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Costs and Decision Making. Some bad decisions. FIVE. 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. Costs and Decision Making.

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costs and decision making
Costs and Decision Making

Some bad decisions.

FIVE

slide2

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
slide3

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.
slide4

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.
slide5

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
slide6

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!
slide7

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.
slide8

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?

slide9

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?
slide10

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?
slide11

Costs and Decision Making

  • Key Terms:
    • Explicit Cost
    • Fixed cost
    • Implicit cost
    • Marginal
    • Marginal benefit
    • Marginal cost
    • Sunk cost
    • Utility