Cost-Benefit Analysis

Vocab comparisons

Trade-offs v. opportunity cost

→ All decisions involve trade-offs

• Trade-off: all of the alternatives that we give up when we make a choice

• Opportunity cost: most desirable alternative given up when you make a choice

Explicit v. implicit costs

• Explicit cost: the traditional out-of-pocket cost associated with making a decision

  • Eg. the price of a movie ticket

• Implicit cost: the opportunity cost of making a decision

  • Eg. the forgone time or wage you could have earned while at the movies

Factor v. transfer payments

• Factor payment: a payment for the factors of production

• Transfer payment: when the government redistributes income

Productive v. allocative efficiency

• Productive efficiency: a situation in which a good or service is produced at the lowest possible cost

• Allocative efficiency: when the mix of goods being produced represents the mix that society most desires

Marginal analysis

• In economics, marginal means “additional”

• Marginal analysis: making decisions based on increments

  • Eg. when you decide to go to the mall, you consider the additional benefit and the additional cost (your opportunity cost)

  • Point: you will continue to do something as long as the marginal benefit is larger than the marginal cost

• Marginal utility: the additional satisfaction or benefit that a consumer derives from buying an additional unit of a commodity or service

  • To determine marginal utility, marginal cost and benefit must be taken into account

    • Marginal cost: the additional benefit to a consumer from consuming one more unit of a good or service

    • Marginal benefit: the cost of producing one more unit of a good

Marginal Utility Rules

• Law of diminishing marginal utility: as you consume anything, the additional satisfaction that you will receive will eventually start to decrease

  • Ie. the more you buy of any good, the less satisfaction you get from each new unit consumed

  • Same point as before

• Utility maximizing rule: equating the ratio of the marginal utility of a good to its price for all goods