WHAT YOU WILL LEARN IN THIS
CHAPTER
chapter:
9
>> Making Decisions
Krugman/Wells
©2009  Worth Publishers
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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 difference between “either–or” and “how much”
decisions
 The principle of marginal analysis
 What sunk costs are and why they should be ignored
 How to make decisions in cases where time is a factor
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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.
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Opportunity Cost of an Additional Year of School
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FOR INQUIRING MINDS
Famous College Dropouts
 What do Bill Gates, Tiger Woods, and Madonna
have in common? None of them have a college
degree.
 Each of them made a rational decision that the
implicit cost of getting a degree would have been too
high. By their late teens, each had a very promising
career that would have to be put on hold to get a
college degree.
 It’s a simple matter of economics: the opportunity
cost of their time at that stage in their lives is just too
high to postpone their careers for a college degree.
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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.
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Its all about the numbers…
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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.
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Profits at Babette’s Cajun Cafe
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►ECONOMICS IN ACTION
Farming in the Shadow of Suburbia
 In 1880, more than half of New England’s land was farmed; by
2006, the amount was down to 10%.
 The remaining farms of New England are mainly located close
to large metropolitan areas. Farmers get high prices for their
produce from city dwellers who are willing to pay a premium for
locally-grown, extremely fresh fruits and vegetables.
 Maintaining the land instead of selling it to property developers
constitutes a large implicit cost of capital.
 About two-thirds of New England’s farms remaining in business
earn very little money but nevertheless, they are maintained out
of a personal commitment and satisfaction derived from farm
life.
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“How Much” Versus “Either–Or” Decisions
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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.
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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.
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Marginal Cost
Marginal cost (per wing)
$4.00
3.00
2.00
Marginal cost curve, MC
1.00
0
1
2
3
4
5
6
7
Quantity of chicken wings
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PITFALLS
Total cost versus marginal cost
 It can be easy to wrongly conclude that marginal
cost and total cost must always move in the same
direction.

What is true is that total cost increases whenever
marginal cost is positive, regardless of whether it is
increasing or decreasing.
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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.
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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.
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Decreasing Marginal Benefit

Each additional lawn mowed produces less benefit
than the previous lawn  with decreasing marginal
benefit, each additional unit produces less benefit
than the unit before.

There is decreasing marginal benefit from an
activity when each additional unit of the activity
produces less benefit than the previous unit.
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Marginal Benefit
Marginal cost
(per wing)
Marginal benefit curve, MB
0
1
2
3
4
5
6
7
Quantity of chicken wings
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Felix’s Net Gain from Mowing Lawns
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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.
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Babette’s Net Gain from Increasing Portion Size
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Babette’s Optimal Portion Size
Net gain
(per wing)
Quantity of
chicken wings
Marginal benefit (marginal cost per wing)
Total net
gain
(profit per
serving)
0
$0
$3.50
1
1.70
2
0.70
3
0.40
4
$4.00
0.10
5
–0.10
6
–0.20
7
3.00
3.50
5.20
5.90
6.30
6.40
6.30
6.10
2.00
Optimal point
1.00
MC
MB
0
1
2
3
4
5
Optimal quantity
6
7
Quantity of chicken wings
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PITFALLS
Muddled at the margin
 The idea of setting marginal benefit equal to
marginal cost sometimes confuses people.

The point is to maximize the total net gain from an
activity. If the marginal benefit from the activity is
greater than the marginal cost, doing a bit less will
increase the total net gain.

So only when the marginal benefit and marginal
cost are equal is the difference between total benefit
and total cost at a maximum.
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►ECONOMICS IN ACTION
The Cost of a Life
 What’s the marginal benefit to society of saving a human
life? In the real world, resources are scarce, so we must
decide how much to spend on saving lives since we cannot
spend infinite amounts.
 The UK government once estimated that improving rail
safety would cost an additional $4.5 million per life saved.
But if that amount was worth spending, then the implication
was that the British government was spending far too little on
traffic safety.
 That’s because the estimated marginal cost per life saved
through highway improvements was only $1.5 million,
making it a much better deal than saving lives through
greater rail safety.
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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. Because they have already
been incurred and are non-recoverable, they have
no effect on future costs and benefits.

