Chapter Nine

Costs, Benefits, and profit.

It’s impossible to make a good decision if we don’t know the costs and [Link] step we need to
recognize the role of opportunity cost that arise because resources are scarce. When we make a
decision it is crucial to think in terms of opportunity cost, economists use the concept of explicit
costs and implicit costs to compare the relationship between opportunity cost and monetary outlays.

Explicit VS Implicit Costs.

An explicit cost is a cost that requires an outlay of money, for example if you decide to spend one
more year at school the explicit cost would be the tuition you have to pay.
An implicit cost does not involve an outlay of money but it’s measured by the value, in dollar terms,
of the benefit that are forgone, for example the implicit cost of spending one more year at school
would be the money you would’ve earned if you had take a job for example.
The opportunity cost of any activity is equal to its explicit cost plus its implicit cost. To consider the
cost of an activity, you should include the cost of using any of your own resources for that activity,
you can calculate the cost of using your own resources by determining what they would have earned
in their next best use.

Accounting Profit VS Economic Profit.

Accounting profit is the revenue minus the explicit cost.
Economic profit is the revenue minus the opportunity cost of resources used and it’s usually less
than the accounting profit because there are almost always implicit costs in addition to explicit costs.
Capital is the total value of the assets of an individual or a firm. An individual’s capital often consist
in stocks banks, cash etc, in case of a business capital is also referred to its equipment, tools, etc.
The implicit cost of capital is the income that owner of the capital could have earned if the capital
had been employed in its best alternative use.

Making “either-or” Decisions

An either- or decision is one in which you must choose between two activities, it’s in contrast with
“how much” decision which requires you to choose how much of a given activity to undertake.
“Either or” decision ex: buy a car or not?, graduate school or no? Etc…
In making economic decision is very important to calculate its opportunity cost. The best way to
make an “Either or” decision is to use the principle of “Either or” decision making: when making a
“Either or” choice between two activities, chose the one with positive economic profit. In making
either or decisions, mistakes most commonly arise when people or business use their own assets in
projects rather than rent or borrow assets. That’s because they fail to account for the implicit cost of
using self-owned capital. Business run by the owner often fail to calculate the opportunity cost of the
owner often fail to calculate the opportunity cost and overestimate their economic profit of staying in
business.

Making “how Much” Decisions: The Role of Marginal Analysis.

How much is a decision at the margin, and we need marginal analysis which involves comparing the
benefit of doing a little bit more of some activity with the cost of doing a little bit more of that
activity. The benefit of doing a little bit of more something is what economists call its marginal
benefit and the cost of doing a little bit more of something is what they call its marginal cost.

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.
Total cost can also be calculated from marginal costs: the total cost of a given quantity is the sum of
the marginal cost of that quantity and of all the previous ones.
Increasing marginal cost occurs when each unit of a good costs more to produce than the previous
unit.
The marginal cost curve is a graphical representation showing how the cost of producing one more
unit depends on the quantity that has already been produced.
A constant marginal cost occurs when the cost of producing an additional unit is the same as the
cost of producing the previous unit, with constant marginal cost, the marginal cost curve is a
horizontal line.
Decreasing marginal cost occurs when marginal cost falls as the number of units produced
increases. With decreasing marginal cost, the marginal cost line is downward sloping. This happens
due to learning effects in production: complicated tasks, workers mistakes etc , but with the time
workers gain experience and generate less mistakes, as a results, overall production has decreased
marginal cost.
For the production of some goods and services the shape of the marginal cost curve changes as the
number of units produced increases.

Marginal Benefit.
In general marginal benefit of producing a good or a service Is the additional benefit earned form
producing one more unit
Decreasing marginal benefit is the benefit from producing one more unit of the good or service falls
as the quantity already produce rises. Marginal benefit can be represented by a marginal benefit
curve, a graphical representation showing how the benefit from producing one more unit depends on
the quantity that has already been produced.
Not all goods or activities exhibit decreasing marginal benefit, in fact there are many goods for which
marginal benefit of production is constant.

Marginal Analysis.
Total profit is the sum of the additional profits generated
Optimal quantity is the quantity that generates the highest possible total profit, it is the quantity at
which margina benefit is greater than or equal to marginal cost. Equivalently, it is the quantity at
which the marginal benefit and marginal cost curves intersect.
The marginal benefit curve lies above the marginal cost curve.
With small quantities the rule for choosing the optimal
quantity is; increase the quantity as long as the marginal benefit from. One more unit is greater than
the marginal cost, but stop before the marginal benefit becomes less than the marginal cost.
On the other hand when decision how much involves large quantity, the rule for choosing the optimal
quantity simplified to: the optimal quantity is the quantity at which marginal benefit is equal to
marginal cost.
The general rule for choosing the optimal quantity is know as the profit maximizing principle of
marginal analysis:when making a profit maximizing “how much” decision, the optimal quantity at
which marginal benefit is greater than or equal to marginal cost.
Graphically, the optimal quantity is the quantity of an activity at which the marginal benefit curve
intersects the marginal cost curve.

