UNIT 2.1 Economics PDF

ECONOMICS UNIT 2 Economics and the dynamics of change UNIT 2.1: "Exploring Economics: Scarcity, Choices, and the Intriguing Human Behavior" Key concept: Change Related concept: Scarcity and sustainability Global Context: Globalisation and sustainabili...

ECONOMICS UNIT 2 Economics and the dynamics of change UNIT 2.1: "Exploring Economics: Scarcity, Choices, and the Intriguing Human Behavior" Key concept: Change Related concept: Scarcity and sustainability Global Context: Globalisation and sustainability Statement of inquiry: Investigating the economic perspectives of the environment and the role of entrepreneurship in addressing societal challenges within a global context. 1  CONTENT 1. What is economics? 3 2. Resources, goods and needs 5 Resources 5 Goods and services 5 Needs 5 2.1 The economic needs 6 Characteristics of needs 6 Types of needs 8 Classi cation of needs 9 The Maslow pyramid and the Covid 9 3. Economic scarcity 11 3.1 How do individuals make decisions? 12 1. First principle: Opportunity cost. 12 2. Sunk cost or irrecoverable cost 14 3. Marginal bene ts or cost 15 4. Incentives 16 4. Economics and Behavioral Science 18 1. People Are Not Always Rational 18 2. People Care About Justice 19 3. People Are Impatient in the Short Term 19 4. Cognitive biases and people's decision-making. 19 What is a cognitive bias? 19 2 fi fi 1. What is economics? ECONOMICS is the science that studies the best way to manage scarce resources in order to satisfy as many of society's needs as possible. Put this way it may not be clear to you, so let's look a little deeper. Resources are scarce Unfortunately, the resources available to any family are scarce to meet all of its needs. There are two reasons for this. - The money available to all families is limited. Just as you may have an allowance, your parents have a limited salary with which they will have to say what things they want to buy. - The time we have is also limited. Even if we had lots and lots of money and could buy what we want, the day has only 24 hours and often we will not be able to satisfy two needs at the same time. Since our money and time are limited, we cannot satisfy all the needs we have. Needs are unlimited If you go to the mall there are bound to be hundreds of products you want to buy. You would love to have that latest model cell phone or a lot of clothes of different brands. I'm sure your family would love to buy a better TV, a new refrigerator or go on a luxurious vacation. The saying "the more you have the more you want" seems to explain human behavior perfectly. The problem is that when we satisfy one need, a new one always arises. You may think that millionaires can satisfy all their needs because they have money to spare. But there are two things you are forgetting: A. Needs reproduce themselves, and once they are satisfied new ones arise: If you start earning more money you will want a bigger house and a better car. At that point you will have the need to protect these expensive assets. You will need a big garage and good security for your home. In addition, if you earn a lot of money you will need someone to advise you on where to invest, a lawyer and other services. As you can see, as you satisfy some needs, new ones arise. B. Time (for many the most valuable resource) will continue to be scarce. You cannot satisfy all your needs because you simply do not have unlimited time. Even if you had infinite money to buy everything you want, you would lack time to be able to do all the activities you want. There is a need to choose Since our resources are scarce (money and time) but our needs are unlimited (they reproduce) we have to choose how we will use these resources and what needs we are going to cover. 3 So, for example, if you only have 20 euros, you will have to choose whether you want to buy that cool t-shirt or those pants you liked. It is also important not to forget your other scarce resource, time. If tomorrow you have an economics exam and you have to study, and your friend proposes you to go to a party in the evening, you will also have to choose between studying or going with your friend. In both cases, you are only satisfying a need And this is where economics comes in, a science that will help you decide how to use your scarce resources in the best possible way so that you can satisfy the greatest number of needs. Scarce of resources The economy helps us to Need to manage resources choose to satisfy the greatest number of needs Unlimited needs That is why economics is called the science of SCARCITY AND CHOICE. In fact, if there were no scarcity of resources and no need to choose, economics would not exist, since there would be nothing to manage. 