Making “Either–Or” Decisions

An “either–or” decision is one in which you must choose between two activities. That’s in contrast to a “how much” decision, which requires you to choose how much of a given activity to undertake. For example, Ashley faced an “either–or” decision: to spend two years in graduate school to obtain a teaching degree, or to work. In contrast, a “how much” decision would be deciding how many hours to study or how many hours to work at a job. Table 9-3 contrasts a variety of “either–or” and “how much” decisions.

“Either-or” decisions

“How much” decisions

Tide or Cheer?

How many days before you do your laundry?

Buy a car or not?

How many miles do you go before an oil change in your car?

An order of nachos or a sandwich?

How many jalapenos on your nachos?

Run your own business or work for someone else?

How many workers should you hire in your company?

Prescribe drug A or drug B for your patients?

How much should a patient take of a drug that generates side effects?

Graduate school or not?

How many hours to study?
Table :

TABLE 9-3 “How Much” versus “Either-Or” Decisions

According to the principle of “either–or” decision making, when faced with an “either–or” choice between two activities, choose the one with the positive economic profit.

In making economic decisions, as we have already emphasized, it is vitally important to calculate opportunity costs correctly. The best way to make an “either–or” decision, the method that leads to the best possible economic outcome, is the straightforward principle of “either–or” decision making. According to this principle, when making an “either–or” choice between two activities, choose the one with the positive economic profit.

Let’s examine Ashley’s dilemma from a different angle to understand how this principle works. If she continues with advertising and goes to work immediately, the value today of her total lifetime earnings is $57,000 (the value today of her earnings over the next two years) + $500,000 (the value today of her total lifetime earnings thereafter) = $557,000. If she gets her teaching degree instead and works as a teacher, the value today of her total lifetime earnings is $600,000 (value today of her lifetime earnings after two years in school) − $40,000 (tuition) − $4,000 (interest payments) = $556,000. The economic profit from continuing in advertising versus becoming a teacher is $557,000 − $556,000 = $1,000.

!worldview! FOR INQUIRING MINDS: A Tale of Two Invasions

ON JUNE 6, 1944, ALLIED SOLDIERS stormed the beaches of Normandy, beginning the liberation of France from German rule. Long before the assault, however, Allied generals had to make a crucial decision: where would the soldiers land?

They had to make an “either–or” decision. Either the invasion force could cross the English Channel at its narrowest point, Calais—which was what the Germans expected—or it could try to surprise the Germans by landing farther west, in Normandy. Since men and landing craft were in limited supply, the Allies could not do both. In fact, they chose to rely on surprise. The German defenses in Normandy were too weak to stop the landings, and the Allies went on to liberate France and win the war.

Thirty years earlier, at the beginning of World War I, German generals had to make a different kind of decision. They, too, planned to invade France, in this case via land, and had decided to mount that invasion through Belgium. The decision they had to make was not an “either–or” but a “how much” decision: how much of their army should be allocated to the invasion force, and enough: the defending French army stopped it 30 miles from Paris. Most military historians believe that by allocating too few men to the attack, von Moltke cost Germany the war. (“How much” decisions are discussed in detail in the next section.)

So Allied generals made the right “either–or” decision in 1944; German generals made the wrong “how much” decision in 1914. The rest is history.

So the right choice for Ashley is to begin work in advertising immediately, which gives her an economic profit of $1,000, rather than become a teacher, which would give her an economic profit of −$1,000. In other words, by becoming a teacher she loses the $1,000 economic profit she would have gained by working in advertising immediately.

In making “either–or” decisions, mistakes most commonly arise when people or businesses use their own assets in projects rather than rent or borrow assets. That’s because they fail to account for the implicit cost of using self-owned capital. In contrast, when they rent or borrow assets, these rental or borrowing costs show up as explicit costs. If, for example, a restaurant owns its equipment and tools, it would have to compute its implicit cost of capital by calculating how much the equipment could be sold for and how much could be earned by using those funds in the next best alternative project.

PITFALLS: WHY ARE THERE ONLY TWO CHOICES?

PITFALLS

WHY ARE THERE ONLY TWO CHOICES?
In “either–or” decision making, we have assumed that there are only two activities to choose from. But, what if, instead of just two alternatives, there are three or more? Does the principle of “either–or” decision making still apply?
Yes, it does. That’s because any choice between three (or more) alternatives can always be boiled down to a series of choices between two alternatives. Here’s an illustration using three alternative activities: A, B, or C. (Remember that this is an “either–or” decision: you can choose only one of the three alternatives.)
Let’s say you begin by considering A versus B: in this comparison, A has a positive economic profit but B yields an economic loss. At this point, you should discard B as a viable choice because A will always be superior to B. The next step is to compare A to C: in this comparison, C has a positive economic profit but A yields an economic loss. You can now discard A because C will always be superior to A. You are now done: since A is better than B, and C is better than A, C is the correct choice.

