Introduction: Cost and Benefit Analysis

Chen Zhao
University of Hong
Kong

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Will you pick up the check?
o There is an opportunity for you to pick up a check of $500 at Disneyland.
The ticket to enter Disneyland costs $400.

o Yes?
o No?

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Will you pick up the check?
o There is an opportunity for you to pick up a check of $100 at Disneyland.
The ticket to enter Disneyland costs $400.

o Yes?
o No?

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The Cost-Benefit Principle
• A rational individual (or a firm or a society) should take an action if the
additional benefits from taking the action are larger than the additional costs

Should I do activity x?

C(x) = the additional costs of doing x

B(x) = the additional benefits of doing x

If B(x) > C(x), do x; if B(x) < C(x), don't.

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The Cost-Benefit Principle
• A rational individual (or a firm or a society) should take an action if the
economic surplus from taking the action is larger than zero

Should I do activity x?

C(x) = the additional costs of doing x

B(x) = the additional benefits of doing x

If ES(x) = B(x) - C(x) > 0, do x; If ES(x) < 0, don't.

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Rationality assumption
o People have goals and try to fulfill them as best as they can.
o Firms maximize profit
o Consumers maximize satisfaction from consumption
o Governments maximize …

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Modelling the complex world
o Economists need models to make inferences, predict outcomes, and make
policies.

o If we try to include all the details of the complex world, it will take forever to
build the model, and the resulted model will be too complicated to use.

o The key is abstraction.

o Identify the most important elements and incorporate them in the model.
o Confront the model with data and modify the model to improve the fit.

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What is a good model?
o The assumptions made in the abstract model (e.g., rationality) may not
include elements that some of us consider important.

o The ultimate test of the model is how well it can fit the data, how well it
can use to predict, not how realistic the assumptions are.

o Rationality is proven to be useful in fitting/predicting people’s behavior.

o Besides, it is more realistic than you may think.

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Inference, Prediction and, hence, Policy
o For rational individuals, actions are chosen to maximize some goals, subject to their respective
constraints.

o Prediction:
o Knowing a decision-maker’s goal and constraint, we can predict.
o Decision-makers: firms, consumers, …

o Inference:
o By observing their choice of actions, we can guess the goals and constraints facing them.

o Policy:
o If we can change their goals/preferences, and/or constraints, we can cause them to choose
a different action.

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Will you go to the drama?
o Based on your experience, you are willing to pay $1200 to see “Sleep No
More”, an immersive drama with locations in New York and Shanghai. The
price of the ticket is $800. Will you go to the drama?

o Yes?
o No?

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Will you go to the drama?
o Based on your experience, you are willing to pay $500 to see “Sleep No
More”, an immersive drama with locations in New York and Shanghai. The
price of the ticket is $800. Will you go to the drama?

o Yes?
o No?

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Inference
o Observed action:
o Jon pays a price of $800 to see the drama.

o Conclusion:
o Jon is willing to pay more than $800 to see the drama.
o Jon has more than $800 in his bank account.
o We will have a better idea with more observations.

What if Brandon did not go to the drama?

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Prediction
o If the price was $700, will Jon go?

o What if the price was $900?

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Policy
o If we want more people to see the drama,
o we can advertise (like what I just did).
o reduce the price of the tickets.

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How many scoops of ice-cream should I have?
o TB(n units) = the total benefit of having n scoops
o TC(n units) = the total cost of having n scoops

o Calculate ES(n units) = TB(n units) - TC(n units) for every n.

o Pick the n which maximizes the economic surplus.

Does there exist an alternative, perhaps easier way to decide?

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How many scoops of ice-cream should I have?
o The key is to convert the original decision to a sequence of “Yes-No”
decisions!
o Start from zero scoop. Should I have the first scoop?
o Start from one scoop. Should I have the second scoop?
o …
o Start from (n-1)-th scoop. Should I have the n-th scoop?

o I would have the n-th scoop if the additional benefit of the n-th scoop is
larger than additional cost of the n-th scoop.

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Thinking at the margin
o Trade-offs are usually at the margin.