4 2. Resources, goods and needs Resources In economics when we talk about resources we refer to everything that allows us to produce goods and services. If we want to produce a loaf of bread, we will need seeds to grow wheat and land on which to grow it (all of which are natural resources), as well as farmers to carry out the production (workers) and tractors and tools (which we call physical capital). Finally we will obtain the loaf of bread, which will be the good that will allow us to satisfy the need to feed ourselves. RESOURCES are those that allow us to produce goods and services. We refer to natural resources, workers and physical capital (machines and tools). These resources are workers, natural resources (they come from nature) and physical capital (machines and tools). All these resources are scarce, since there are not enough of them to create all the goods we want and to satisfy everyone's needs. Goods and services Goods and services are that which satisfies a need. Food satisfies the need for food, a cell phone satisfies the need for communication and information, a car satisfies the need for transportation, and an economics class satisfies the need for education. The main difference between goods and services is that goods are tangible, i.e. we can touch them (food, car, cell phone), but a service is something intangible (a soccer match that satisfies our need for leisure or an economics class). GOODS AND SERVICES are everything that satisfies a need. While goods are tangible, services are intangible. Needs A need is the sensation of lack coupled with the desire to satisfy it. In other words, for us to have a need, we must feel that something is missing and also want to satisfy that need. But we must not confuse the need with the goods and services that allow us to satisfy it. Therefore, if you want a video console you have to be clear that the video console is not a need in itself, but it is a good that allows you to satisfy the need for entertainment. 5 2.1 The economic needs In the year 2000, no one in a high school owned a cell phone. But from that year on, everyone started to buy one, why? Was it suddenly necessary? Actually "having a cell phone" is not a necessity in itself. At that moment the cell phone (which is a good) began to cover much better a key need in the human being. Communication. Twenty years ago, every time you wanted to communicate with a friend, you had to call his or her parents' landline and often had to go through the awkward question of who is that person? Also, your friends were not always at home and in that case, communication was impossible. Sometimes you would meet someone and they wouldn't show up. Not knowing what was going on forced you to wait for long periods of time. Sometimes your friend was grounded, sometimes he didn't have time to do his homework, and sometimes he was just late. You can't imagine the arguments caused by the lack of communication. The cell phone was clearly a good that allowed us to satisfy an unsatisfied need: communication. We have just seen that economics tries to satisfy as many needs as possible given the scarce resources we have. But before we see how we can achieve such a difficult task we need to know the characteristics of needs. Characteristics of needs 1. Needs are unlimited As we have already said in the previous point, this is because needs reproduce themselves and we always want more and because our time is limited. 2. The same need can be satis ed in several ways. José Luis is passionate about video games and spends every Saturday night with the video game console. His classmates call him a geek and tell him that he is very boring for not wanting to go out and have a coke with them. Are his classmates right? Certainly not. José Luis has a need for entertainment just like they do, but while his classmates satisfy their need by going out partying, what José Luis enjoys is playing Fortnite. We can say that people share the majority of needs: security, food, communication, transportation etc. But the key here is that each of those needs can be satisfied differently through different goods. Understanding the difference between needs and goods is key in economics. So, for the need for entertainment many people use Netflix, others watch a soccer game, some go shopping and others read a book. What should be clear is that economics does not enter into whether it is better to go out partying or stay at home playing video games. What the economy (and you) is interested in is whether you satisfy your need. 6 fi 3. Needs are felt differently - Hey teacher, I looked at your Instagram and you are the least connected person of all my contacts, why don't you use the app? - Well, most teenagers recognize the need to be connected to social networks, but that doesn't happen to everyone. Some people develop some needs to a greater degree than others. This is because needs are influenced by many factors: - Where we live. Depending on where we live we may have different needs. We all need to feel safe, but in countries like the United States that need seems to be more developed and many people have a gun at home, something unlikely if we live in Spain. Curiously, statistics say that having a gun increases the probability of being shot. Ironic, isn't it? - The environment in which we move. Many times we will have a much more developed need depending on who we relate to. If you look at your peers, chances are many are wearing Nike, Adidas, Reebok or Converse sneakers and most of them are white. - Advertising and fashion. We receive an average of 3,000 advertising impacts every day, so advertising can make us feel some needs more strongly. Some people feel the need to always have the latest thing that comes out. - Age. The strength with which we feel some needs varies with age. Young people tend to need to be connected all day long and spend hours on social networks, while older people tend not to have this need as strongly developed. Hence, 75% of people who use Instagram are under 35 years old. In short, there are factors that make the needs are different in each person and in each society. 