9: Decision Making by Individuals and Firms

SUMMARY

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.
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 outlay of money. Other opportunity costs, however, are implicit costs; they involve no outlay of money but are measured by the dollar value of the benefits that are forgone. Both explicit and implicit costs should be taken into account in making decisions. Many decisions involve the use of capital and time, for both individuals and firms. So they should base decisions on economic profit, which takes into account implicit costs such as the opportunity cost of time and the implicit cost of capital. Making decisions based on accounting profit can be misleading. It is often considerably larger than the economic profit because it includes only explicit costs and not implicit costs.
According to the principle of “either–or” decision making, when faced with an “either–or” choice between two activities, one should choose the activity with the positive economic profit.
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 of that good or service. The marginal benefit of producing a good or service is the additional benefit earned 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.
In the case of constant marginal cost, each additional unit costs the same amount to produce as the previous unit. However, marginal cost and marginal benefit typically depend on how much of the activity has already been done. With increasing marginal cost, each unit costs more to produce than the previous unit and is represented by an upward-sloping marginal cost curve. With decreasing marginal cost, each unit costs less to produce than the previous unit, leading to a downward-sloping marginal cost curve. In the case of decreasing marginal benefit, each additional unit produces a smaller benefit than the unit before.
The optimal quantity is the quantity that generates the highest possible total profit. According to the profit-maximizing principle of marginal analysis, the optimal quantity is the quantity at which marginal benefit is greater than or equal to marginal cost. It is the quantity at which the marginal cost curve and the marginal benefit curve intersect.
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.
With rational behavior, individuals will choose the available option that leads to the outcome they most prefer. Bounded rationality occurs because the effort needed to find the best economic payoff is costly. Risk aversion causes individuals to sacrifice some economic payoff in order to avoid a potential loss. People might also prefer outcomes with worse economic payoffs because they are concerned about fairness.
An irrational choice leaves someone worse off than if they had chosen another available option. It takes the form of misperceptions of opportunity cost; overconfidence; unrealistic expectations about future behavior; mental accounting, in which dollars are valued unequally; loss aversion, an oversensitivity to loss; and status quo bias, avoiding a decision by sticking with the status quo.