CHAPTER 7 Making Decisions

Opportunity Cost and Decisions An explicit cost is a cost that involves actually laying out money. An implicit cost does not require an outlay of money; it is measured by the value, in dollar terms, of the benefits that are forgone.

Opportunity Cost of an Additional Year of School

Accounting Profit Versus Economic Profit The accounting profit of a business is the business’s revenue minus the explicit costs and depreciation. The economic profit of a business is the business’s revenue minus the opportunity cost of its resources. It is often less than the accounting profit. (factor in implicit costs)

Capital The capital of a business is the value of its assets—equipment, buildings, tools, inventory, and financial assets. The implicit cost of capital is the opportunity cost of the capital used by a business—the income the owner could have realized from that capital if it had been used in its next best alternative way.

Profits at Kathy’s Kopy Shoppe

Marginal Cost The marginal cost of an activity is the additional cost incurred by doing one more unit of that activity.

Increasing Marginal Cost Felix’s marginal cost is greater the more lawns he has already mowed. That is, each time he mows a lawn, the additional cost of doing yet another lawn goes up. There is increasing marginal cost from an activity when each additional unit of the activity costs more than the previous unit.

Felix’s Marginal Cost of Mowing Lawns: The Marginal Cost Curve

Marginal Benefit The marginal benefit from an activity is the additional benefit derived from undertaking one more unit of that activity.

Decreasing Marginal Benefit Each additional lawn mowed produces less benefit than the previous lawn There is decreasing marginal benefit from an activity when each additional unit of the activity produces less benefit than the previous unit.

Felix’s Marginal Benefit of Mowing Lawns: The Marginal Benefit Curve

Felix’s Net Gain from Mowing Lawns

Felix’s Net Gain from Mowing Lawns

The Optimal Quantity The optimal quantity of an activity is the quantity at which the marginal benefit curve and the marginal cost curve intersect. Here they intersect at approximately 5 lawns: the total net gain is maximized at 5 lawns, generating $66.50 in net gain for Felix.

Sunk Cost A sunk cost is a cost that has already been incurred and is nonrecoverable. A sunk cost should be ignored in decisions about future actions. Sunk costs should be ignored in making decisions about future actions because they have no influence on their costs and benefits.

The Concept of Present Value When someone borrows money for a year, the interest rate is the price, calculated as a percentage of the amount borrowed, charged by the lender. Interest = cost of renting money The interest rate can be used to compare the value of a dollar realized today with the value of a dollar realized later, because it correctly measures the cost of delaying a dollar of benefit (and the benefit of delaying a dollar of cost). The present value of $1 one year from now: $1/(1 + r)

Present Value (multiple years) What is $1 realized two years in the future worth today? The present value formula is equal to $1/(1 + r)N

Net Present Value The net present value of a project is the present value of current and future benefits minus the present value of current and future costs.

The End of Chapter 7