1. WHAT YOU WILL LEARN IN THIS CHAPTER chapter: 9 >> Krugman/Wells Economics ©2009  Worth Publishers Making Decisions

2. WHAT YOU WILL LEARN IN THIS CHAPTER  How economists model decision making by individuals and firms  The importance of implicit as well as explicit costs in decision making  The difference between accounting profit and economic profit, and why economic profit is the correct basis for decisions  The principle of marginal analysis  What sunk costs are and why they should be ignored

3. 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.

4. Opportunity Cost of an Additional Year of School

5. 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.

6. Profits at Babette’s Cajun Cafe

7. 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.

8. Constant Marginal Cost  For every additional chicken wing per serving, Babette’s marginal cost is $0.80. Babette’s portion size decision has what economists call constant marginal cost: each chicken wing costs the same amount to produce as the previous one.  Production of a good or service has constant marginal cost when each additional unit costs the same to produce as the previous one.

9. 76543210 $4.00 3.00 2.00 1.00 Marginal cost (per wing) Quantity of chicken wings Marginal cost curve, MC Marginal Cost

10. Marginal Benefit The marginal benefit of producing a good or service is the additional benefit earned from producing one more unit of that good or service.

11. Marginal Cost - Marginal Benefit  The marginal cost curve shows how the cost of producing one more unit depends on the quantity that has already been produced.  Production of a good or service has increasing marginal cost when each additional unit costs more to produce than the previous one.  The marginal benefit of a good or service is the additional benefit derived from producing one more unit of that good or service.  The marginal benefit curve shows how the benefit from producing one more unit depends on the quantity that has already been produced.

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

13. 76543210 Marginal benefit curve, MB Marginal cost (per wing) Quantity of chicken wings Marginal Benefit

14. Felix’s Net Gain from Mowing Lawns

15. Marginal Analysis  The optimal quantity is the quantity that generates the maximum possible total net gain.  The principle of marginal analysis says that the optimal quantity is the quantity at which marginal benefit is equal to marginal cost.

16. Babette’s Net Gain from Increasing Portion Size

17. Babette’s Optimal Portion Size 76543210 $4.00 3.00 2.00 1.00 Marginal benefit (marginal cost per wing) Quantity of chicken wings Optimal point MC MB Optimal quantity 0 1 2 3 4 5 6 7 Total net gain (profit per serving) Net gain (per wing) Quantity of chicken wings $0 3.50 5.20 5.90 6.30 6.40 6.30 6.10 $3.50 1.70 0.70 0.40 0.10 –0.10 –0.20

18. Sunk Cost  A sunk cost is a cost that has already been incurred and is non-recoverable. A sunk cost should be ignored in decisions about future actions.  Sunk costs should be ignored in making decisions about future actions.  They have already been incurred and are non- recoverable, they have no effect on future costs and benefits.