4. Needs are not xed With the outbreak of COVID-19 we saw how new needs appeared and how many others developed much more. One new need was undoubtedly the need to protect oneself from contact with people and objects, which multiplied the purchase of masks and gloves to such an extent that for weeks it was impossible to buy them anywhere. One need we already had was that of hygiene, but with the pandemic this need developed to previously unsuspected levels. Many people disinfected everything they touched or bought in supermarkets, which triggered the sale of alcohol and bleach. Hand washing became the best way to avoid contagion, which multiplied the sale of alcohol gel. Needs are not fixed, but vary with the times. The evolution of society itself or changes in technology can cause new needs to arise (even if there is a war or a lethal virus). For example, in the old days people lived in small villages and many hardly ever left. But with the evolution to big cities people became separated from their acquaintances. Many needs developed, such as the need to maintain contact. With the development of technology, having the internet or a cell phone has become essential to meet these needs. 7 fi Types of needs There are many classifications of needs. We will focus on the difference between primary and secondary. Basic or primary needs. Primary needs are those that must be satisfied in order to survive: food, clothing and housing. In a developed society they are practically covered for the majority of the population. However, the evolution of our society has broadened the concept of primary needs, for example, to include education and health care. Thus, today, primary needs are considered to be all those that must be satisfied in order to be able to exercise fully as a citizen. Human welfare is not only about mere survival, but also about being able to have everything that allows the integral development (economic, social and cultural) of the person without feeling excluded by society. For example, the Internet is becoming more and more necessary and not having access to it can lead to certain exclusion. Similarly, a refrigerator or a telephone is not basic for survival (and years ago many people did not have one), but when society evolves and the vast majority of citizens consider a need as basic, those who do not meet it are at risk of social exclusion. From this point of view, education, healthcare, internet or a refrigerator are also primary needs, even if they are not essential for survival. It is precisely this concept that allows us to differentiate between two types of poverty. Absolute poverty: the lack of goods to meet the primary needs. Relative Poverty: when even if their basic needs are covered, individuals are suffering from a certain social exclusion due to their low income. Secondary needs. Secondary needs are those that allow me to increase my well-being by covering them. Apart from the basic needs, man has other types of needs that are increasingly evolved, such as leisure, communication, etc. Once the human being covers these primary needs, he focuses on those that allow him to increase his satisfaction and well-being. They are unlimited and as they are covered, new ones arise. Moreover, they depend on the place or time in which we live. For example, many people find it essential to wear expensive brands, a need they probably do not have in a small village. 8  Classi cation of needs The Maslow pyramid and the Covid Everything that happened around March 14, 2020 with the COVID-19 confinement is already part of Spanish history. It is unbelievable how the events were precipitated. At the beginning of March those who bought masks were called crazy. On Friday, March 13, thousands of people were fleeing from the places where the virus was at its strongest. On the afternoon of the 14th, it was impossible to buy toilet paper, a steak or a can of tuna. On the 15th, people already confined to their balconies went out to clap their hands for ten minutes. But what the hell happened in just a few days? Maslow's pyramid had entered the scene. Maslow's scale of needs is often described as a pyramid consisting of ve levels. The basic idea of this hierarchy is that the highest needs occupy our attention only when the needs lower on the pyramid have been satis ed. That is, until I meet a need at a lower level, I will not feel the needs at the next level. LEVEL 1: Basic needs. These are basic physiological needs to maintain survival. Eating, sleeping, protection from the cold, etc. As long as the human being does not satisfy these needs, he does not care about the others. As of March 10, COVID-19 cases began to multiply in Madrid. As many Madrileños have homes in beach areas, many took advantage of Friday the 13th to go there. Criticism of these people rained down on the networks, calling them selfish for putting the cities they were visiting at risk. Let's not get confused, here we must distinguish those who simply wanted to spend the weekend in a beach resort from those who literally fled in fear of a lethal virus. In the latter, the most basic need of all was activated: the need to preserve life. LEVEL 2: Safety and security needs. These arise when the physiological needs have already been met. These are the needs to feel safe and protected. Human beings always want to consolidate what they have achieved and guarantee that they can be safe. On Saturday 14th it seemed clear that the confinement that had already occurred in Italy would reach Spain. The fear of what was going to happen activated the