1. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 0 Some Common Pitfalls for Decision Makers

2. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 1 Pitfalls  #1 Ignoring Opportunity Costs  #2 Failing to Ignore Sunk Costs  #3 Failing to Understand the Average-Marginal Distinction

3. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 2 Ignoring Opportunity Costs  Intelligent decisions require recog- nizing opportunity costs  Opportunity cost  The value of the next-best alternative that must be forgone in order to engage in that activity

4. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 3 Nothing Is Free  Using a good we already own is not free  It could have been sold in the marketplace  The value it could have been sold for is its opportunity cost  Ask yourself  “Should I iron my shirt OR watch the end of the movie?  Not just, “Should I iron my shirt?”

5. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 4 Opportunity Cost Over Time  Having to pay someone a dollar a year from now is not the same as having to pay someone a dollar today  Opportunity costs are different: The opportunity costs of resources used in the future are are lower then the opportunity cost of using resources today

6. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 5 Time Value of Money  A given dollar amount today is equal to a larger dollar amount in the future  Money can be invested in an interest- bearing account in the meantime  Banks paying interest on borrowed money are simply reimbursing the lender for the opportunity costs of not being able to use the money he or she has lent

7. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 6 Relationship between Costs and Benefits  A reciprocal relationship exists between costs and benefits  When you take an action and do not receive a benefit that you otherwise would have, that is a cost of taking the action  When you take an action and do not receive a cost that you otherwise would have, that is a benefit of taking the action

8. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 7 Summary of Ignoring Opportunity Costs  It is important to account for all relevant opportunity costs  The value of a resource depends upon its best alternative use, even if you got it “free”  Remember to count the time value of money

9. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 8 Failure to Ignore Sunk Costs  Sunk cost: A cost that is beyond recovery at the moment a decision must be made  Pitfall #2: People are influenced by sunk costs when they should be ignored  This pitfall is the reverse of Pitfall #1

10. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 9 Sunk Costs  Sunk costs must be incurred whether or not an action is taken  It is money, e.g., that you cannot recover  Therefore, they are irrelevant to a decision on whether to take an action  Rational decision makers weigh the benefits to only the additional costs that must be incurred

11. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 10 Summary of Not Ignoring Sunk Costs  Ignore sunk costs--those that cannot be avoided even if the action is not taken

12. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 11 Failure to Understand the Average-Marginal Decision  People often compare average costs and average benefits  But, the relevant costs and benefits are always marginal

13. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 12 Average vs. Marginal  Average costs are total costs per unit of activity  Average benefits are total benefits per unit of activity  Marginal costs are the additional costs of adding a unit of activity  Marginal benefits are the additional benefits of adding a unit of activity  Averages can be greater than, equal to, or less than marginals

14. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 13 Positive Net Gain  Comparing the marginal cost to the marginal benefit of the next unit tells whether or not there is a net gain  If the net gain is positive, then the next unit should be undertaken

15. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 14 Allocation of Resources  Allocate each unit of a resource to the production activity that has the highest marginal benefit  Allocate the resources so that the marginal benefit is the same in every activity

16. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 15 Costs  Fixed Costs  Costs that do not vary with the level of an activity  All sunk costs are fixed costs, but not all fixed costs are sunk costs. Some fixed costs may be recoverable  Variable Costs  Costs that do vary with the level of an activity

17. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 2 - 16 Summary of Ignoring Average-Marginal Distinction  Cost-benefit principle  The level of an activity should be increased if, and only if, the marginal benefit exceeds the marginal cost  Not “if, and only if, the average benefit exceeds the average costs”