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The Rules of Decision Making

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

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The Rules of Decision Making

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  1. The Rules of Decision Making Marginal Analysis

  2. 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

  3. 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”

  4. 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?

  5. Marginal Costs vs Marginal Benefits • Decreasing returns and increasing marginal costs: Hours worked Total Output M.OutputM.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

  6. 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

  7. The Optimal Choice MC $ 5 MB Q 0 QO= 4

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