next level of need, to guarantee security. Families went to supermarkets to buy 20 kilos of meat to freeze, 50 cans of tinned food and 80 rolls of toilet paper among other things. Masks, bottles of alcohol and hydroalcoholic gel were sold out, along with many other hygiene products. LEVEL 3: Social needs. Once the human being feels safe, he/she will look for relationships with others, to be part of a community, to group in families, friendships, a couple. Among these needs are: friendship, companionship, affection and love. On the 15th we were already confined and safe in our homes with a full pantry and refrigerator. At that point the next level, social needs, was activated. Phone calls and video calls increased by 50% because of the innate need we have to 9 fi fi fi relate to others. The children painted rainbows and taped them on the windows as a way to interact with other children they could not see. LEVEL 4: Esteem or recognition needs. Once an individual belongs to a group, he/she will want to have some recognition within the group. We all want to feel recognized and valued by others. In a war against a virus, our soldiers were the health workers. At 8 o'clock in the evening, people would rush to the balconies to applaud the paramedics who risked their lives for us. They would go outside the hospital for 5 minutes to receive the applause. For two months the applause continued, but it soon became a recognition of ourselves. We would go out to the balconies to applaud and receive the applause of others, the song "I will survive" became the motto during these applauses. Our way of contributing to stop the virus was to lock ourselves at home. Sometimes we think that this is a defect of those who seek recognition. Make no mistake, the need for recognition is as human as all the others. LEVEL 5: Need for self-actualization This last level is somewhat different and Maslow used several terms to name it: "growth motivation", "need to be" and "self-actualization". It consists of becoming as much as possible, "the maximum expression of the self". According to some sociologists, there are people who never satisfy this need, because once they achieve their goals, they set other goals. During the pandemic more than 50,000 health workers were infected in Spain and many of them died. Faced with a shortage of personnel, many people volunteered to help, risking their health and even their lives. In many of them, the need for self-realization had been activated. 10  3. Economic scarcity When you are a teenager, it is common to have an allowance. Some have more than others, and I'm sure you all want to have more. Some save to buy a motorcycle, others a play, and others spend it going out with friends. The key here is that we have scarce resources and we have to choose which needs to satisfy. We have economic scarcity. As a result of the two key ideas we have seen in the previous point, resources are scarce and there is a need to choose, the problem of economic scarcity arises. ECONOMIC SCARCITY is not the absolute lack of a good, but the fact that it is not possible to obtain all the goods we want with the resources we have, and, therefore, we will not be able to satisfy all the needs we have, but we will not be able to satisfy all our needs. Therefore, we must not confuse poverty (or physical scarcity) and economic scarcity. Economic scarcity has 2 characteristics. 1. It is universal. It affects everyone, albeit in different ways. While the concern of many African families is how to eat every day, or that of many Spaniards to make ends meet, many rich people like Di Caprio or Brad Pitt have other needs such as buying a bigger mansion, the latest model car or the most expensive watches. In other words, we all have scarce resources (even the richest) that prevent us from satisfying our unlimited needs. 2. It is relative, because we all feel it differently. Needs can be very different in countries such as Brazil than they are in Spain. In fact, in Brazil the crime rate is much higher than in Spain, so it is logical that Brazilians feel they need to spend more on security. Thus, you may feel differently about your needs than your friends. They may prioritize factors such as esteem or fame and that leads them to buy more branded clothes and you may not feel that need as strongly and others. Therefore, people with a lot of money may feel that they lack more needs than people who earn less. The concept of need is therefore relative. PHYSICAL SCARCITY ECONOMIC SCARCITY We could say that it is the It arises because lack of goods and services resources are scarce and to satisfy minimum needs. we cannot satisfy all our That is, it would be having needs , which causes us dif culties to feed ourselves, to have to choose. In dress ourselves or have a other words, the human home. In underdeveloped being will always have to countries there is hardly any choose what best suits possibility of satisfying basic their needs based on the needs. budget that have. 11 fi 3.1 How do individuals make decisions? 