9: Decision Making by Individuals and Firms

!arrow! What You Will Learn in This Chapter

  • What You Will Learn in This Chapter

  • Why good decision making begins with accurately defining costs and benefits

  • The importance of implicit and explicit costs in decision making

  • How accounting profit and economic profit differ, and why economic profit is the correct basis for decisions

  • Why there are three different types of economic decisions: “either–or,” “how much,” and those involving sunk costs

  • The principles of decision making that correspond to each type of economic decision

  • Why people sometimes behave in irrational yet predictable ways

  • How to make decisions involving time (in this chapter’s appendix)

GOING BACK TO SCHOOL

Grad school or job? Ashley Hildreth had to make that decision.
Photo by Hildreth

IN THE SPRING OF 2010, ASHLEY Hildreth, a class of 2008 journalism major at the University of Oregon, was deeply frustrated. After working for 18 months in what she described as a “dead-end, part-time job” in the food industry, she decided to apply to a master’s degree program in teaching.
In explaining her decision, she pointed to the many job applications she submitted without a single call back for an interview. What she hoped for was an entry-level opportunity in advertising and marketing or an administrative position with a nonprofit. What she got instead was silence or gentle rejections. After considering her options, she decided to apply for graduate school.
Hildreth was far from alone in her decision. In the spring of 2010, because of a poor job market, colleges and universities across the country were reporting a record number of applications. Applications soared not just for bachelor and associate degree programs. As Hildreth’s story illustrates, they also soared for graduate and continuing education programs of all sorts.
Whatever the state of the job market, however, every year millions of people—just like you—face a choice about work versus continued schooling: should I continue another year (or semester, or quarter) in school, or should I get a job? That is, they are making a decision.
This chapter is about the economics of making decisions: how to make a decision that results in the best possible economic outcome. Economists have formulated principles of decision making that lead to the best possible—often called “optimal”—outcome, regardless of whether the decision maker is a consumer or a producer.
We’ll start by examining three different types of economic decisions, each with a corresponding principle, or method, of decision making that leads to the best possible economic outcome. In this chapter, we’ll see why economists consider decision making to be the very essence of microeconomics.
Despite the fact that people should use the principles of economic decision making to achieve the best possible economic outcome, they sometimes fail to do so. In other words, people are not always rational when making decisions.
For example, a shopper in pursuit of a bargain may knowingly spend more on gasoline than he or she saves. Yet economists have also discovered that people are frequently irrational in predictable ways. In this chapter, we’ll learn about these tendencies when we discuss behavioral economics, the branch of economics that studies predictably irrational economic behavior.