Presentation on theme: "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."— Presentation transcript:
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 1.67. 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???