1. First principle: Opportunity cost. At the beginning of the COVID-19 outbreak, many countries were faced with an important decision: to confine or not to confine their citizens. The decision was not a trivial one. If not confined, the virus would continue to spread and the cost would be the death of many thousands of people. The other option was to confine the citizens, but that would lead to the closure of thousands of companies and the loss of hundreds of thousands of jobs that would leave many families in serious economic problems. And what would you have done, the stock market or life? As people we have to be constantly making decisions. What we have to understand is that every time we decide to do something with our money or our time, we are giving up other things. In other words, every decision has an opportunity cost. A decision consists of choosing one among several possible alternatives, rejecting the rest. The problem in economics is that if we choose to satisfy some needs we have to give up satisfying others (these are unlimited while our resources are scarce). The concept of opportunity cost then arises. OPPORTUNITY COST is what is given up when making a decision. The name refers to the opportunity lost by rejecting a particular option. Let's look at it with an example. You have won the economics olympiad and you are offered a scholarship with which you can study for free the career of your choice. Your options are to study Economics or Law. As you can only choose one, the opportunity cost is clear: If I study economics, my opportunity cost is that I give up studying law. Obviously the opportunity cost of studying law is that I cannot study economics. 12 On this occasion, since we have a scholarship we see that there is no cost of money. Here the decision has no more mystery than to stay with the career that we like the most. But what happens if one of the choices includes a monetary cost? Imagine that when you win the economics olympiad you are told that the scholarship is only for the university in your city, and economics is not offered there. Now if you want to study economics you would have to go abroad, and pay both tuition fees and all the cost of living abroad. Let's assume that in 4 years the total cost of tuition, housing and food amounts to 30,000 euros. Now studying economics has an added cost, not only can I not study law, but I have spent 30,000 euros. Opportunity cost: Monetary costs plus invisible costs. Imagine that now the decision is to study economics (without a scholarship) or to start working. What would be the cost of studying now? We could think that the cost would be the 30,000 euros of tuition fees and living abroad, but we would be making a big mistake; we have forgotten that if we study we are giving up working and therefore we are giving up all the income we would get in those 4 years. The money I stop earning is what we call an invisible or non-monetary cost. What about the cost of starting to work? There is no immediate monetary cost, but there is an important invisible cost: I will not have time to study, so I will usually have access to worse jobs in the future and end up earning much less money. Sometimes, when making a decision we give up money (monetary costs) but also our most valuable resource, time. Therefore, to the monetary cost we must add the invisible costs of what we stop doing or the money we stop earning in that time. Not all invisible costs are related to time; if my father wants me to study and I decide to work, this decision will have an invisible (non-monetary) cost: that my father will be disappointed in me. 13 In the year 2000 many students dropped out of school and started to work because there was a construction boom that required thousands of bricklayers who could be paid more than 2000 euros per month. These colleagues used to come with their big BMW cars to "show off" in front of those who are now your professors, poor university students then, that we met to drink the sad cokes that our poor budget allowed us. At that time, those "rich" bricklayers felt like winners, and our opportunity cost really high. We had given up a lot of money to get a good education. As life would have it, years later the crisis would hit and the bricklayers would be out of work, sell their cars and sign up for night school. We, who had become teachers, would be there to explain to them the opportunity cost. 2. Sunk cost or irrecoverable cost A common mistake when making a decision is to take into account past costs that cannot be recovered at the time of the decision. These costs are called sunk costs. IRRECOVERABLE COSTS are costs from the past that do not influence the future decision. To take them into account is a mistake. These costs have already occurred, therefore, taking them into account is wrong because in the decision only present and future costs and benefits should be considered, never the past ones, which are irrecoverable. Example Two friends "El Glori" and "El Flaco" are about to go to a concert on a hot summer night. They are not particularly excited, but Glori has already bought his ticket for 15 euros and Flaco has been given one as a gift. At the last minute, they receive a call from their friend "Coyote" who invites them to his house with swimming pool and barbecue to celebrate a birthday party that they will remember for decades. The conversation between Glori and Flaco goes something like this. Flaco: - Well, obviously we are going to the party, the concert doesn't look very good and this birthday party looks spectacular. Glori: - But I already bought my ticket for 15 euros and I don't want to throw my money away. Flaco: - But this party is going to be much better. Glori, the minstrels will make songs about this party, epics will be written about what happens today. Glori: - Sure, you got a free ticket and you don't lose for going to the party. I paid 15 euros and it's not the same. You go if you want, I'm going to the concert. Unfortunately, El Flaco could not convince Glori to go to the birthday party. Glori analyzed the opportunity cost principle and thought that he would rather pay 15 euros than go to the party. If he had been more financially savvy he probably would have realized his mistake. Glori's problem is that his analysis is incorrect. Going to the party does not mean losing 15 euros. 