‘catch-up service’ doesn’t sound fancy enough) and you watch an episode of, e.g., ‘Victoria’ online, you get ads for Viking Cruise Lines in the middle of it. Always the same ad, too, so one turns off the volume and just waits out the 25 or 30 seconds or whatever it is. Or you decide that you’ve gotten the point (such as it is) of ‘Victoria’ and don’t have to watch all the episodes…

9

JFA 03.15.18 at 2:38 pm

“Once the decision has been made to fly, the opportunity cost of a seat on the plane is close to zero.” That “opportunity cost” should be “marginal cost”.

“But this marginal cost is far below the average cost per passenger of providing the service, that is, the opportunity cost of an alternative service divided by the number of passengers.” That “opportunity cost” should be “total cost”.

“For example, many flight attendants make only a little more than servers in restaurants.” You might want to link to actual data rather than anecdote.

10

Sebastian H 03.15.18 at 3:07 pm

“people for whom comfort and ease of travel is/was just as important or more important than price, who could usu. afford to fly when they needed or wanted to in the pre-dereg. era, and for whom paying a lower fare does not make up for the discomfort and inconvenience of feeling often like a sardine packed in a can of sometimes half-stale air”

This is what I call the entitlement fallacy. Rich people who could afford to fly pre deregulation but who are now put off by the discomfort of sitting too close to poor people have an easy solution—first class tickets. On most flights you can get a first class ticket for an inflation adjusted cost of less than the pre deregulation ticket. So you could pay the old price and get close to the old level of service. The difference now is that poorer people can also share in the ability to travel by air. If that isn’t good enough for you we are getting into the case of positional goods which is a different (though to my mind underexplored) area.

11

philip 03.15.18 at 4:02 pm

For airlines isn’t the biggest marginal cost extra fuel? It might be worth adding in and it doesn’t affect the overall argument.

12

LFC 03.15.18 at 6:13 pm

Sebastian @10
I feared my comment on airline dereg. might be misinterpreted in the way Sebastian H has, in my view, somewhat misinterpreted it. I think my view is perhaps a bit idiosyncratic and shaped by memories that are now hazy.

I was 22 or so when dereg. happened. So most of my flying in the pre-dereg era, when I was a kid, was not paid for by me, and I also don’t remember it in all that much detail. But the seats were somewhat more spaced apart, is my recollection, and the whole process somewhat more relaxed and pleasant. Now the changes toward less comfort might not all be attributable entirely and/or directly to deregulation, as in recent years the TSA era has intervened, and of course population has grown.

I’m all for more people being able to fly as a matter of morality and policy. And I never buy a first-class ticket on the quite rare occasions I fly these days b/c I don’t want to shell out for one and don’t view myself as the kind of person who flies first class (even if, in some purely calculative sense, I cd afford it, which is an open question).

But I do have these dim memories of an era when flying was, or could be, kind of fun. At least in terms of domestic US air travel, I think those days are long over, including prob. for many first-class travelers. Domestic US air travel is safe and often quite efficient, and of course more widely affordable than in the past. But it’s not much fun. When the pilot in the cockpit happens to be a perfectionist and executes on a nice-weather day a particularly smooth, flawless landing (as happened a few years ago when I was flying from the east coast to SFO), that’s nice. But generally, it’s not much fun any more. On the scale of global problems and world-historical declensions, this doesn’t register as even a tiny blip. But since the topic of airline dereg. was being covered in the chapter, I thought it was worth mentioning. Perhaps I was wrong, and it isn’t.

13

John Quiggin 03.16.18 at 1:17 am

@10 Can you give me evidence on the claim that first-class travel is cheaper than pre-deregulation economy.

This source says that in quality terms, they are about equivalent, but I haven’t been able to find good data on US first-class fares. In Australia, they rose substantially after deregulation.

https://www.usatoday.com/story/travel/advice/2015/04/19/first-class/25928621/

14

John Quiggin 03.16.18 at 1:25 am

Some very quick evidence. Average prices have fallen by around 50 per cent in real terms since deregulation. But, on a quick survey, first class prices appear to be significantly more than twice the basic economy fare. If this impression is correct, I conclude that the real cost of modern first class is more than the pre-deregulation economy fare for a service of similar or lower quality.

15

Scott P. 03.16.18 at 6:06 am

But I do have these dim memories of an era when flying was, or could be, kind of fun.

When you’re young, and other people are paying, lots of things are fun.

16

Conall Boyle 03.16.18 at 9:27 am

I once played golf with a sidekick of O’Leary of Ryanair (!), and was eager to ask about pricing. He explained that they have eight (I think) guys who monitor how each flight is booking up, and adjust prices accordingly. Their aim, he claimed, was to fly with full planes, unlike Easyjet which aimed to maximise revenue per flight.

