Chapter 17, Lesson 2

 Making a trade-off is giving up one alternative good or service for another.  If you choose to buy one thing, you may not be able to afford to buy another.  A trade-off does not necessarily have to apply to money, though.  For instance, the trade-off for passing a test might be that you stay in and study instead of going out.  Governments and businesses also make trade-offs.  They have to decide where their time and money is best spent.

 Opportunity cost is the cost of the next-best use of your money or time when you choose to do one thing rather than another.  In economics, the term is reserved only for the next-most-attractive alternative.  For instance, if a city government has to choose between spending money on park improvements or fixing sidewalks, and they decide to make park improvements, the opportunity cost would be the unrepaired sidewalks.  It works the same way with time.  If you choose to watch 1 hour of tv, that is one less hour for you to study.

 In order to make any sort of decision about their business or lifestyle, they have to assess their costs.  Fixed costs are expenses that do not change.  This could be something like rent or insurance; it is the same every month.  Variable costs do change depending on what happens that month.  If you drive more that month, then your gas expenditure goes up.  If a business stays open longer hours, their labor costs go up.  Total cost is the fixed costs and variable costs combined.  When businesses face a decision, they typically think about increasing or decreasing activities in small units.  They look at their marginal cost, which is the increase in expenses caused by producing another unit of something.  How much will it cost for Ford to produce 1 more car or for Chilis to stay open 1 more hour?

 Revenue is the money a business receives from selling its goods or services.  If you add up all of the sales from your lemonade stand for a month, that is your revenue.  Marginal revenue is the additional income received from each increase in one unit of sales.  For instance, if you keep your stand open 1 hour longer or if you start selling iced tea as well, how much more will you make?  Marginal analysis compares the additional benefit of doing something with the additional cost of doing it.  If the additional benefit is greater than the additional cost, the rule is to do it.  If the cost is greater than the benefit, the rule is not to do it.  For instance, if selling iced tea causes you to get more customers and make more revenue, great!  If it turns out that tea is too expensive and your costs go up too much, don’t do it.

 When doing a marginal analysis, the rule is to continue doing something until the marginal cost is equal to the marginal revenue.  For instance, a business that usually closes at 5 decides it might be a good idea to stay open later.  They have to pay their staff more to do it and keep the lights on longer, but they also keep the customers coming.  Staying open until 6 and then 7 allowed them to increase their total revenue, and they made enough money to make up for their extra costs and still make a profit.  Things started to drop off, though, when they stayed open until 8.  Not enough people came in for that last hour, so there was no benefit to staying open.

 Benefit-cost analysis compares the size of the benefit with the size of the cost by dividing the two.  This type of analysis helps businesses choose among 2, 3, or more projects.  For instance, a restaurant may be trying to decide whether to serve tuna or flounder as their new dish.  The tuna is expected to bring in $100 more in sales per day, but it will cost $80.  We divide 100 by 80 and come up with 1.25 which is the benefit-cost ratio.  The flounder is expected to bring in $150 more in sales per day, but it will cost $90.  We divide 150 by 90 and find that the benefit-cost ratio is  Therefore, the flounder option is better.

 The decisions most people face cannot always be evaluated in terms of money.  Yet even those decisions can be analyzed with marginal analysis.  For example, suppose you are deciding how long a nap to take.  One hour of sleep will really help get your energy back, but for every hour after that, there are other things you really should be doing.  The things you don’t get done would be your opportunity costs, and therefore the longer you sleep the higher your marginal costs.  Still, a nap sure would be nice right now, right???