Costs and Decision Making

1. Costs and Decision Making Some bad decisions. FIVE

2. Costs and Decision Making • In this chapter: • Explaining Human Behavior • Importance of Marginal Analysis • The Improper Estimation of Costs • Wedding Dresses, Cheap Books and 24-hour Wal-Marts

3. Costs and Decision Making • Explaining Human Behavior • Economists make assumptions about human behavior: • People are motivated by self-interest • NOT selfishness • People will more likely make decisions based on their needs and wants, and those of their family and friends. • You work at McDonald’s to earn a paycheck, not to make sure there are enough french fries available. • How does this theory explain charitable giving? • People are rational • People will always do the thing the BELIEVE will make them better off, not worse off.

4. Costs and Decision Making • Explaining Human Behavior • Economists make assumptions about human behavior: • People compare costs and benefits to make decisions. • People weigh benefits received (pros) from an action against costs (cons) of doing it. • When pros of doing something outweigh cons, people will choose to do it. • If the choice was made o NOT do it, economists assume the decision-maker believed the costs to be greater than the benefits. • People tend to make decisions at the margin.

5. Costs and Decision Making • Marginal Analysis • Using marginal benefits and marginal costs to make a decision. • Marginal = additional, or extra • Marginal costs and marginal benefits are the relevant costs and benefits to compare. • Marginal costs (MC) = additional costs of doing (producing, consuming, buying) something. • Marginal benefits (MB) = additional benefits of doing (producing, consuming, buying) something. • If MB > MC, do it. If MB < MC, don’t do it. Keep doing it til MB=MC. • Maximum utility, maximum profit, can be found where MB = MC

6. Costs and Decision Making • Improper Estimation of Costs • Many business and personal decisions are incorrect because the wrong costs are included on the cost side of the analysis: • Should not ignore implicit costs • Implicit costs = opportunity costs • Explicit costs = actually money costs • The TRUE cost of anything is the opportunity cost!

7. Costs and Decision Making • Improper Estimation of Costs • Many business and personal decisions are incorrect because the wrong costs are included on the cost side of the analysis: • Should ignore fixed and sunk costs • Fixed costs = costs that don’t change as levels of the activity change • Sunk costs = costs you already paid that cannot be recovered. • These costs would not be different whether you decide to do it or don’t do it.

8. Costs and Decision Making • Improper Estimation of Costs • Fixed Costs Example: • You are taking a trip to Vegas, trying to decide whether to fly or drive. You make the following table: This analysis suggests you should fly. Is it correct?

9. Costs and Decision Making • Improper Estimation of Costs • Sunk Costs Example: • You and a friend are at a movie. Your tickets cost $10 each. You are 30 minutes into the movie and you both hate it. You turn to your friend and say, “I can’t sit here another minute. I’ve got a big economics test tomorrow and this movie isn’t worth losing study time. Let’s go.” Your friend responds, “We can’t go, it cost $10 to get in! If we leave we will have wasted that $10, and I don’t have any more money til Friday.” • What are the costs and benefits of walking out of the movie?

10. Costs and Decision Making • Some cost decision examples • How does a restaurant decide whether to open a bit early and serve breakfast? • The Wal-Mart near my house is usually empty on weeknights between midnight and 6am (I asked). How could it possibly make sense for them to stay open 24 hours? • Barnes and Noble has a bargain table with books marked down as low as $5. The original price on the books could be as high as $30 or more. How can they afford to do that? Aren’t they losing money? • Why do drive-up ATM buttons have braille on them? • Why do wedding dresses, which will be worn only once, cost so much while tuxedos, which could be worn on several occasions, are rented?

11. Costs and Decision Making • Key Terms: • Explicit Cost • Fixed cost • Implicit cost • Marginal • Marginal benefit • Marginal cost • Sunk cost • Utility