Q. Why might these canny market operators have different market strategies? Haven’t they read their economic textbooks?

That was 10 or more years ago (I’ve given up the golf), but I doubt if there is any reliable AI algorithm that would replace the human operator.

17

nastywoman 03.16.18 at 10:13 am

”I conclude that the real cost of modern first class is more than the pre-deregulation economy fare for a service of similar or lower quality.”

As we – just lately flew first class from Stuttgart to Atlanta and economy back from NY to Zürich WE have concluded that ”modern first class” is not worth the much higher price for a service of supposedly much higher quality. Especially for the food the airline still owes US ”Schmerzengeld” as I always hear the ole-time traveller say: It was eatable before deregulation – and that’s thing about this ”deregulation thing” – it might work out (kind of) or it might end up like the privatization of something like the German Bundesbahn –
a very, very disappointing… disaster?

And that’s why these type of (old-fashioned?) so called ”free market” economics are so disturbingly unfree – like if you suddenly need a hotel room in LA and you find out that there is some kind of NBA thing and all hotels (unregulated) have pumped up their prices to outrageous and can we call it ”usury” degrees – and yes – supposedly it always was like that – that the economy of airlines and hotels was seasonal – but WE were told that lately all the racketeers and profiteers totally absolutely overdo it – and that’s what seems to be kind of ”new” about these economics of the 21th century and so – if WE would have a chance to write about economics – it would just be ONE main lesson –

Apply ”Game Theory”
– and plenty of it!

18

nastywoman 03.16.18 at 10:30 am

– and about @16 ‘I doubt if there is any reliable AI algorithm that would replace the human operator.”

Let’s say you are shopping for hotel prices in the US and you play the game – the Trick and Traps cartoon did play – and in order to find how some prices for certain dates… grow or change – and if it would be better to book in plenty of time or just ”last minute” – you might encounter an algorithm who seems to understand that YOU really want certain dates and thusly – if you check too often – tries to ”win” and ”win” against you – a human operator probably wouldn’t be able to ”win” – and that’s why it is sooo unfair if in Gambling -(”contemporary economics”) some F… faces use such (evil) algorithm and why actually the first lesson of any lesson about economics should be:

Tricks and Traps!

19

nastywoman 03.16.18 at 10:51 am

– and in the ”Tricks and Traps category” the currently probably most annoying ”economics” are in the ”US – we rent a car game”?

So all these poor (US) rental car agents who really depend on some additional income from insurance or other commissions BE-cause they are NOT payed any livable wages or salaries try to ”Trick and Trap” out their customers to the utmost degree.

And if the effort to sell YOU some additional insurance or ”upgrade” YOU to a much more expensive car has been fruitless you might get punished by having to wait for the car you reserved for such a long time that next time you might tell yourself – and the ”Agent”:

Good Lord! – just give me the damn Camaro Convertible and I rub the extra charges off on it’s tires after every stoplight!

20

steven t johnson 03.16.18 at 1:29 pm

It seems to me uncontestable that markets for concert tickets do not clear. If one is analyzing that market as a demonstration in principle that opportunity costs codetermine price structure, this would seem to be a problem for holding the story to be relevant at all. Nor does it seem to be nitpicking to observe that real world economy seems to operate primarily by exchange of freely reproducible goods and services. It’s not at all clear that concerts count.

In addition to these general considerations, the tickets parable is really weird. The correct conclusion to draw is not that even professional economists understand the opportunity cost principle, haha, but to ask a question: If calculating opportunity costs is so difficult, even for people trained to think about them, in what sense is it feasible to assume that revealed preferences successfully convey information about opportunity costs? I mean, aside from the prior commitment to the proposition that only a capitalist market can reveal preference. Hazlitt as the man who invented consumer sovereignty!

The cheating in the tickets parable was notable, though no one else has bothered to remark on it. First, who gives away one free ticket? The person who is inviting someone to come with them of course. The opportunity cost in a realistic ticket problem includes the cost/benefit of the company. Maybe you could call it joint consumption, but then, as I recall, economics has trouble dealing with joint production (I may be out of date, to be sure.) I suppose the same may be true of joint consumption. The non-monetary costs of how much your companion at the concert will enjoy Clapton versus Dylan and how that affects the concert-going experience simply is ruled out. In practice, no matter what the lip service, I think the only opportunity costs that count in a market system are the ones expressible as a monetary value to a single person. Hence the desperate effort to falsify the problem so that a single “correct” value can be found.

Second, the stipulation there is no resale value is preposterous. Also, resale is not even required. The obvious course of action is to try to swap tickets with someone who found a reason to prefer Clapton after all. There are almost certainly two parties involved on the other part of a swap.