“There’s no use crying over spilled milk.”
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►ECONOMICS IN ACTION
A Billion Here, a Billion There…




If there's any industry that exemplifies the principle that sunk costs
don’t matter, it has to be the biotech industry. These firms use
cutting-edge bioengineering techniques to combat disease.
It takes about seven to eight years, on average, to develop and
bring a new drug to the market. There is also a huge failure rate
along the way, as only one in five drugs tested on humans ever
gets to the market.
Xoma company has suffered setbacks on several drugs addressing
diseases as varied as acne and complications from organ
transplants. Since 1981, it has never earned a profit on one of its
own drugs and has burned through more than $700 million dollars.
Xoma keeps going because it possesses a very promising
technology and because shrewd investors understand the principle
of sunk costs.
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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.

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 realized one year from now is equal to
$1/(1 + r): the amount of money you must lend out today in
order to have $1 in one year. It is the value to you today of $1
realized one year from now.
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Present Value





Let’s call $V the amount of money you need to lend
today, at an interest rate of r in order to have $1 in two
years.
So if you lend $V today, you will receive $V(1 + r) in one
year.
And if you re-lend that sum for yet another year, you will
receive $V × (1 + r) × (1 + r) = $V × (1 + r)2 at the end of
the second year.
At the end of two years, $V will be worth $V × (1 + r)2;
If r = 0.10, then this becomes $V × (1.10)2 = $V × (1.21).
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Present Value

What is $1 realized two years in the future worth today?

In order for the amount lent today, $V, to be worth $1 two
years from now, it must satisfy this formula:
$V × (1 + r)2 = $1

If r = 0.10, $V = $1/(1 + r)2 = $1/1.21 = $0.83

The present value formula is equal to $1/(1 + r) N
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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.
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►ECONOMICS IN ACTION
How Big Is That Jackpot, Anyway?
 On March 6, 2007, Mega Millions set the record for the
largest jackpot ever in North America, for a payout of $390
million. The $390 million was available only if you chose to
take your winnings in the form of an “annuity” consisting of
an annual payment for the next 26 years. If you wanted the
cash up front, the jackpot was only $233 million and change.
 If the winner took the annuity, the lottery would have invested
the money in U.S. government bonds and using the
prevailing interest rates at the time, the present value of a
$390 million spread over 26 years was just about $233
million.
 So why didn’t they just call it a $233 million jackpot? Well,
$390 million sounds more impressive! But it was really the
same thing.
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SUMMARY
1. All economic decisions involve the allocation of scarce
resources. Some decisions are “either–or” decisions, other
decisions are “how much” decisions.
2. The cost of using a resource for a particular activity is the
opportunity cost of that resource. Some opportunity costs
are explicit costs; they involve a direct payment of cash.
Other opportunity costs, however, are implicit costs; they
involve no outlay of money but represent the inflows of
cash that are forgone. Companies use capital and their
owners’ time. So companies should base decisions on
economic profit, which takes into account implicit costs
such as the opportunity cost of the owners’ time and the
implicit cost of capital.
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SUMMARY
3. A “how much” decision is made using marginal analysis,
which involves comparing the benefit to the cost of doing
an additional unit of an activity. The marginal cost of
producing a good or service is the additional cost incurred
by producing one more unit of that good or service. The
marginal benefit of producing a good or service is the
additional benefit earned by producing one more unit.
4. In the case of constant marginal cost, each additional
unit costs the same amount to produce as the unit before;
this is represented by a horizontal marginal cost curve.
With increasing marginal cost, each unit costs more to
produce than the unit before. In the case of decreasing
marginal benefit, each additional unit produces a smaller
benefit than the unit before.
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SUMMARY
5. According to the principle of marginal analysis, the
optimal quantity—the quantity that generates the
maximum possible total net gain—is the quantity at which
marginal benefit is equal to marginal cost.
6. A cost that has already been incurred and that is
nonrecoverable is a sunk cost. Sunk costs should be
ignored in decisions about future actions—they have no
effect on future benefits and costs.
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SUMMARY
7. To evaluate a project in which costs or benefits are
realized in the future, you must first transform them into
their present values using the interest rate, r. The
present value of $1 realized one year from now is $1/(1 +
r), the amount of money you must lend out today to have
$1 one year from now. Once this transformation is done,
you should choose the project with the highest net
present value.
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The End of Chapter 9
Coming attraction:
Chapter 10:
The Rational Customer
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