Chapter 9 Costs Benefits and Profits Explicit versus Implicit Costs o The opportunity cost of a decision can be broken down into explicit and implicit costs o Explicit costs are costs that involve an outlay of money i e the explicit cost of school is tuition o Implicit costs are costs that do not involve an outlay of money instead it is measured in the value of the benefits that are foregone i e the income you could have made if you had not gone to school for that year o Many times the implicit costs are ignored and only explicit costs are taken into account when making a decision this is a mistake because implicit costs are usually a lot greater than explicit and ignoring them could cause misguided decision Accounting Profit vs Economic Profit o Accounting profit equal to revenue minus explicit cost o Economic profit equal to revenue minus the opportunity cost of resources the total explicit and implicit costs usually less than the accounting profit This is what economists prefer when gauging profit o Capital the total value of assets owned by an individual or firm physical assets plus financial assets o The implicit cost of capital 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 o Either Or Decision you must decide between two activities Principle of Either Or decision making when making an eitheror decision between two activities choose the one with the positive economic profit For example if you calculate the profit of both choices in the future and Choice A gives you 1 000 more than Choice B you would choose A If you have more than one choice you can still use the principle simply go through all the choices and use a sort of bracket system compare choice A to choice B the winner of that pairing goes against choice C the winner of that goes against choice D etc Making How Much Decisions The Role of Marginal Analysis How Much Decision you must decide how much of a given activity to undertake Marginal analysis comparing the benefit of doing a little more of an activity to the cost of doing a little more o Marginal Cost the cost of producing or consuming one more unit of a good o 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 unit of a good costs more to produce than the previous one this is usually what happens in real life situations i e the marginal cost of continuing your education increases every year because each year you are more educated and therefore could make more money if you were not in school marginal cost curve is positive sloping Constant marginal cost each unit of a good costs the same to produce as the last marginal cost curve is a straight line Decreasing marginal cost each unit of a good cost less to produce than the previous unit i e could happen when you become more experienced in making something originally you might be sluggish and mistake prone but when you become more experienced and efficient costs are less and less to produce marginal cost curve is a negative sloping line Marginal cost can fluctuate as well m cost can originally be decreasing as workers learn how to make the product efficiently then become increasing as the production goes on Total cost vs marginal cost Just because total cost is increasing does not mean marginal cost has to be increasing If marginal cost is decreasing total cost is still increasing because the marginal cost is above zero and therefore is still continuously adding to the total cost albeit at a decreasing level each time Therefore total cost increases as long as marginal cost is greater than zero o Marginal Benefit the benefit of producing or consuming one more unit of a good Marginal benefit curve a graph showing the benefit of producing one more unit depends on the quantity that has already been produced Decreasing Marginal Benefit each additional unit produced yields a smaller benefit than the previous unit benefit is still positive but is becoming less and less positive Marginal benefit can also be constant which happens pretty often Marginal Analysis o Profit Marginal benefit marginal cost o Optimal quantity the quantity that generates the highest possible total profit This occurs right before profit turns negative or before marginal cost becomes greater than marginal benefit The optimal point when graphed is when marginal cost and marginal benefit intersect if marginal benefit is higher then the person can gain more if marginal cost is higher then the person should stop using more of that service When looking at total profit in a table the optimal point is the highest number in the total profit column i e if the profit goes from 0 to 10 to 20 to 10 the optimal point would be where total profit 20 o Profit maximizing principle of marginal analysis when making a profit maximizing how much decision the optimal quantity is the largest quantity at which marginal benefit is greater than or equal to marginal cost o Why do we set the marginal cost and marginal benefit equal to each other to reach optimal quantity This is the point at which you will make your peak profit When one side is greater than the other you could do better Additionally when looking at the additional profit between each additional unit the marginal profit technically this is more of a meta profit analysis In other words the marginal profit is really just showing the frequency of the profit gain So when additional profit is negative that doesn t mean profit itself is negative it simply means that you re not increasing profit for this unit as much as you were for the last unit you used look at the chart on p 253 to understand this Sunk Costs a cost that has already been incurred and is non recoverable a sunk cost should be ignored in decisions about future actions Behavioral Economics Most economic models are built on the assumption that people try to get the best economic outcome for themselves However this isn t always the case Rational decisions are ones that give the decider his or her preferred outcome not necessarily the best economic outcome o Usually the rational decision IS the best economic payoff people can another option for a reason other than economic payoff and still be rational because they re still choosing the option they want most Reasons people will choose options that do not give them the best economic payoff o