14 Glori's analysis should be different. The 15 euros are already spent and are irrecoverable, so we forget about them. Let's think only about the benefits and costs of going to the birthday and going to the concert. The costs of going to the concert and the party are 0 in both cases and the benefits of the birthday are much higher. Glori should have gone to the party because he was not going to lose 15 euros as he said (that money was already spent and was irrecoverable). What he did lose was an anthological birthday, but that... is another story. 3. Marginal bene ts or cost So far we have focused on decisions with 2 different options: Do I study for the exam or do I go with my friend? Do I buy a T-shirt or a pair of pants? Do I study a career or do I work? Do I go with Borja Mari or to the movies? But in our life many times the decision is not to do something or not to do it, that is to say, not everything is black or white. Sometimes the decision is how much to do. That is, once I have decided that I am going to study, I don't have to do it for 24 hours. Marginal analysis helps me to know how many hours I should study (this interests you eh). In this case, what we have to look at is the benefit and cost of repeating the action. This is what we call marginal analysis. So, marginal analysis analyzes whether the last decision we made is correct or not: do I buy one more T-shirt? do I study one more hour? do I do one more university degree? The answer is always the same: Only if the benefit received is greater than the cost of repeating the action one more time. THE MARGINAL BENEFIT tells me the benefit I have obtained by repeating the action one more time. The MARGINAL COST is the cost of repeating the action one more time. An example: The mobile device dilemma Alberto's mobile device has broken and he has to buy a new one. He has two options. BQ Aquarius cell phone: it costs 150 euros and Alberto believes it has all the basics for his day-to- day life. Samsung cell phone: it costs 400 euros. The camera is better and so is the operating system. Alberto has the 400 euros saved, he wants to buy the Samsung, but does not want to run out of savings. What should he do? MARGINAL BENEFIT FOR BUYING SAMSUNG: enjoy a better camara and a good operating system MARGINAL COST FOR BUYING SAMSUNG: 250€ and run out of 15 savings. fi Solution Alberto must analyze the marginal benefit and marginal cost. That is, the cost of repeating the action one more time. In this case, repeating the action does not mean buying 2 cell phones, but buying a more expensive cell phone (the Samsung instead of the BQ). As you can see, the marginal benefit is that which improves the Samsung over the BQ. The marginal cost of the Samsung is not 400 euros (which is the total cost), it will be the 250 that there is a difference. In other words, going from the BQ to the Samsung has a cost of 250 euros. If for Alberto to have that better camera and operating system is worth 250 euros or more, he should buy the Samsung. If, on the other hand, it is worth less than 250 euros, he should buy the BQ. 4. Incentives When you get to college you see that there are many who take it easy. Imagine the real case of Carlos, he has no aptitude problem, he simply loves his life as a student and does not feel like starting to work. Considering that all college expenses are paid by his parents his analysis is as follows: "If I start working, my marginal benefit is the salary at which I would start at 800. On the other hand, my marginal cost is that I will NOT be able to continue with my life of leisure and tranquility that I am sticking to." The analysis is quite simple. Carlos prefers his life of leisure to 800 euros. MARGINAL BENEFIT OF WORKING : 800€ per month MARGINAL COST OF WORKING : Not being able to continue with his university life. But Carlos' parents know that this is a lousy decision. They don't realize that the longer it takes them to start working, the harder it will be to find a good job and earn a living wage. In other words, he does not take into account that the real opportunity cost is all the present costs (the 800 euros he loses by not working) and future costs (you will earn more in the future). But imagine that Carlos' father proposes the following to him: to make him the director of his company with a salary of 3000 euros per month the day after finishing his degree. Since people make their decisions by comparing benefits and costs, their behavior may change if either costs or benefits are modified. In other words, people respond to incentives. An INCENTIVE is anything that changes the bene ts or costs of a decision, so it can change the decision made. 16 fi You can be one of those students who are satisfied with a 5, which would make you study only 1 hour in the example of the previous section and thus go to the movies and have dinner with your friend. But if your father tells you that he will buy you a motorcycle, a console or the latest model cell phone if you get an A in that economic work, it is