Principles of Economics Brief Chapter 1

Three Important Decision Pitfalls of Cost Benefit Analysis

Pitfall 1: Measuring costs and benefits as proportions rather than absolute dollar amounts Pitfall 2: Ignoring implicit costs Pitfall 3: Failure to think at the margin

RECAP: Three Important Decision Pitfalls

1. The pitfall of measuring costs or benefits proportionally. Many decision makers treat a change in cost or benefit as insignificant if it constitutes only a small proportion of the original amount. Absolute dollar amounts, not proportions, should be employed to measure costs and benefits. 2. The pitfall of ignoring implicit costs. When performing a cost-benefit analysis of an action, it is important to account for all relevant costs, including the implicit value of alternatives that must be forgone in order to carry out the action. A resource may have a high implicit cost, even if you originally got it "for free"

Thinking at the margin: What is a sunk cost?

A cost that is beyond recovery at the moment a decision must be made.

Cost benefit principle notes

The Cost benefit principle tells us that you should take an action if the benefit of doing so exceeds the cost. The benefit of taking any action is the dollar value of everything you gain by taking it. The cost of taking any action is the dollar value of everything you give up by taking it.

Thinking at the margin: What is marginal benefit?

The increase in total benefit that results from carrying out one additional unit of an activity.

Thinking at the margin: What is marginal cost?

The increase in total cost that results from carrying out one additional unit of an activity.

Thinking at the margin: What is average cost?

The total cost of undertaking "n" units of an activity divided by "n".

Thinking at the margin: What is average benefit?

The total benefit of undertaking "n" units of an activity divided by "n".

What is the Scarcity Principle (No Free Lunch Principle)?

Although we have boundless needs and wants, the resources available to us are limited. So having more of one good thing means have less of another.

What is the Cost-Benefit Principle?

An individual (or firm or society) should act if, and only if, the extra benefits from taking the action are greater or at least equal to the costs.

What is economic surplus?

The economic surplus from taking any action is the benefit of taking the action minus its cost.

Pitfall 1: Measuring costs and benefits as proportions rather than absolute dollar amounts

Even people who seem to know they should weight the pros and cons of the actions they are contemplating sometimes don't have a clear sense of how to measure the relevant costs and benefits. The benefit is not the proportional you save on the original price. Rather, it is the absolute dollar amount you save.

Pitfall 2: Ignoring implicit costs

Many of us tend to overlook the implicit value of activities that fail to happen. The key to using the Cost-Benefit principle correctly lies in recognizing precisely what taking a given action prevents us from doing.

RECAP: Cost-Benefit Analysis

Scarcity is a basic fact of economic life. Because of it, having more of one good thing almost always means having less of another (The Scarcity Principle). The Cost-Benefit principle holds that an individual (or firm or society) should take an action if, and only if, the extra benefit from taking the action is at least as great as the extra cost. The benefit of taking any action minus the cost of taking the action is called the economic surplus from that action. Hence, the Cost-Benefit principle suggests that we take only those actions that create additional economic surplus.

What is a rational person in basic economics?

Someone with well-defined goals who tries to fulfill those goals as best he or she can. In studying choice under scarcity, we'll usually begin with the premise that people are rational.

Pitfall 3: Failure to think at the margin

The only costs that should influence a decision about whether to take an action are those we can avoid by not taking the action. Similarly, the only benefits we should consider are those that would not occur unless the action were taken. Many decision makers appear to be influenced by costs or benefits that would have occurred no matter what. Thus, people are often influenced by sunk costs - costs that are beyond recovery at the moment a decision is made. Sunk costs must be borne whether or not action is taken, so they are irrelevant to the decision of whether to take the action. When the problem is to discover the proper level for an activity, the cost-benefit rule is to keep increasing the level as long as the marginal benefit of the activity exceeds its marginal cost.

What is opportunity cost?

The opportunity cost of an activity is the value of what must be forgone to undertake the activity.

What is economics?

The study of how people make choices under conditions of scarcity and of the results of those choices for society.