The Rules of Decision Making

Marginal Analysis

Opportunity Costs• Because our resources are scarce every decision that

we make entails an opportunity cost• Opportunity costs are not always obvious

• Explicit costs: costs requiring actual payments • Implicit costs: foregone benefits of (already owned)

resources consumed or used in production of a good or service

» Implicit cost of capital » Implicit cost of labor» Implicit cost of goods (already owned)

• Sunk Costs: Already incurred costs that cannot be recovered and, thus, our decisions will have no effect on

Accounting Profit vs. Economic Profit • Accounting Profit = Total Revenue - Total Explicit Costs• Economic Profit = Total Revenue – Total Explicit Costs - Implicit Costs

• Accounting profits tend to overstate profits; when implicit costs are not accounted for a reported business profit is an exaggerated measure of profit

• When there are implicit costs “accounting profit” is greater than “business profit”

• When a firm’s accounting profit is equal to its implicit costs its “economic profit” is zero and its accounting profit is considered “normal profit”

Making Decisions at the Margin

• Most of our decisions are made following our “marginal analysis” of costs and benefits

• To achieve a given outcome we often have to make a choice from among alternative means; we normally try to make the “least costly” choice among the available means

• Some times our decisions result in benefits as well as costs;

• How much food should you buy?• How many years of schooling should you have?• How many hours should you work? • How many workers should you hire?• How much should save/invest?

Marginal Costs vs Marginal Benefits

• Decreasing returns and increasing marginal costs:

Hours worked Total Output M.Output M.Cost

0 0 0

1 10 10 2

2 18 8 2.50

3 24 6 3.33

4 28 4 5

5 30 2 10

Marginal Costs vs Marginal Benefits

• Decreasing returns and increasing marginal costs:

Hours worked M.Cost T.Benefit M.Benefit

0 0 0

1 2 20 20

2 2.50 27 7

3 3.33 32 5

4 5 37 5

5 10 36 1

The Optimal Choice

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