The Rules of Decision Making
Marginal Analysis
Opportunity Costs
• Because our resources are scarce every decision that
we make entails an opportunity cost
• Opportunity costs are not always obvious
• Explicit costs: costs requiring actual payments
• Implicit costs: foregone benefits of (already owned)
resources consumed or used in production of a good or
service
» Implicit cost of capital
» Implicit cost of labor
» Implicit cost of goods (already owned)
• Sunk Costs: Already incurred costs that cannot be
recovered and, thus, our decisions will have no
effect on
Accounting Profit vs. Economic Profit
• Accounting Profit = Total Revenue - Total Explicit Costs
• Economic Profit = Total Revenue – Total Explicit Costs
- Implicit Costs
• Accounting profits tend to overstate profits; when implicit
costs are not accounted for a reported business profit is an
exaggerated measure of profit
• When there are implicit costs “accounting profit” is
greater than “business profit”
• When a firm’s accounting profit is equal to its implicit
costs its “economic profit” is zero and its accounting
profit is considered “normal profit”
Making Decisions at the Margin
• Most of our decisions are made following our
“marginal analysis” of costs and benefits
• To achieve a given outcome we often have to make a
choice from among alternative means; we normally
try to make the “least costly” choice among the
available means
• Some times our decisions result in benefits as well as
costs;
•
•
•
•
•
How much food should you buy?
How many years of schooling should you have?
How many hours should you work?
How many workers should you hire?
How much should save/invest?
Marginal Costs vs Marginal
Benefits
• Decreasing returns and increasing marginal
costs:
Hours worked
0
1
2
3
4
5
Total Output M.Output
0
0
10
10
18
8
24
6
28
4
30
2
M.Cost
2
2.50
3.33
5
10
Marginal Costs vs Marginal
Benefits
• Decreasing returns and increasing marginal
costs:
Hours worked
0
1
2
3
4
5
M.Cost
0
2
2.50
3.33
5
10
T.Benefit
0
20
27
32
37
36
M.Benefit
20
7
5
5
1
The Optimal Choice
MC
$
5
MB
0
QO= 4
Q