A Principle with Many Uses.

The profit-maximizing principle of marginal analysis can be applied to just about any “how much”
decision in which you want to maximize the Total profit for an activity.
It is equally applicable to production decision, consumption decisions and policy decisions.

A preview: How Consumption Decisions are Different.

Consumption decisions are different from production decisions because when individuals make
choices, they face a limited amount of income, so when they choose more than one good to
consume they must choose less of another good.
In contrast, decisions tha involve maximizing profit by producing a good or service are not affected
by income limitations.

Sunk Costs.
Sunk costs are costs that people should ignore while making decisions. They are costs that have
already been incurred and are not recoverable, so they are irrelevant in making decision about what
to do in future.

Behavioral Economics
Behavioral economics is a branch of economics that combines economic modeling with insight from
human psychology in order to understand how people actually make economic choices. People
sometimes make choices that do not lead to the highest possible monetary payoff, these choices are
rational when people value something other than a monetary payoff. People also engage in irrational
behavior, choosing an option that leaves them worse off than others available options.

Rational, but Human, Too.

If you’re rational, you will choose the available option that lead to the outcome you must prefer, it’s
not always the outcome that will give you the highest possible monetary payoff, because you care
about something other than the size of the monetary payoff. There are four reason why people might
prefer a lower monetary payoff:
– Concern about Fairness: people often care about fairness as well as about the size of the
economic payoff to themselves. For example gift giving, if you care about another person welfare
it’s normal to reduce your monetary payoff in order to give that person a gift.
– Non monetary Rewards: are benefits or payoff that are not financial in nature, they take form of
“feel- good” experience such as vacation travel, quality time with family etc… non monetary
rewards generate feeling of satisfaction. This can be explained with the principle of diminishing
marginal utility. The satisfaction gained by consuming one more unit of a good falls as the
amount of the good already consumed rises.
– Bounded Rationality: is the “good enough” method of decision making, is making a choice that is
close to but not exactly the one that leads to the highest possible payoff because the effort of
finding the best payoff is too costly. Behavioral economists have studied the concept of
bounded rationality and found that we often can make choices in this way.
– Risk Aversion: because life is uncertain and the future unknown, a choice comes with significant
risks. So even if you think a choice will give you the best payoff of all your available options, you
may forgo it because you find the possibility that things could turn out badly too, so we call this
risk aversion, the willingness to sacrifice some economic payoff in order to avoid a potential loss.

Irrationality: an economist’s view.

Sometimes people are irrational, they make choices that leave them worse off than choosing another
available option. People’s irrational behavior typically stems from eight mistakes they make when
thinking about economic decision:
1. Misperception of opportunity costs
People tend to ignore the opportunity cost when doesn’t involve an outlay of cash and could lead to
the sunk cost fallacy: making a decision based on the belief that a sunk cost is an opportunity cost.
Once an outlay in unrecoverable, it no longer an opportunity cost and should be ignored in future
decision making
2. Overconfidence
It’s a function of ego: we think we know more than we actually do. It often persuades people that
they are in better financial shape than they actually are, it can also lead to bad investment and
spending decisions. It also can lead people to make a large spending decision without doing research
on the pros and cons, relying instead on anecdotal evidence.
3. Unrealistic expectations about future behavior.
It’s another form of overconfidence and it’s when you’re overly optimistic about your future behavior
like for example “ tomorrow I’ll study, tmrw you’ll spend less etc”.
4. Counting dollars Unequally.
Mental accounting is the habit on mentally assign dollars to different accounts, making some dollars
worth more than others.
5. Loss Aversion
Is an oversensitivity to loss, that lead to an unwillingness to recognize a loss and move on. Most
people find painful to admit a loss so they avoid selling for much longer than they should.
6. Framing Bias.
Is the tendency to make a decision based on how the choices are presented, or framed, rather than
on a comparison of their true values. It’s a mental shortcut that people often take when faced with a
lot of data. Also limited sales like black Friday, lead the shoppers to buy more because the prices are
perceived to be lower for a limited amount of time compared to a policy of keeping prices at a
constant, low level.
7. FOMO.
It’s the tendency to invest in an asset based on past performance arising from the fear that one is a
loser if one doesn’t make a big profit like earlier investors.
8. Status Quo Bias.
Is the tendency to avoid making a decision altogether and sticking with the status quo. Rational
people tho know that the act of not making a choice is still a choice.
Some people claim that exhibit status quo bias is a form of decision paralysis, when you have more
options people find its harder to to make a decision, other says it’s due to loss aversion and the fear
of regret, to think that if Ido nothing then I won’t have to regret my choice. The recognition of status
quo bias has led to the practice of incorporating nudges which is a formulation of the status quo
choice intended to shift people to more rational choices when they are prone to status quo bias.

Rational Models for Irrational People?

Models based on rational behavior still provide robust predictions about how people behave in most
market, economists also search for predictably irrational behavior in an attempt to build better
models of how people behave.