Slide 2 - 0
Some Common Pitfalls for Decision
Makers
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
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 2 - 2
Ignoring Opportunity Costs
Intelligent decisions require recognizing opportunity costs
Opportunity cost
The value of the next-best alternative that
must be forgone in order to engage in that
activity
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?”
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
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 interestbearing 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
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
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
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
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
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
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
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
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
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
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
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”
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.