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

Marginal Costs vs Marginal Benefits Decreasing returns and increasing marginal costs: Hours worked M.Cost T.Benefit M.Benefit

The Optimal Choice $ Q 0 Q O = 4 5 MB MC