Decision Making by Individuals and Firms

Chapter 9: Decision Making by Individuals and Firms

What We Will Learn

• Importance of accurately defining costs and benefits in decision making.

• Distinction between explicit and implicit costs.

• Difference between accounting profit and economic profit; economic profit as the basis for decisions.

• Understanding three types of decisions and the concept of sunk costs.

• Analysis of irrational yet predictable behaviors in decision making.

Costs, Benefits, and Profits

• Decisions depend on comparing costs with benefits.

• Quality of decisions correlates with understanding of costs and benefits.

Explicit and Implicit Costs

• Explicit Costs: Costs that require an actual monetary outlay.

• Implicit Costs: Costs not requiring an outlay, representing the value of benefits that are foregone.

  • When analyzing an activity’s cost, include overhead costs like time and resources.

  • Include opportunity cost (what is given up for the activity).

• Opportunity Cost: Summation of explicit and implicit costs.

Case Studies on Costs

1. Case 1: Borrowing $100,000

   • Explicit Cost: $5,000 (5% interest on the loan).

   • Implicit Cost: $0 (no funds being used from own savings).

2. Case 2: Using Savings and Borrowing

   • Explicit Cost: $3,000 (interest on $60,000 loan).

   • Implicit Cost: $2,000 (foregone interest from $40,000 savings).

Profit Definitions: Accounting vs. Economic

• Accounting Profit: Total revenue minus explicit costs.

• Economic Profit: Total revenue minus explicit and implicit costs.

  • Economic profit provides a complete picture, considering opportunity costs.

  • Economic profit often less than accounting profit and preferred by economists for decision-making.

Economic vs. Accounting Profits: Case Example

• Increase in rent affects profitability:

  • If renting: Both accounting and economic profit decrease by $500.

  • If owning: Accounting profit remains the same; economic profit decreases due to implicit costs.

Real-Life Example: Freelancing vs. a Steady Job

• Accounting Profit from freelancing: Revenue minus explicit costs.

• Economic Profit from freelancing: Revenue minus explicit costs and the implicit cost of the job offer.

Restaurant Example for Profit Calculation

• Revenue: $300,000

• Explicit Costs:

  • Wages: $120,000

  • Rent: $100,000

  • Ingredients: $50,000

  • Total Explicit Costs: $270,000

• Accounting Profit: $300,000 - $270,000 = $30,000

• Implicit Costs:

  • Foregone Wages: $80,000

  • Foregone Return: $7,000 (from savings)

  • Total Implicit Costs: $87,000

• Total Costs (Explicit + Implicit): $357,000

• Economic Profit: $300,000 - $357,000 = -$57,000 (a loss).

Implicit Cost of Capital

• Capital: Total asset value, including physical and financial assets.

• Implicit Cost of Capital: Opportunity cost of using capital instead of earning income via alternative investments.

Types of Decisions

1. Either-Or Choices: Choose the option with greater economic profit.

2. Complex Choices: More nuanced decisions requiring marginal analysis.

Making "How Much" Decisions

• Key to marginal decision-making is evaluating additional costs and benefits.

• Marginal Cost: Additional cost incurred from producing one more unit.

• Shapes of Marginal Cost Curves:

  1. Increasing Marginal Cost: Cost increases with each unit produced.

  2. Constant Marginal Cost: Cost remains the same per unit.

  3. Decreasing Marginal Cost: Cost decreases due to learning efficiency.

Marginal Analysis

• Marginal Benefit: Additional benefit derived from producing one more unit.

• Optimal Quantity: Highest possible total profit; occur where marginal benefit equals marginal cost.

• Example of deciding production levels illustrates technique.

Graphing Optimal Quantity

• Compare Marginal Benefits and Costs to determine optimal class attendance based on costs and benefits.

Sunk Costs

• Sunk Cost: A cost that cannot be recovered; should not factor into future decisions.

• Example of product development where prior investment shouldn't dictate future decisions.

Behavioral Economics

• Behavioral Economics: Study of less-than-perfect choices in decision-making; combines economic theory and psychology.

• Challenges to rationality in economics:

  1. Misperceptions of opportunity costs.

  2. Overconfidence in investment abilities.

  3. Unrealistic expectations about future behavior.

  4. Mental accounting.

  5. Loss aversion.

  6. Status quo bias.

Decision-Making Mistakes

• Various common mistakes stem from inherent biases in decision-making processes, revealing where individuals may deviate from rational choices.

Retirement Savings and Opt-Out Solutions

• Discusses the common under-saving for retirement and how changing from an opt-in to an opt-out system could significantly increase participation in savings plans.

Present Value Concepts

• Explanation of present value as a means to compare costs today with future revenues.

• Formula for calculating present value:

  • Understanding how interest rates affect present values.

Future Value Considerations

• Expanding present value concepts to more complex scenarios involving multiple years and cash flows.