ECONOMIC DECISION MAKING IS PRETTY SIMPLE BECAUSE IT ONLY INVOLVES

A FEW TERMS AND RULES. IN FACT, YOU PROBABLY

ALREADY THINK ABOUT MANY PROBLEMS IN THE

SAME WAY THAT ECONOMISTS DO.

Making Economic Decisions

Trade-Offs

Scarcity forces people to make choices about how they will use their resources

Most economic decisions are made with common sense and careful analysis

In economic choices, people exchange one good or service for another

The trade-off is the alternative you face if you decide to do one thing rather than another

Example: If you decide to buy $100 jeans, then your trade-off is the $100

Opportunity Cost

The cost of the next best use of your time and money when you choose to do one thing over another

Includes more than just moneyalso takes into accounts all the possible

discomforts and inconveniences linked to the choice made

The opportunity cost of any action is the value of what is given up because the choice was made

The opportunity cost is generated from the next highest ranked alternative, not all alternatives

For example: Suppose Congress votes to spend $2 billion for projects to clean up polluted rivers. The opportunity cost of the vote is the next best alternative use of those same tax dollars. Congress could have used the money for increased funding on space research. In this example, the opportunity cost of cleaning up polluted rivers is less funding for the space program.

Being aware of trade-offs and opportunity costs is important in making economic decisions: you will make wiser use of your own resources if you are aware of the opportunity costs and trade-offs.

Other Measures of Cost

Fixed Costs- expenses that are the same no matter how many units of a good that are produced

Examples: mortgage payments and property taxes

Variable costs-expenses that change with the number of units of a good that is produced

Examples: wages and materials -these expenses increase as production is

increased or decrease as production is decreased

Total costs- the addition of the variable and fixed costs together

-many businesses focus on the average total cost

-to arrive at the average total cost, divide the total cost by the quantity produced

Marginal costs- the extra cost of producing one additional unit of output

Example: if it cost $2000 to produce 50 items and $2050 to produce 51 items, the marginal cost is $50

Measures of Revenue

Businesses use two key measures to decide what output will produce the greatest profit

Total revenue- the number of units sold multiplied by the average price per unit

Example: 50 units sold at $40 each= $2000 total revenue

Marginal Revenue- the change in total revenue for selling one more unit of output

Marginal Benefit- the additional or extra benefit associated with an action

Cost Benefit Analysis

Model that is create by economists to compare marginal costs and marginal benefits of a decision

Rational economic decision making tells us to choose an action when the benefits are greater than the costs

If the costs outweigh the benefits, then the chosen option should be rejected

Example: If you produce something that costs $10 and you cannot sell the item for $10, then there is no benefit

Using Cost Benefit Analysis

Look at the graph on page 413 of your online textbookSuppose you are a farmer trying to decide how much

of your 25 acres to plant. Assume the marginal cost of planting and harvesting are the same for all 25 acres (the horizontal line on the graph). Let’s assume that some of the land is better than other. As a result, the size of the harvest that you can expect from each acre goes down as the number increases, as you plant the most fertile land first. As more is planted, the less fertile land must be used. The downward-sloping line would represent the diminishing marginal benefits.

The graph makes it easy to see how much land you should plant. Clearly, you should plant the first 5 acres because the marginal cost is low when compared to the benefits to be gained. It would make sense to plant up to 15 acres because to that point the marginal benefit is greater than the marginal cost. You would not want to plant more than 15 acres because the extra cost is greater than the benefit.