Marginal means additional

o MB(n-th unit): the additional benefit due to the n-th unit.

o TB(n units) – TB(n-1 units)
o MC(n-th unit): the additional cost due to the n-th unit.
o TC(n units) – TC(n-1 units)

o Should I do the n-th unit of activity X?

o Yes, if MB(n-th unit) > MC(n-th unit)

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Thinking at the margin
o Should I do the n-th unit of activity X?
o Yes, if MB(n-th unit) > MC(n-th unit)

o Assumptions:
o MB is non-increasing in additional units
o MC is non-decreasing in additional units
o Under these assumptions, you can stop as soon as you say no

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Thinking at the margin
o Should I do the n-th unit of activity X?
o Yes, if MB(n-th unit) > MC(n-th unit)

o When goods or activities are perfectly divisible, do the additional ∆ unit of activity X if an
only if
TB(Q+ ∆ units) - TB(Q units) > TC(Q + ∆ units) - TC(Q units)
o Divide by ∆ and let ∆ approach 0, the rule becomes:
o continue to do the activity if and only if
MB(Q units) > MC(Q units)
o MB = the derivative of total benefit
o MC = the derivative of total cost
o Optimal Q is given by MB(Q) = MC(Q)

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Reducing the death rate of the Prisoner Transport Business
o In 1787, the British government hired sea captains to ship convicted felons
to Australia.
o The Brits had no love for the convicts. Typically, more than one third of the
men died and the rest arrived beaten, starved, and sick.

o How does the government reduce the death rate?

Policy: Pay the ship captains by the number of living

convict on arrival.

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Reducing the death rate of the Prisoner Transport Business
o Understand the decision of the captains:

o Should the captain raise the number of surviving convicts on arrival by 1

person?
o Yes, if the benefit of doing so is higher than the cost of doing so.

o What is the marginal benefit before the policy change?

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Thinking on the margin in the Prisoner Transport Business
o How many convicts should the captain keep alive?
o Should the captain keep alive the first convict?
o Should the captain keep alive the second convict?
o…
o Should the captain keep alive the n-th convict?

o By paying the ship captains by the number of living convicts on arrival, the
benefit of keeping one additional convict alive is raised. Thus, the captains
will keep more convicts alive.

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Reducing the death rate of the Prisoner Transport Business
o In 1787, the British government had hired sea captains to ship convicted
felons to Australia.
o The Brits had no love for the convicts. Typically, more than one third of the
men died and the rest arrived beaten, starved, and sick.

Policy: After the ship captains were paid per living

convict on arrival, the death rate fell from over 33% to
less than 1%.

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Lesson: Incentives Matter
o Incentives: rewards and penalties that motivate behavior.
o People respond to incentives in predictable ways.
o Self-interest is an important incentive in economics.

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Incentives in the garment and textile industry
o In the 60s to 80s, garment and textile industry in Hong Kong hired a lot of
workers. If you were the boss of a garment and textile company, how would
you pay your workers?

A) By hours of work

B) By pieces of completed garment items

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Allocation of Gatherers in a Real-time Strategy (RTS) Game

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Allocation of Gatherers to Two Gold Mines
o We have four gatherers. How many miners should we send to the east
mine or the west mine given the average output as shown below?

Average output per gatherer (gold/minute)

Number of gatherers East West
1 10 13
2 10 12
3 10 11
4 10 10

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Allocation of gatherers
Average output per gatherer (gold/minute)
Number of gatherers East West
1 10 13
2 10 12
3 10 11
4 10 10

Marginal output per gatherer (gold/minute)

Number of gatherers East West
1 10 13
2 10 11 (=24-13)
3 10 9 (=33-24)
4 10 7 (=40-33)
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Allocation of gatherers
Marginal output per gatherer (gold/minute)
Number of gatherers East West
1 10 13
2 10 11 (=24-13)
3 10 9 (=33-24)
4 10 7 (=40-33)

Should I send the first gatherer to the east?

No. B(East 1) = 10 < B(West 1) = 13
Should I send the second gatherer to the east?
No. B(East 1) = 10 < B(West 2) = 11
Should I send the third gatherer to the east?
Yes. B(East 1) = 10 > B(West 3) = 9
Should I send the fourth gatherer to the east?
Yes. B(East 2) = 10 > B(West 3) = 9 29
Allocation of fixed amount of resources
(still thinking at margin)
o When allocating a fixed amount of resources among several activities,
allocate the additional unit of resources to activities with the highest
marginal benefits.

o When the resource is perfectly divisible, allocate the resources such that
MB(A1)=MB(A2)=…=MB(An)
o Assume there does not exist two activities such that one is always better than the other.

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Lesson: Trade-offs are Everywhere
o For every choice something is gained, something lost.

o The opportunity cost of a choice:

the value of the opportunities lost.
o Includes monetary and nonmonetary costs
o Includes explicit and implicit costs.

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What to include and what not to include?
o You spend $100 on meals every day. There is an opportunity for you to pick up
a check of $450 at Disneyland. The ticket to Disneyland costs $400. Should you
pick up the check?

o Yes
o No

o Do we include the $100 dollars on meals in our cost and benefit analysis?

o B=450, C=400
o B=450, C=500

o Why?

