MAKING DECISIONS—BENEFITS AND COSS OF MAKING A DECISION
The core of ECONOMICS is the analysis of benefits and costs of decisions made by individuals, households, firms, governments, and other
organizations.
The decisions involve making choices among various alternatives—how to allocate scarce resources among different alternatives. What is the
optimum allocation of resources?
Optimum allocation of resources means, in making a decision, compare the benefits and costs of the various choices and choose that option which
maximizes the net benefit (Cost – Benefit).
The Nature of Costs
In economics all costs are defined as opportunity costs. The true cost of getting or producing something is what one must give up to obtain or
produce that thing.
Explicit costs versus implicit costs
Explicit costs are costs that are reflected in exchange or transactions between two parties and typically involves monetary outlays.
Implicit costs reflect the opportunity cost of resources owned. They do not involve an outlay of money.
Implicit cost of capital
Capital assets are buildings, machinery, tools, inventory, and financial assets. The implicit cost of capital is the opportunity cost of capital—the
income (return) realized from the best alternative use of the capital assets.
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Explicit and implicit costs of operating a woodworking workshop
Explicit costs
Implicit costs
Staff wages and benefits
$100,000
Forgone income from capital
Wood and other supplies
150,000
Implicit rent on the workshop
Utilities
6,000
Forgone alternative salary
Insurance
4,000
Depreciation allowance
10,000
Total explicit cost
$270,000
Total explicit cost
Total opportunity cost = Explicit costs + Implicit costs =
$14,000
36,000
80,000
$130,000
$400,000
Total market value of capital equipment = $200,000
Prevailing annual interest rate = 7%
Accounting Profit versus Economic Profit
Accounting profit is determined as revenue minus explicit costs (including depreciation allowance).
Economic profit is determined as revenue minus total opportunity cost.
Total revenue from sale of furniture products
Explicit costs (including depreciation)
$420,000
$270,000
Accounting profit
$150,000
Explicit costs (including depreciation)
Implicit costs
Total opportunity cost
$270,000
$130,000
$400,000
Economic profit
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$20,000
Making “How Much” Decisions: The Role of Marginal Analysis
Most decisions are made at the margin by comparing the additional cost of the action (marginal cost) to its additional benefit (marginal benefit).
As long as Bob’s furniture manufacturing business is making a profit by, say, making 100 pieces of furniture a month, his concern is if he is
maximizing profits by producing 100 units. If he can add to his profits by producing more, then he is not maximizing his profits. His output of
Q = 100 is not optimal. To determine if he can add to his profit by expanding his output to say 110 units, he must compare the additional cost of
expanded production to the additional revenue (benefit) from increased sales . He would thus be comparing marginal cost to marginal revenue.
Explaining “optimal” decision using a little math
Benefit function:
Cost function:
Quantity
Q
0
1
2
3
4
5
6
7
8
9
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B = 45Q – 3Q²
C = 5Q + 2Q²
Total benefit
B = 45Q – 3Q²
$0
42
78
108
132
150
162
168
168
162
Total cost
C = 5Q + 2Q²
$0
7
18
33
52
75
102
133
168
207
Marginal benefit
MB = ∆B ⁄ ∆Q
$42
36
30
24
18
12
6
0
-6
Marginal cost
MC = ∆C ⁄ ∆Q
$7
11
15
19
23
27
31
35
39
220
200
180
160
C and B
140
120
100
80
60
40
20
0
0
1
2
3
4
5
Q
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6
7
8
9
10
Marginal Benefit and Marginal Cost for Very Small Changes in Quantity
Using the first derivative of the B and C functions.
B = 45Q – 3Q²
C = 5Q + 2Q²
Quantity
Q
0
1
2
3
4
5
6
7
8
9
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MB = = 45 – 6Q
MC = = 5 + 4Q
Total benefit
B = 45Q – 3Q²
$0
42
78
108
132
150
162
168
168
162
Total cost
C = 5Q + 2Q²
$0
7
18
33
52
75
102
133
168
207
NB = B – C
35
60
75
80
75
60
35
0
-45
Marginal benefit
MB = 45 – 6Q
45
39
33
27
21
15
9
3
-3
-9
Marginal cost
MC = 5 + 4Q
5
9
13
17
21
25
29
33
37
41
220
Q
0
1
2
3
4
5
6
7
8
9
MB
45
39
33
27
21
15
9
3
-3
-9
TC
0
7
18
33
52
75
102
133
168
207
MC
5
9
13
17
21
25
29
33
37
41
200
180
160
140
B and C
TB
0
42
78
108
132
150
162
168
168
162
120
100
80
60
40
20
0
0
1
2
3
4
5
6
7
8
9
10
Q
50
45
40
35
MB and MC
Q
0
1
2
3
4
5
6
7
8
9
30
25
20
15
10
5
0
0
1
2
3
4
5
6
7
8
9
10
Q
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