Chapter 9 Making Decisions

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1 Goldwasser AP Microeconomics Chapter 9 Making Decisions BEFORE YOU READ THE CHAPTER Summary Chapter 9 explores two questions either-or and how much and then provides a framework for making decisions arising from these two questions. The chapter considers the importance of opportunity cost when making a decision about which of two possible activities to do, while marginal analysis is introduced as an approach to decision making that focuses on how much of an activity is the right level. The chapter also explores which costs need to be incorporated into decision-making analysis and which costs the sunk costs- should be ignored when making decisions. Lastly, in its discussions of present value, the chapter provides a method for measuring costs and benefits when these costs and benefits arrive at different times. Chapter Objectives Objective #1. Due to scarcity or resources, it is not possible to do everything. This scarcity of resources implies that the true cost of anything can best be measured in terms of its opportunity costs, or the value of consumption or production that is forgone when a choice is made to consume or produce something else. Objective #2. There are two broad categories of costs: explicit costs and implicit costs. Explicit costs are costs that require a direct outlay of money. Implicit costs do not involve an outlay of money but are instead equal to the value in dollars of all the benefits that are forgone when making a particular decision. Economic decision making requires consideration of both explicit and implicit costs. Objective #3. The economic cost of any activity you do should include the cost of using any of your own resources for that activity.

2 Objective #4. There are two general types of profits: accounting profits and economic profits. The accounting profit of a business is equal to it total revenue minus its explicit cost and depreciation. Depreciation measures the dollar value of the reduction in value of capital equipment a business owns it is the dollar value of the capital that wears out at a business. Depreciation is measured per year. Economic profit for a business equals the business s total revenue minus its total costs where those total costs include both the explicit and implicit costs of operating the business and well as depreciation costs. In particular, economic profits include the implicit cost of capital and the implicit cost of the owner s time and energy. Both capital and the owner s time and energy could be used in other ways, and the opportunity costs of these resources needs to be incorporated into the measure of total costs when measuring economic profit. The implicit cost of capital is the opportunity cost of the capital used by a business, while the implicit cost of the owner s time and energy is the opportunity cost of that time and energy. Objective #5. Marginal analysis compares the benefit of doing a little bit more of an activity with the cost of doing a little bit more of the activity. Marginal benefit measures the benefit of doing a little bit more of the activity while marginal cost measures the cost of doing a little bit more of the activity. Marginal cost is measured as the change in total cost from producing one additional unit of the good. Marginal costs may be decreasing, constant, or increasing as production increases. In Figure 9.1, quantity measured on the horizontal axis and marginal cost (MC) is measured on the vertical axis in dollars per unit of output. Marginal cost decreases as output increases from 0 units to Q1 units, marginal cost is constant as output increases from Q1 to Q2 units, and marginal cost increases as output increases beyond Q2 units. In other words, at outputs less than Q1, marginal cost is greater than MC1 but decreases as output increases; at outputs between Q1 and Q2, marginal cost is constant and equal to MC1; and at outputs greater than Q2, marginal cost is greater than MC1 and increases as output increases.

3 Marginal benefit is the change in total benefits from consuming or producing one more unit of the good. Marginal benefit typically decreases as quantity increases; each additional unit of the good yields less benefit than the previous increase in output. Not all goods have decreasing marginal benefit: some goods exhibit constant marginal benefit, in which the benefit from producing each additional unit of the good is the same regardless of how many units have already been produced. Figure 9.2 illustrates a marginal benefit curve. Marginal benefit is measured in dollars per unit. Objective #6. The principle of marginal analysis states that the optimal quantity of an activity is that quantity where the marginal benefit equals the marginal cost. When production of an activity occurs at the point where marginal benefit equals marginal cost, the total net gain from the activity is maximized. When marginal benefit is greater than marginal cost, too little of the good is being produced since the production of one more unit of the good adds more benefits than costs; when marginal benefit is less than marginal cost, too much of the good is being produced since the addition to costs from producing the last unit of the good is greater than the addition to benefits from producing the last unit. Figure 9.3 illustrates the optimal quantity of the good, Q*, where marginal costs equal marginal benefits.