quite likely that you will dedicate the 3 hours necessary for the A. Incentives can be positive (reward) or negative (punishment). If your father tells you that he will take away your cell phone if you don't get an A, it is quite likely that you will also try harder. In this case the incentive would be negative. The importance of incentives Incentives are very important in economics. For example, when it is very hot, bar terraces fill up and the tables inside are empty. In this situation a bar loses half of its possible clientele. An incentive sometimes used by bars is to make the prices of the terrace more expensive, in order to encourage people to enter the bar. The same is done by some stores like "telepizza" that charge cheaper for their products if you pick them up yourself and don't ask for delivery. So when the State wants to discourage the consumption of some good (such as tobacco, very harmful to health), what it does is to apply a tax to make the product more expensive. If you are one of those foolish smokers, you should know that of the 5 euros that some brands of tobacco cost, 4 are taxes. As the cost of smoking increases, fewer people smoke. The State "punishes" the decision to smoke by increasing its costs. This is one of the reasons why many people change their decision from "smoking" to "quit smoking". What happened to Carlos, tell you that he finished his degree in 6 months and started as a director of his father's company the next day. Let's say that Carlos considered that his student life was worth more than 800 euros per month, but not more than the 3000 euros his father was offering him. The incentive clearly worked. 17 4. Economics and Behavioral Science Introduction Economics studies human behavior, but it's not the only science that does so. Psychology also aims to explain how people make decisions. While economics and psychology focus on different issues, they have recently merged in what is known as behavioral economics. What is Behavioral Economics? Behavioral economics is an area of economics that integrates insights from psychology. Some of the perspectives it incorporates are: 1. People Are Not Always Rational Traditional economics assumes that individuals are part of a unique species: the "Homo Economicus." It supposes that these individuals are always rational. If they run a business, they will always make decisions that maximize profits. As consumers, they will always choose products at prices that lead to maximum satisfaction, all achieved through a perfect analysis of costs and benefits. Real people, however, are "Homo Sapiens," not "Homo Economicus." They can be impulsive or emotional in their purchases. Some studies have identified several errors: A. People are too con dent. Most people are very sure of their abilities and knowledge. For example, in a study, individuals were asked numerical questions like "How many countries are in Europe?" and were told to respond with an interval they were almost sure would be correct. The experiment revealed that people were overly confident in their abilities, giving very narrow intervals, yet they frequently made mistakes (by the way, Europe has 50 countries). B. People assign too much importance to a small number of lived experiences. For example, if we want to buy a computer on Amazon, we see one that is highly rated by thousands of users. Then, a friend tells us that they bought it a month ago and it has already broken. If we are rational, we would think that our friend is just one person among thousands of Amazon reviewers. However, because our friend's story feels so real, many people will give it more importance than they should when making decisions. C. People are reluctant to change their way of thinking. People tend to interpret facts in a way that confirms their opinions. For example, in a Real Madrid vs. Barcelona soccer match, most fans believe that the referee usually favors the opposing team. If there is a penalty that could be doubtful for Barcelona, most Barcelona fans will interpret it as a clear penalty, while most Real Madrid fans will insist it wasn't. 18 fi 2. People Care About Justice Sometimes, people make irrational decisions because they perceive an injustice. For instance, imagine you have a garden, and a heavy snowfall covers it. To prevent damage, you need to remove the snow, but you have tools at home that would require a great effort. You go to a hardware store to buy a shovel, and they tell you it costs 60 euros. If you are rational, you would buy the shovel if you believe the effort saved (the benefit of the shovel) outweighs the 60 euros cost. However, imagine that you know the shovel was priced at 20 euros last week, and all hardware stores have raised their prices due to the snowfall. Many people, even if willing to pay 60 euros, will leave the store in anger upon learning about the price hike, feeling the store is taking advantage of the situation. 