WHAT YOU WILL LEARN IN THIS CHAPTER chapter: 9 >> Krugman/Wells Economics ©2009  Worth Publishers Making Decisions

WHAT YOU WILL LEARN IN THIS CHAPTER  How economists model decision making by individuals and firms  The importance of implicit as well as explicit costs in decision making  The difference between accounting profit and economic profit, and why economic profit is the correct basis for decisions  The difference between “either–or” and “how much” decisions  The principle of marginal analysis  What sunk costs are and why they should be ignored  How to make decisions in cases where time is a factor

Opportunity Cost and Decisions  An explicit cost is a cost that involves actually laying out money.  An implicit cost does not require an outlay of money; it is measured by the value, in dollar terms, of the benefits that are forgone.

Opportunity Cost of an Additional Year of School

Accounting Profit Versus Economic Profit  The accounting profit of a business is the business’s revenue minus the explicit costs and depreciation.  The economic profit of a business is the business’s revenue minus the opportunity cost of its resources. It is often less than the accounting profit.

Capital  The capital of a business is the value of its assets.  The implicit cost of capital is the opportunity cost of the capital used by a business.

Profits at Babette’s Cajun Cafe

“How Much” Versus “Either–Or” Decisions

Marginal Cost The marginal cost of producing a good or service is the additional cost incurred by producing one more unit of that good or service.

Constant Marginal Cost  For every additional chicken wing per serving, Babette’s marginal cost is $0.80. Babette’s portion size decision has what economists call constant marginal cost: each chicken wing costs the same amount to produce as the previous one.  Production of a good or service has constant marginal cost when each additional unit costs the same to produce as the previous one.

$ Marginal cost (per wing) Quantity of chicken wings Marginal cost curve, MC Marginal Cost

Marginal Benefit The marginal benefit of producing a good or service is the additional benefit earned from producing one more unit of that good or service.

Marginal Cost - Marginal Benefit  The 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 increasing marginal cost when each additional unit costs more to produce than the previous one.  The marginal benefit of a good or service is the additional benefit derived from producing one more unit of that good or service.  The marginal benefit curve shows how the benefit from producing one more unit depends on the quantity that has already been produced.

Decreasing Marginal Benefit  Each additional lawn mowed produces less benefit than the previous lawn  with decreasing marginal benefit, each additional unit produces less benefit than the unit before.  There is decreasing marginal benefit from an activity when each additional unit of the activity produces less benefit than the previous unit.

Marginal benefit curve, MB Marginal cost (per wing) Quantity of chicken wings Marginal Benefit

Felix’s Net Gain from Mowing Lawns

Marginal Analysis  The optimal quantity is the quantity that generates the maximum possible total net gain.  The principle of marginal analysis says that the optimal quantity is the quantity at which marginal benefit is equal to marginal cost.

Babette’s Net Gain from Increasing Portion Size

Babette’s Optimal Portion Size $ Marginal benefit (marginal cost per wing) Quantity of chicken wings Optimal point MC MB Optimal quantity Total net gain (profit per serving) Net gain (per wing) Quantity of chicken wings $ $ –0.10 –0.20

Sunk Cost  A sunk cost is a cost that has already been incurred and is non-recoverable. A sunk cost should be ignored in decisions about future actions.  Sunk costs should be ignored in making decisions about future actions.  They have already been incurred and are non- recoverable, they have no effect on future costs and benefits.

The Concept of Present Value  When someone borrows money for a year, the interest rate is the price, calculated as a percentage of the amount borrowed, charged by the lender.  The interest rate can be used to compare the value of a dollar realized today with the value of a dollar realized later, because it correctly measures the cost of delaying a dollar of benefit (and the benefit of delaying a dollar of cost).  The present value of $1 realized one year from now is equal to $1/(1 + r): the amount of money you must lend out today in order to have $1 in one year. It is the value to you today of $1 realized one year from now.

Present Value  Let’s call $V the amount of money you need to lend today, at an interest rate of r in order to have $1 in two years.  So if you lend $V today, you will receive $V(1 + r) in one year.  And if you re-lend that sum for yet another year, you will receive $V × (1 + r) × (1 + r) = $V × (1 + r) 2 at the end of the second year.  At the end of two years, $V will be worth $V × (1 + r) 2 ;  If r = 0.10, then this becomes $V × (1.10) 2 = $V × (1.21).

Present Value  What is $1 realized two years in the future worth today?  In order for the amount lent today, $V, to be worth $1 two years from now, it must satisfy this formula: $V × (1 + r) 2 = $1  If r = 0.10, $V = $1/(1 + r)2 = $1/1.21 = $0.83  The present value formula is equal to $1/(1 + r) N

Net Present Value The net present value of a project is the present value of current and future benefits minus the present value of current and future costs.

SUMMARY 1.All economic decisions involve the allocation of scarce resources. Some decisions are “either–or” decisions, other decisions are “how much” decisions. 2.The cost of using a resource for a particular activity is the opportunity cost of that resource. Some opportunity costs are explicit costs; they involve a direct payment of cash. Other opportunity costs, however, are implicit costs; they involve no outlay of money but represent the inflows of cash that are forgone. Companies use capital and their owners’ time. So companies should base decisions on economic profit, which takes into account implicit costs such as the opportunity cost of the owners’ time and the implicit cost of capital.

SUMMARY 3.A “how much” decision is made using marginal analysis, which involves comparing the benefit to the cost of doing an additional unit of an activity. The marginal cost of producing a good or service is the additional cost incurred by producing one more unit of that good or service. The marginal benefit of producing a good or service is the additional benefit earned by producing one more unit. 4.In the case of constant marginal cost, each additional unit costs the same amount to produce as the unit before; this is represented by a horizontal marginal cost curve. With increasing marginal cost, each unit costs more to produce than the unit before. In the case of decreasing marginal benefit, each additional unit produces a smaller benefit than the unit before.

SUMMARY 5.According to the principle of marginal analysis, the optimal quantity is the quantity at which marginal benefit is equal to marginal cost. 6.A cost that has already been incurred and that is nonrecoverable is a sunk cost. 7.To evaluate a project in which costs or benefits are realized in the future, you must first transform them into their present values using the interest rate, r. The present value of $1 realized one year from now is $1/(1 + r), the amount of money you must lend out today to have $1 one year from now. Once this transformation is done, you should choose the project with the highest net present value.