Third, the assumption that purchase of the Dylan tickets is a matter of course simply is not true. The projected net benefit of $10 from the lonely Dylan ticket forgets that the extra $50 (well, $100 for the date’s ticket too,) has no opportunity cost of its own, as in purchase of some other consumption item. Buying Dylan ticket(s) means giving up something else. The allegedly correct answer ignores opportunity cost, even as the parable means to demonstrate how to calculate opportunity cost.

Fourth, since the parable does not tell us the cost of the Clapton ticket(s,) much less what the universal consumer would gladly pay for it (them,) then there is no way to calculate the opportunity cost for purchasing the Dylan tickets, even if you assumed no opportunity cost for the cash to pay for it. (That’s mad, I know, but it’s not my parable, yet it is implicit in the story.) As a demonstration in principle that calculating opportunity costs is an essential part of how free market pricing…well, again, it seems like it’s more of a made up story designed to justify the premise that markets are consumer sovereignty, and the economic problem is how consumers confront scarcity. Man versus nature, not man versus man.

Even worse, it’s individual man versus nature. The superficially more realistic examples of airline deregulation, college education and advertising insist even more strenuously that only the monetary value to a single person matters. That’s why billboard advertising is treated as never providing useful information, not even about hotels and restaurants, and always a cost, as if the scenery was the purpose of the drive. Sometimes it is, yes. Drivers gawking at scenery can be a cost though. The discussion of opportunity costs in airline deregulation forgets the opportunity costs of eliminating bus and rail transportation. The discussion of college education forgets to discuss the opportunity costs to employers of producing excess workers. How does anyone talk about the value of networks in elite colleges and forget the educational composition of, say, the Supreme Court. Lesson one insists that only monetary return to individuals counts as opportunity cost.

One of the issues where an insightful treatment of opportunity cost arises I think is comparative advantage. Viewed individually, Ricardian comparative advantage always wins. But in real history, the opportunity cost to economic development by foregoing protection in favor of free trade, have been immense, with devastating consequences to human welfare. Lesson one rules out acknowledging this, by principle. The apologetic function seems obvious to me.

Additionally, lesson one insists on equating all economic choices with consumption choices under scarcity. In real economic life, the primary opportunity costs are foregone profits. That is, they are production choices. To make a case that lesson one describes an effective arrangement, whether in some undefinable full employment or always, it seems to me that one needs to demonstrate that production for profit leads to optimum feasible results. Aside from being kind of counterfactual (and rewriting all history as progress toward the Final Society,) it seems a theory of profit would be required. Otherwise, opportunity costs of production choices would be largely measurable by changes in output. This is most certainly not the case.

If economics were openly acknowledge to be ideal theory, I suppose this wouldn’t be an objective. But economics is supposed to objective, and scientific, in ways never accepted for other social sciences, if one even acknowledges there is such a thing. There are many who won’t even accept there is such a thing as scientific approach to history, who repeat economic nostrums as revelations written by God’s finger in nature. I get that the poster plans to modify the lesson to incorporate some limited exceptions. But there are not really any externalities in nature, there are only costs external to individual transactions. Trying to modify lesson one so that you can argue lesson one sometimes, but not others, seems to me like wanting to be a little bit pregnant.

21

nastywoman 03.16.18 at 4:33 pm

@20
– Parable critic reminded me that WE probably also would have picked all kind of different (contemporary) parables for a lesson about contemporary economics – but is that really the point? – as a friend of mine – a Ballet Dancer once was invited to a very famous US University to demonstrate the Science of Physics -(in a more entertaining way) – by her getting ”on point” and then (how long?) being able to ”stay” on point – in order to give Scientists a more… ’emotional’? or perhaps ‘unscientific’ of some gravity laws.

And so I thought the show-ticket parable was… more… funny than the Airline-ticket thing as the food in First Class was really bad on our flight from Stuttgart to Atlanta…

22

John Quiggin 03.17.18 at 12:09 am

@20 These objections seem odd to me. I have received free tickets to events under circumstances where neither resale nor trade was a practical option.

23

steven t johnson 03.17.18 at 1:12 am

John Quiggin@22 There are indeed occasions when free tickets are given out too late for resale or trade. (If it had been me, with my luck, I’d have already bought the Dylan tickets.) Economic science is vindicated!

24

bruce wilder 03.18.18 at 8:08 pm

A late note on the airline case:

The airline is in a Red Queen’s Race as far as booking passengers is concerned: they want to fill the empty seats, as you say in your narrative, and if they succeed in filling the empty seats, (the non-intuitive part) they want a bigger plane so there will again be empty seats to fill. (!!)

Economies of scale in the plane mean that the cheapest plane to fly to carry any fixed number of passengers will have empty seats. A full plane is never the cheapest plane to fly (lowest average cost per passenger carried). Lowest average cost per passenger is always achieved by a bigger plane rather than a full plane.

I think it might sharpen the narrative of opportunity cost to note that aspect of the dilemma faced by the airlines.

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