3. People Are Impatient in the Short Term Economics textbooks also assume that people have stable preferences where the time horizon does not matter. If we are impatient, we will be so today, tomorrow, and in ten years. However, behavioral economics argues that people are much more impatient in the short term than in the long term. For instance, a smoker promises to quit smoking for their health in the long term but lights up another cigarette just ten minutes later. Someone looking to lose weight commits to a balanced diet but breaks it at the first opportunity with pizza or french fries. A student knows they need to do homework and study consistently for better grades but ends up spending hours on their phone. This inconsistency in making long-term decisions and breaking them in the short term is irrational and can have economic costs. For example, a person who commits to going to the gym 3 or 4 times a week and buys a full subscription. They later break their promise and barely go a few days a month, making a "pay-per-visit" option more cost-effective if they only visit the gym occasionally. 4. Cognitive biases and people's decision-making. Psychologists and behavioral economists have identified a series of cognitive biases that affect people's decision-making. What is a cognitive bias? A COGNITIVE BIAS is a psychological effect that causes a distortion in the way information from the outside world is perceived. This creates a distortion or lack of logic that leads to decisions tending to be in error. 19 Types of cognitive biases: A. Mental Accounting: People often divide their money into different categories known as mental accounts, depending on how they plan to use it. For example, some individuals might splurge while on vacation because they feel they've earned it or because they've already spent a significant amount of money, thinking, "What's another 20 euros on this vacation when I've already spent so much?" However, the same people might scrutinize prices at a supermarket to save those same 20 €. People also have different mental accounts based on the source of the money. Specifically, people tend to value money they've worked hard to earn or save more and spend it more carefully. On the other hand, they place less value on money obtained easily, such as winning a prize, and are more willing to spend it. This doesn't make sense since they should treat all money with the same care. People also have different mental accounts based on the source of the money. Specifically, people tend to value money they've worked hard to earn or save more and spend it more carefully. On the other hand, they place less value on money obtained easily, such as winning a prize, and are more willing to spend it. This doesn't make sense since they should treat all money with the same care. B. Anchoring Effect: People tend to give too much importance to the first information they receive because it creates an anchor in their subconscious. For example, if I ask you, "Do you think Cervantes lived more or less than 40 years?" and then I ask, "At what age do you think Cervantes died?" The number 40 becomes anchored in your mind, and you're likely to give a similar number (Cervantes died at the age of 68). An example of anchoring is the price that comes to mind when you first see a product. This is a strategy often used by many stores, initially stating that something has a very high price, only to later reduce it to make it seem more affordable. C. Herd Effect: Sometimes, people do certain things because others are doing them. For example, if you're moved to a different class halfway through the school year and see everyone taking notes from the teacher, you're quite likely to do the same. When choosing a café for a coffee, you may select a crowded one over another because it's busier. Many pubs and nightclubs try to capitalize on this effect by offering early discounts or promotions to attract customers to their establishments, which then serve as bait to attract more customers later. D. Framing Effect: People may be inclined to make different decisions depending on how options are presented to them. Typically, we choose options presented in a positive manner. For example, if you were given two options, which would you choose: a brand of milk that is 99% fat- free or one that contains only 1% fat? Many people choose the first option because it seems healthier, when in reality, both brands have the same fat percentage. Cosmetic companies always convey the message of "feeling younger" instead of "slowing down aging.” E. Endowment Effect: People tend to value an item more when they already own it. For example, a homeowner often asks for a higher price when selling their house compared to what they would offer to buy that same house. Many companies leverage this effect by initially offering a product at a very low price (such as a subscription to a premium TV platform). Once consumers consider the product as "theirs," they are more willing to accept price increases. 20 F. Loss Aversion: Most people prefer to avoid losses rather than make gains. For example, if you find a 5 euro bill on the street, you'd be happy. However, if you lose that money afterward, the feeling of loss would be greater than the initial positive feeling. Imagine there's an investment opportunity with a 50% chance of making money and a 50% chance of losing money. The potential gain is 100 euros, and the possible loss is 50. Logically, you should make the investment, but many people won't because they fear the potential loss, even if the potential gain is much larger. G. Decoy Effect: It shows how the introduction of a third product can change the choice between the first two. For example, if you're offered a mobile phone for 300€ and another for 350€, some may choose the first, and others the second. However, if they introduce a much more expensive model, say 800€, most people will now choose the 350€ mobile phone, as they believe they can get the "intermediate model" for only 50 euros more. 21