Ecn 201 1st Edition Lecture 11Outline of Last Lecture I. Price elasticity of supplyII. TaxesIII. Deadweight LossIV. VocabV. The Tax SystemOutline of Current LectureI. Explicit and Implicit CostsII. ProfitIII. Cost of CapitalIV. Decision MakingV. Behavioral EconomicsVI. IrrationalityCurrent LectureDecision Making by Individuals and FirmsCosts, Benefits, and Profits-Decisions depend on comparing costs to benefits-The quality of their decisions depends on how well they understand costs and benefits.Ex. When you want children and how many you wantCost-All cost ultimately is the opportunity cost-Opportunity cost: anything you must give up to get something. It contains Explicit Costs and Implicit CostsExplicit vs Implicit Costs-An explicit cost is a cost that requires an outlay of money-An implicit cost does not require an outlay of money; it is measured by the value, in dollar terms, of benefits that are forgoneEx. Cost of books (explicit) Wages forgone because of being a full-time student (implicit)Definitions of Profit: Accounting vs. Economic Profit-Accounting profit = revenue – explicit cost.-Economic profit = revenue – explicit cost – implicit cost.-Economic profit:- equals revenue minus the opportunity cost of all resources used.These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- is usually less than accounting profit- shows a more complete picture of costs- helps businesses and individuals make better informed decisions- is the measure economists prefer.The Implicit Cost of Capital-Capital is the total value of assets owned by an individual or firmphysical assets + financial assets-The implicit cost of capital is the opportunity cost of the use of one’s own capitalEx: how about put the tuition fee you are paying now to URI in the bank deposit and earn interest?Implicit cost of capital would be the interest rate you can earn based on the tuition fee you payDecision Making-There are different types of decisions:1. A choice between two alternatives (“either–or”)2. A more complex choice that requires us to choose at the margin (“how much?”)Ex. Come to the university or not? Buy a car or not? Eat sandwich or Chinese? How many hours to study? How much bread to buy this week?Making “Either-Or” Decisions-Principle of “either–or” decision making: when faced with an “either–or” choice between two activities (all else equal) choose the one with the positive economic profit.Example Question: What if, instead of just two options, there are three or more? Does the principle of “either–or” decision making still apply?Yes. Any choice between three or more options can always be boiled down to a series of choices between two alternatives.Making “How Much” Decisions-The Role of Marginal Analysis: To make good “how much?” decisions requires weighing the additional costs and benefits of each increase.-Marginal cost: the additional cost incurred by producing one more unit of that good or service.Ex. What does it cost to make one more doll?-The marginal cost curve shows how the cost of producing one more unit depends on the quantity that has already been produced.-Increasing marginal cost: Each additional unit costs more to produce than the previous one.-Constant marginal cost: Each additional unit costs the same to produce as the previous one.-Decreasing marginal cost: Each additional unit costs less to produce than the previous one.-Marginal benefit: The additional benefit derived from producing one more unit of that good or service.-Marginal benefit curve: shows how the benefit from producing one more unit depends on the quantity that has already been produced-Profit-maximizing principle of marginal analysis: Choose the optimal quantity satisfiesmarginal benefit ≥ marginal cost-Sunk cost: a cost that has already been incurred and is not recoverable. A sunk cost should be ignored indecisions about future actions (but this is sometimes hard to do).Behavioral Economics-We assume humans are mostly rational-A rational decision maker always chooses the available option that leads to the outcome he or she mostprefers.-An irrational decision maker chooses an option that leaves him or her worse off than choosing another available option.-Three reasons people might rationally choose a worse payoff:- Concerns about fairness: Tipping waiters- Bounded rationality—“good enough”: Making a choice that is close to (but not exactly) the highest possible profit MAY MAKE SENSE because the effort of finding the best payoff is too costly. $2.99- Risk aversion: Willingness to sacrifice some economic payoff in order to avoid a potential loss IS FAIRLY COMMON.Irrationality: An Economist’s Views-There are known (and predictable) holes in our rationality that stem from six established decision-making mistakes.1. Misperceptions of opportunity costs: If we don’t understand all of the costs, we cannot make a rational choice. For example: Ignoring non-monetary cost, which is still the part of opportunity cost2. Overconfidence: Nonprofessional investors: We tend to think we know more than we actually do.3. Unrealistic expectations about future behavior: Most of us are overly optimistic about our future behavior and level of discipline.4. Counting dollars unequally: Mental accounting: the habit of mentally assigning dollars to different values so that some dollars are worth more than others. (E.g., spending more with credit cards than cash)5. Loss aversion: an oversensitivity to loss that leads to unwillingness to recognize a loss and move on. $100 loss ≠ $100 gain6. Status quo bias: the tendency to avoid making a decision altogether.In Austria, almost 100% choose voluntary organ donation. In neighboring (and culturally similar) Germany: 12%. Sweden: 86%. Denmark: 4%.The common thread: in Sweden and Austria the form contains an “opt-out” box for donation. In Germany and Denmark you must check a box to “opt-in” to the