4 Objective #7. Sunk costs refer to costs that have already been incurred. When making decisions about future activities, sunk costs should be ignored since they have no influence on the actual costs and benefits that the future activity generates. Objective #8. The present value calculation is a method for evaluating the value today of a payment to be received or made at some point in the future. This calculation is useful when comparing the benefits and costs from an activity when these benefits and costs arrive at different points in time. By using present values in evaluating a project, you can evaluate the project as if all the costs and benefits from the project were occurring today rather than at different times. The present value calculation recognizes that a dollar held today is worth more than a dollar held a year from now. You can use the interest rate to compare the value of a dollar today to a dollar received at some point in the future: the interest rate measures the cost to you of delaying the receipt of a dollar of benefit, or the benefit to you of delaying the payment of a dollar of cost. Suppose you lend out $x today with the expectation that you will be repaid a dollar a year from now. The dollar you receive a year from now should be equal to $x plus the interest you receive from the borrower. If interest rate is represented as r, then we can express this idea as follows: the payment you receive a year from now ($1) equals x(1+r). Thus $x is the present value of the $1 you receive a year from now, and the present value of a payment of $1 made a year from now is $x=1/(1+r). This method converts future dollars into their present values so that the time factor issue can be eliminated when making decisions. The present value concept can be expanded to a number of years. For example, the present value of a payment made N years from now is (future value)/(1+r) N. The net present value is the present value of current and future benefits minus the present value of current and future costs. When comparing potential projects, the project with the highest net present value is financially the most attractive project to undertake.

5 Key Terms Notes explicit cost a cost that involves actually laying out money implicit cost a cost that does not require the outlay of money; it is measured by the value, in dollar terms, of forgone benefits. accounting profit a business s revenue minus the explicit cost and depreciation. economic profit a business s revenue minus the opportunity cost of resources; usually less than the accounting profit. capital the combined value of a business s assets; includes equipment, buildings, tools, inventory, and financial assets. implicit cost of capital the opportunity cost of the capital used by a business; that is, the income that could have been realized had the capital been used in the next best alternative way. marginal cost the additional cost incurred by producing one more unit of a good or service. constant marginal cost each additional unit costs the same to produce as the previous one. marginal cost curve a graphical representation showing how the cost of producing one more unit depends on the quantity that has already been produced. increasing marginal cost the case in which each additional unit costs more to produce than the previous one. marginal benefit the additional benefit derived from producing one more unit of a good or service.

6 decreasing marginal benefit the case in which each additional unit of an activity produces less benefit than the previous unit. marginal benefit curve a graphical representation showing how the benefit from producing one more unit depends on the quantity that has already been produced. optimal quantity the quantity that generates the maximum possible total net gain principle of marginal analysis the proposition that the optimal quantity is the quantity at which marginal benefit is equal to marginal cost. sunk cost a cost that has already been incurred and is not recoverable. interest rate the price, calculated as a percentage of the amount borrowed, charged by the lender. present value the amount of money needed at the present time to produce, at the prevailing interest rate, a given amount of money at a specified future time. net present value the present value of current and future benefits minus the present value of current and future costs.

7 AFTER YOU READ THE CHAPTER Tips Tip #1. This chapter returns to the concept of opportunity cost. Economists measure costs using the concept of opportunity cost, or the value of the consumption or production forgone when a consumer or a producer chooses to consume or produce something else. You may find it helpful to review the earlier discussion of opportunity cost in this text. Tip #2. When measuring costs, economists include both explicit and implicit costs. This means that opportunity costs are incorporated into the measures of costs that economists calculate, and it implies that decision making based on economic analysis must include implicit costs. Tip #3. It is important that you understand the distinction between accounting and economic profits. Throughout this course, the focus will be on economic profits, since it is this measure that includes all the opportunity costs of producing a good or service. Accounting profit, although often referred to within the media and the business community, does not provide a full measure of the costs of producing a good or service. As you think about this issue, remember that the owner of the business incurs an opportunity cost associated with the use of their time and capital, and it is important to include this opportunity cost when evaluating the profitability of the enterprise. Tip #4. By this point in the course, you should be growing comfortable with the discussion of marginal costs and marginal benefits and why the optimal level of production occurs when the marginal cost equals marginal benefit. If marginal cost is greater than marginal benefit, too much of the good is being produced. If marginal cost is less than marginal benefit, too little of the good is being produced. Tip #5. The calculation of present value is a calculation that allows you to compare a stream of payments occurring over time to another stream of payments occurring over some other period of time. This calculation is highly useful, and you should practice using it until you are comfortable with the concept as well as the technique.