In addition, businesses run by the owner (an entrepreneur) often fail to calculate the opportunity cost of the owner’s time in running the business. In that way, small businesses often underestimate their opportunity costs and overestimate their economic profit of staying in business.

Are we implying that the hundreds of thousands who have chosen to go back to school rather than find work in recent years are misguided? Not necessarily. As we mentioned before, the poor job market has greatly diminished the opportunity cost of forgone wages for many students, making continuing their education the optimal choice for them.

The following Economics in Action illustrates just how important it is in real life to understand the difference between accounting profit and economic profit.

ECONOMICS in Action: Farming in the Shadow of Suburbia

Farming in the Shadow of Suburbia

Beyond the sprawling suburbs, most of New England is covered by dense forest. But this is not the forest primeval: if you hike through the woods, you encounter many stone walls, relics of the region’s agricultural past when stone walls enclosed fields and pastures. In 1880, more than half of New England’s land was farmed; by 2013, the amount was down to 10%.

In densely populated areas, working farms incur a large implicit cost of capital.
John Archer/Getty Images

The remaining farms of New England are mainly located close to large metropolitan areas. There farmers get high prices for their produce from city dwellers who are willing to pay a premium for locally grown, extremely fresh fruits and vegetables.

But now even these farms are under economic pressure caused by a rise in the implicit cost of farming close to a metropolitan area. As metropolitan areas have expanded during the last two decades, farmers increasingly ask themselves whether they could do better by selling their land to property developers.

In 2013, the average value of an acre of farmland in the United States as a whole was $2,900; in Rhode Island, the most densely populated of the New England states, the average was $11,800. The Federal Reserve Bank of Boston has noted that “high land prices put intense pressure on the region’s farms to generate incomes that are substantial enough to justify keeping the land in agriculture.”

The important point is that the pressure is intense even if the farmer owns the land because the land is a form of capital used to run the business. So maintaining the land as a farm instead of selling it to a developer constitutes a large implicit cost of capital.

A fact provided by the U.S. Department of Agriculture (USDA) helps us put a dollar figure on the portion of the implicit cost of capital due to development pressure for some Rhode Island farms. In 2004, a USDA program designed to prevent development of Rhode Island farmland by paying owners for the “development rights” to their land paid an average of $4,949 per acre for those rights alone. By 2013, the amount had risen to more than $11,800.

About two-thirds of New England’s farms remaining in business earn very little money. They are maintained as “rural residences” by people with other sources of income—not because operating them is an optimal choice, but more out of a personal commitment and the satisfaction these people derive from farm life. Although many businesses have important implicit costs, they can also have important benefits to their owners that go beyond the revenue earned.

Quick Review

  • All costs are opportunity costs. They can be divided into explicit costs and implicit costs.

  • An activity’s accounting profit is not necessarily equal to its economic profit.

  • Due to the implicit cost of capital—the opportunity cost of using self-owned capital—and the opportunity cost of one’s own time, economic profit is often substantially less than accounting profit.

  • The principle of “either–or” decision making says that when making an “either–or” choice between two activities, choose the one with the positive economic profit.

9-1

  1. Question 9.1

    Karma and Don run a furniture-refinishing business from their home. Which of the following represent an explicit cost of the business and which represent an implicit cost?

    1. Supplies such as paint stripper, varnish, polish, sandpaper, and so on

    2. Basement space that has been converted into a workroom

    3. Wages paid to a part-time helper

    4. A van that they inherited and use only for transporting furniture

    5. The job at a larger furniture restorer that Karma gave up in order to run the business

  2. Question 9.2

    Assume that Ashley has a third alternative to consider: entering a two-year apprenticeship program for skilled machinists that would, upon completion, make her a licensed machinist. During the apprenticeship, she earns a reduced salary of $15,000 per year. At the end of the apprenticeship, the value of her lifetime earnings is $725,000. What is Ashley’s best career choice?

  3. Question 9.3

    Suppose you have three alternatives—A, B, and C—and you can undertake only one of them. In comparing A versus B, you find that B has an economic profit and A yields an economic loss. But in comparing A versus C, you find that C has an economic profit and A yields an economic loss. How do you decide what to do?

Solutions appear at back of book.