Chapter 9: Making Decisions

Economic Profit

A business's revenue minus the opportunity cost of resources; usually less than the accounting profit

Implicit Cost

A cost that does not require the outlay of money; it is measured by the value, in dollar terms, of forgone benefits

Sunk Cost

A cost that has already been incurred and is not recoverable.

Summary 6: Sunk Costs

A cost that has already been incurred and that is nonrecoverable is a sunk cost. Sunk costs should be ignored in decisions about future actions because they have no effect on future benefits and costs.

Explicit Cost

A cost that involves actually laying out money

Marginal Benefit Curve

A graphical representation showing how the benefit from producing one more unit depends on the quantity that has already been produced

Marginal Cost Curve

A graphical representation showing how the cost of producing one more unit depends on the quantity that has already been produced

Concept of a Sunk Cost

A sunk cost should be ignored in decisions regarding future actions. Because they have already been incurred and are nonrecoverable, they have no effect on future costs and benefits.

Concept of Costs

All costs are opportunity costs. they are divided into explicit costs and implicit costs

Concept of Reporting Profit

Companies report their accounting profit, which is not necessarily equal to their economic profit

Concept of the Difference between Accounting and Economic Profit

Due to the implicit cost of capital- the opportunity cost of a companies capital- and the opportunity cost of the owner's time, economic profit is often substantially less than accounting profit

Constant Marginal Cost

Each additional unit costs the same to produce as the previous one

Summary 4: Marginal Cost and Marginal Benefit

In the case of constant marginal cost, each additional unit costs the same amount to produce as the unit before; this is represented by a horizontal marginal cost curve. However, the marginal cost and marginal benefit typically depend on how much activity has already been done. With increasing marginal cost, each unit costs more to produce than the unit before and is represented by and upward-sloping marginal cost curve. In the case of decreasing marginal benefit, each additional unit produces a smaller benefit than the unit before and is represented by a downward-sloping marginal benefit curve.

Present Value

The amount of money needed at the present time to produce, at the prevailing interest rate, a given amount of money at a specified future time

Increasing Marginal Cost

The case in which each additional unit costs more to produce than the previous one

Decreasing Marginal Benefit

The case in which each additional unit of an activity produces less benefit than the previous unit

Summary 2: Opportunity Costs and Decisions

The cost of using a resource for a particular activity is the opportunity cost of that resource. Some opportunity costs are explicit costs; they involve a direct payment of cash. Other opportunity costs, however, are implicit costs; they involve no outlay of money but represent the inflows of cash that are foregone. Both explicit and implicit costs should be taken into account in making decisions. Companies use capital and their owners' time. So companies should base decisions on economic profit, which takes into account the implicit costs such as the opportunity cost of the owners' time and the implicit cost of capital. The accounting profit, which companies calculate for the purposes of taxes and public reporting, is often considerably larger than the economic profit because it includes only explicit costs and depreciation, not implicit costs.

Concept of Marginal Benefit (graphically)

The marginal benefit of producing a good or service is represented by the marginal benefit curve. A downward-sloping marginal benefit curve reflects decreasing marginal benefit.

Concept of Marginal Cost (Graphically)

The marginal cost of producing a good or service is represented graphically by the marginal cost curve. A horizontal marginal cost curve reflects constant marginal cost. Increasing marginal cost is represented by an upward-sloping marginal cost curve.

Implicit Cost of Capital

The opportunity cost of the capital used by a business; that is, the income that could have been realized had the capital been used in the next best alternative way

Concept of Optimal Quantity (Graphically)

The optimal quantity is found by applying the principle of marginal analysis. It says that the optimal quantity is the quantity at which marginal benefits is equal to the marginal costs. Equivalently, it is the quantity at which the marginal cost curve intersects the marginal benefit curve.

Summary 5: Marginal Analysis

The optimal quantity is the quantity that generated the maximum possible total net gain. According to the principle of marginal analysis, the optimal quantity is the quantity at which marginal benefit is equal to marginal cost. It is the quantity at which the marginal cost curve and the marginal benefits curve intersect.

Net Present Value

The present value of current and future benefits minus the present value of current and future costs

Interest Rate

The price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for one year

Principle of Marginal Analysis

The proposition that the optimal quantity is the quantity at which marginal benefit is equal to marginal cost

Optimal Quantity

The quantity that generates the maximum possible total net gain

Concept of Using Percent Value

When comparing several projects in which cost and benefits arrive at different times, you should choose the project that generates the highest net value.

Concept of Present Value

When cost or benefits arrive at different times, you must take the complication created by time into account. This is done by transforming any dollars realized in the future into their present value.

Concept of Interest Rates

$1 in benefit is realized a year from now is worth $1/(1+r) today, where r is the interest rate. Similarly, $1 in cost is realized a year from now is valued at a cost of $1/(1+r) today.

Summary 3: Making "How Much" Decisions- The Role of Marginal Analysis

A "How Much" decision is made using marginal analysis, which involves comparing the benefit to the cost of doing an additional unit of an activity. The marginal cost of producing a good or service is the additional cost incurred by producing one more unit. The marginal cost curve is the graphical illustration of marginal cost, and the marginal benefit curve is the graphical illustration of marginal benefit.

Concept of Type of Decision MA is

A "how much" decision is made by using marginal analysis

Accounting Profit

A business's revenue minus the explicit cost and depreciation

Summary 1: Making Decisions

All economic decisions involve the allocation of scarce resources. Some decisions are "either-or" decisions, in which the question is whether or not to do something. Other decisions are "how much" decisions, in which the question is how much of a resource to put into a given activity.

Summary 7: The Concept of Present Value

In order to evaluate a project in which costs or benefits are realized in the future, you must first transform them into their present values using interest rate, r. The present value of $1 realized one year from now is $1/(1+r). Once transformation is done, you should choose the project with the highest net percent value.

Marginal Benefit

The additional benefit derived from producing one more unit of a good or service

Marginal Cost

The additional cost incurred by producing one more unit of a good or service

Capital

The combined value of a business's assets; includes equipment, buildings, tools, inventory, and financial assets