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What to include in the opportunity cost?
o You spend $100 on meals every day. There is an opportunity for you to pick
up a check of $300 at Disneyland. The ticket to Disneyland costs $400. You
happened to own a non-refundable ticket. Should you pick up the check?
o Yes
o No

o Do we include the $400 dollars in our cost and benefit analysis?

o B=300, C=0

o B=300, C=400
o B=300, C=500

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What to include in the opportunity cost?
o You spend $100 on meals every day. There is an opportunity for you to pick
up a check of $300 at Disneyland. The ticket to Disneyland costs $400. You
happened to own a fully refundable ticket. Should you pick up the check?
o Yes
o No

o Do we include the $400 dollars in our cost and benefit analysis?
o B=300, C=0
o B=300, C=400
o B=300, C=500

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What to include in the opportunity cost?
o Do not mechanically include any benefit and cost that will not be affected by
your decision, at the time of making the decision.

o Sunk cost is a cost that is beyond recovery at the moment the decision is
made.

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What to include in the opportunity cost?
o You won three free tickets, one to see the concert by Jay Chou, one to go to
Disneyland to pick up a $400 check, and one to go to Ocean Park to pick up

$500 check.
o You cannot resell any of these tickets (ID will be checked at entrance).
o Everything happens the same time. Assume there are no other costs or
benefits.
o Based on this information, what is the opportunity cost of seeing Jay Chou?

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What to include and what not to include?
o Opportunity cost of an activity is the value of the next best alternative that
must be forgone in order to undertake the activity.

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What to include and what not to include?
o You won a free, non-refundable ticket to see the concert by Jay Chou.
Also, at the same time, you have the opportunity to go to Disneyland to
pick up a $450 check. The ticket costs $400.
o Assume there are no other costs or benefits beyond what is given.
o Based on this information, what is the opportunity cost of seeing Jay Chou?
o 450
o 400
o 50


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What to include and what not to include?
o Opportunity cost of an activity is the value of the next best alternative that
must be forgone in order to undertake the activity.

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Will you help Uncle Paul?
After an exchange in England, you were about to return to Hong Kong. You
noticed that Air Jordan I sneakers were sold at HK$1,800 a pair at Hong Kong
stores and about HK$500 in England. You had been planning to bring back a
pair and sell it at about HK$1,300. Then Uncle Paul asked you to get a pair
back for him, and promised to pay you the cost (HK$500). You value the
chance of helping Uncle Paul at $x.

How will your decision to help him depend on x? (Assume you can only bring 1
pair back.)

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Will you help Uncle Paul?
Imagine you have not yet purchased the sneakers.
o The benefit of helping Uncle Paul?
o Your valuation of helping Uncle Paul
= x + 500 - 500
=x
o The cost of helping Uncle Paul?
o Helping Uncle Paul, you will lose the opportunity of bringing back the sneakers and
reselling them yourself.
o What you could have gotten
= 1300 - 500
= 800
o Benefit – Cost = x - 800
 You should help Uncle Paul if x > 800.

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Will you help Uncle Paul? (An alternative calculation)
Imagine you are already back with the sneakers.
o The benefit of helping Uncle Paul?
o Your valuation of helping Uncle Paul + reimbursement from Uncle Paul
= x + 500
o The cost of helping Uncle Paul?
o Helping Uncle Paul, you will lose the opportunity of reselling the sneakers
yourself.
o What you could have gotten
= 1300
o Benefit – cost = x + 500 - 1300 = x - 800
 You should help Uncle Paul if x > 800.

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Same decision, despite different approaches of calculating
the cost and benefit
o We may categorize the cost and benefit slightly differently, but if we have
included all the cost and benefits properly, we should
o get the same Economic Surplus, and
o arrive at the same decision/conclusion.

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Institutions Matter
o Good institutions align self-interest with the social interest.

o Usually, free market does the job.

o “The Invisible Hand”

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 “It is not from the benevolence
of the butcher, the brewer,
or the baker that we expect
our dinner, but from their
regard to their own
interest.”
-Adam Smith,
The Wealth of Nations

Adam Smith saw the invisible hand

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Alignment of self-interest with
social interest
o Because Ricky Wong, the founder of HKBN, wanted the profit, we had high-
speed broadband in Hong Kong.

o He built the fiber-optic network because the benefit of doing so is larger than
its cost!

Did he do it because he wanted to improve our well-being?

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Which country has better institutions?

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