Chapter 9 Decision Making by Individuals and Firms Costs Benefits and Profits when making a decision it s critical to define the costs and benefits recognize the opportunity cost first opportunity costs arises because resources are scarce accounting profit and economic profit are ways of measuring whether the benefit of an action is greater than the cost Explicit versus Implicit Costs explicit cost a cost that requires an outlay of money example the explicit cost of an additional year of schooling includes tuition implicit cost does not require an outlay of money it is measured by the value in dollar terms or benefits that are forgone example the implicit cost of an additional year of schooling includes the income you would have earned if you had taken a job instead total opportunity cost total explicit cost total implicit cost Accounting Profit versus Economic Profit pg 245 accounting profit is equal to revenue minus explicit cost economic profit is equal to revenue minus the opportunity cost of resources used it is usually less than the accounting profit profit means economic profit capital the total value of assets owned by an individual or firm physical assets plus financial assets physical assets building equipment tools and inventory financial assets cash stocks and bonds implicit cost of capital is the opportunity cost of the use of one s own capital the income earned if the capital had been employed in its next best alternative use Making Either Or Decisions must choose between two activities principle of either or decision making when faced with an either or choice between two activities choose the one with the positive economic profit mistakes most commonly arise when people or businesses use their own assets in projects rather than rent or borrow assets Making How Much Decisions The Role of Marginal Analysis decision at the margin marginal analysis comparing the benefit of doing a little bit more of some activity with the cost of doing a little bit more of that activity the benefit of doing a little bit more of something is what economists call marginal benefit and the cost of doing a little bit more of something is what they call its marginal cost Marginal Cost marginal cost of producing a good or service is the additional cost incurred by producing one more unit of that good or service production of a good or service has increasing marginal cost when each additional unit costs more to produce than the previous one marginal cost curve shows how the cost of producing one more unit depends on the quantity that has already been produced production of a good or service has constant marginal cost when each additional unit costs the same to produce as the previous one production of a good or service has decreasing marginal cost when each additional unit costs less to produce than the previous one marginal benefit of a good or service is the additional benefit derived from producing one more unit of that good or service Marginal Benefit decreasing marginal benefit from an activity when each additional unit of the activity yields less benefit than the previous unit the benefit from producing one more unit of the good or service falls as the quantity already produced rises marginal benefit curve shows how the benefit from producing one more unit depends on the quantity that has already been produced constant benefit the additional benefit from producing one more unit is the same regardless of the number of units already produced Marginal Analysis pg 252 optimal quantity the quantity that generates the highest possible total profit with small quantities the rule for choosing the optimal quantity is increase the quantity as long as the marginal benefit becomes less than the marginal cost the optimal quantity is the quantity at which marginal benefit is equal to marginal cost profit maximizing principle of marginal analysis when faced with a profit maximizing how much decision the optimal quantity is the largest quantity at which the marginal benefit is greater than or equal to marginal cost graphically the optimal quantity is the quantity of an activity as which the marginal benefit curve intersects the marginal cost curve A Principle with Many Uses the profit maximizing principle of marginal analysis can be aplied to just about any how much decision in which you want to maximize the total profit for an activity it s applicable to production decisions consumption decisions and policy decisions examples a producer must decide on the size of the new store is is constructing it makes this decision by comparing the marginal benefit or enlarging the store by 1 square value of the additional sales it makes from that additional square foot of the marginal cost the cost of constructing and maintaining the the optimal store size is the largest size at which marginal foot 9the floor space to additional square foot benefit is greater than or equal to marginal cost many useful drugs have side effects that depends on the dosage so a physician must drug optimal amelioration is consider the marginal cost in terms of side effects of increasing the dosage of a versus the marginal benefit of improving health by increasing the dosage the dosage level is the largest level at which the marginal benefit of disease greater than or equal to the marginal cost of side effects a farmer must decide how much fertilizer to apply more fertilizer increases crop yield but also costs more the optimal amount of fertilizer is the largest quantity at marginal benefit of higher crop yield is greater than or equal to the purchasing and applying more fertilizer which the marginal cost of A Preview How Consumption Decisions Are Different when individuals make choices they face a limited amount of income Sunk Costs costs people should ignore when making decisions sunk cost a cost that has already been incurred and is nonrecoverable a sunk cost should be ignored in decisions about future action Behavioral Economics people consistently engage in irrational behavior choosing an option that leaves them worse off than other available options sometimes it s entirely rational for people to make a choice that is different from the one that generates the highest possible profit for themselves Rational but Human Too rational decision maker chooses the available option that leads to the outcome he or she most prefers the outcome you prefer may not give you the best possible economic payoff there are three principal reasons why