Counting the Costs
Errors and omissions in making
economic decisions
Frank/Bernanke, Chapter 1 (part 2)
Error 1: Forgetting opportunity
costs
The economic cost of an action includes the
cost of opportunities not taken:
-- the cost of college includes not only
tuition, but also wages not collected
because of the job not taken.
-- the cost to GM of manufacturing more
SUVs includes not only the price of steel
and plastic and glass, but the profit not
made on sedans which were not produced.
Example: the Wallflowers and the Wilburys (Frank,
ch.1, prob. 10 -- modified)
Wallflowers are giving a free concert; the Wilburys are
giving a concert which will cost $8 on the same night.
You prefer the Wilburys; your reservation price for
hearing their concert (if you had no other option) is $12.
What is the cost of hearing the Wallflowers?
Their concert is free, but going to it means giving up the
opportunity to hear the Wilburys and gain
$ 4 of economic surplus
($12 reservation price - $ 8 cost)
Go to the Wallflowers only if you value their concert at
more than $4, the value of the opportunity foregone.
Kwame Nkrumah the Decision Maker
Soap …?
Selling Ghana’s soap:
http://www.island.net/~ydrums/black.htm
… or cocoa?
Example: interest on loans
• Interest on loans is often regarded as unfair –
• Aristotle found it “unnatural”
• In the Middle Ages, it was labeled “usury” and
regarded as sinful.
• Most countries still maintain “usury laws” limiting
the amount of interest that can be charged.
•
•
http://www.time.com/time/europe/biz/magazine/0,9868,99926,00.html
Note that there is an economic justification for some limits on the rate of
interest: see from the University of Bari:
http://www.dse.uniba.it/Seminari/CocoDemeza.htm
Interest and opportunity cost
• The opportunity cost argument for interest is
simple: if you loan money to anyone, you give up
the opportunity to invest it productively.
• “wherever a great deal can be made by the use
of money, a great deal will commonly be given
for the use of it” – Adam Smith, Wealth of
Nations, (Book I, ch. 9, p. 90 of Cannan edition)
• Hence, “in our North American and West Indian
colonies, not only the wages of labour, but the
interest of money, and consequently the profits
of stock, are higher than in England” (p. 94)
Mike the Mushroom Farmer
• Mike knows that if he invests his spare cash in
mushrooms, he can make a profit of 20 percent
at the end of one year, and expects the price to
remain constant.
• If Zoe asks Mike for a loan of $10,000, she
should not be surprised to be asked to pay 20
percent interest – Mike is giving up the
opportunity to make that much profit.
• In practice, adjustments will be made for the risk
that the loan is not repaid (“risk premium”), and
for the risk that mushroom price will fall.
Error 2: considering “sunk costs”
• “Sunk costs” or “fixed costs” are costs which will
be incurred whether or not an action is taken.
• They should be ignored in deciding on a course
of action.
• If you’ve bought the (non-refundable) ticket to
the football game, should you attend during a
blizzard? Your answer should be the same as if
you were given the ticket for free.
Fixed and Variable Costs
• If you own a car, you have to pay:
– Fixed costs such as loan payments and
insurance
– Variable costs such as gasoline, new tires (the
old ones wear out only if the car is driven)
– The decision about whether to take a trip
should be based on the variable costs alone,
since these are the only costs that will change
if you take the trip.
Average and marginal costs
• The fixed/variable distinction is closely related to
the average/marginal distinction.
• Total costs = Fixed costs plus variable costs.
• Average cost = Total cost divided by number of
units of a good (or level of activity).
• Marginal cost = Change in variable cost resulting
from one more unit of a good (or an increase in
the level of an activity).
– Note that the definition could have said “Change in
total cost…”, since variable costs are the only ones
that change.
The Pajama Game
The musical did have an economic
theme – a dispute over a wage
increase of seven and a half
cents.
Here, we assume you are the
manager, worried about:
1. How to pay the interest on the
money you borrowed to build
the pajama factory.
2. How to keep track of the costs
of producing pajamas.
http://www.sonymusic.com/clips/selection/30/089253/089253_01_02_30.wav
Click above for the title song.
TC = 10000 + 5 Q
• The above cost equation is a way of tying
together the different cost concepts.
• Total cost = Fixed cost + variable cost
• The 10,000 is fixed – you will pay $ 10,000
whether or not you produce a single pair of
pajamas (interest on loans to build plant)
• The 5 Q term varies with quantity – you will pay
another $ 5 for each pair of pajamas you
produce (for cloth, buttons, labor)
Average cost
• Average cost = Total cost divided by Quantity
• If Q = 1000, TC = 10,000 + 5 (1,000) or
TC = $15,000
• If Q = 1,000 then AC = $ 15,000 divided by
1000, or Average Cost = $ 15.00.
• Repeat for Q = 2000, to find
• TC (at 2000) = 10,000 + 5 (2,000) = $ 20,000
• AC (at 2000) = $ 20,000 divided by 2,000 or
average cost = $ 10.00
• Note that average cost decreases with output
Variable and Marginal Cost
• Total Cost = 10,000 + 5 Q
• Fixed cost = 10,000 (doesn’t change with Q)
• Variable cost = 5 Q (increases when Q
increases)
• Marginal cost = $ 5
– Every EXTRA unit of production means an EXTRA
cost of $ 5.
– Note that in this case marginal cost does not increase
with quantity.
Graph of total cost
Costs ($)
Total Cost = 10,000 + 5 Q
Fixed cost = 10,000
$ 10,000
1000
2000
Pajamas
Graph of total cost
Costs ($)
Total Cost = 10,000 + 5 Q
$20,000
$15,000
Fixed cost = 10,000
$ 10,000
1000
2000
Pajamas
Graph of total cost
Costs ($)
Total Cost = 10,000 + 5 Q
$20,000
$15,000
Fixed cost = 10,000
$ 10,000
1000
2000
Pajamas